What Are the Specific Best Execution Obligations for an OTF Operator Using Discretionary Matching?

Concept

An Organised Trading Facility (OTF) operator’s use of discretionary matching introduces a layer of human judgment into the execution process, fundamentally altering the calculus of best execution. Unlike a purely automated venue, where algorithms follow rigid, non-discretionary rules, the OTF framework under the Markets in Financial Instruments Directive (MiFID II) empowers the operator to make specific choices. These choices include when to place or retract an order and whether to match two opposing orders. This discretion is the central design feature of an OTF, intended to facilitate liquidity in complex, often bespoke or illiquid instruments where algorithmic matching alone would fail.

The core obligation is to ensure that this discretion is always exercised to achieve the “best possible result” for the client. This is a significant responsibility, moving the operator’s role from a passive facilitator of trades to an active agent with a fiduciary-like duty. The architecture of this compliance system rests on a clear and demonstrable framework that governs every discretionary decision.

The operator must systematically prove that their choices are not arbitrary but are guided by a robust, client-centric policy. This involves a continuous process of data gathering, analysis, and justification, ensuring that factors like price, cost, and likelihood of execution are properly weighed in a dynamic market environment.

The Nature of Discretionary Power

Discretion within an OTF is not an unrestricted authority. It is a specific, regulated power that manifests in two primary forms ▴ Order Level Discretion and Execution Level Discretion. Order Level Discretion involves the decision to introduce an order to the trading system or to remove it. An executing broker within the OTF might determine that market conditions are unfavorable or that a better result could be achieved by holding back an order.

Execution Level Discretion is the decision to match or not match two opposing orders that the system has identified as a potential trade. The broker might override a potential match if they believe, for instance, that a better price is achievable moments later or that executing a small portion of a large order would lead to adverse market impact.

Each exercise of this power must be justifiable against the firm’s established best execution policy. This policy is the foundational document that translates the high-level regulatory requirement into a concrete operational plan. It must detail, for each class of financial instrument, the factors that will be prioritized and the venues or liquidity sources that will be considered. For an OTF dealing in complex derivatives, for example, the policy would likely prioritize likelihood of execution and managing market impact over pure speed, reflecting the unique characteristics of those instruments.

What Defines the Best Possible Result?

MiFID II mandates that firms take “all sufficient steps” to obtain the best possible result for their clients. This is a higher standard than the previous “all reasonable steps” and requires a more proactive and evidence-based approach. The regulation specifies a set of execution factors that must be considered. While price and costs are often seen as paramount, they are part of a broader set of considerations.

The core execution factors include price, costs, speed, likelihood of execution and settlement, and the size and nature of the order.

The relative importance of these factors is not fixed. It shifts based on the client’s objectives, the type of financial instrument, and the prevailing market conditions. For a retail client, total consideration (price plus costs) is typically the most important factor. For an institutional client executing a large block trade in an illiquid bond, the likelihood of execution and minimizing market impact might far outweigh the raw price of the first tranche.

The OTF operator’s obligation is to have a system that correctly weighs these factors in real-time and can demonstrate why a particular balance was chosen for a specific trade. This requires a sophisticated understanding of both the client’s needs and the microstructure of the market in which they operate.

Strategy

Developing a compliant strategy for an OTF using discretionary matching requires building an operational architecture centered on two pillars ▴ a robust Order Execution Policy and a rigorous monitoring framework. This strategy is not merely about writing a document; it is about embedding a decision-making logic into the firm’s daily operations that is both flexible enough to handle discretionary trading and rigid enough to stand up to regulatory scrutiny. The goal is to create a system where every discretionary action is a direct and defensible implementation of the firm’s stated policy.

The first step is the codification of the firm’s approach in the Order Execution Policy. This document must be sufficiently detailed to provide clear guidance to the executing brokers who exercise discretion. It needs to explicitly state how the firm will balance the various execution factors for different types of clients and financial instruments.

For instance, the policy must clarify the circumstances under which the likelihood of execution will take precedence over immediate price improvement. This document serves as the strategic blueprint for all trading activity on the OTF.

Crafting the Order Execution Policy

The Order Execution Policy is the central strategic document. It must clearly articulate the processes the OTF operator will follow to ensure best execution. This involves more than just listing the execution factors; it requires a detailed explanation of their application in practice.

• Relative Importance of Factors The policy must define the criteria used to determine the relative importance of the execution factors. This will depend on the client’s categorization (retail or professional), the characteristics of the order (e.g. size, urgency), and the nature of the financial instrument (e.g. liquid equity vs. bespoke OTC derivative).
• Execution Venue Selection The policy must list the execution venues the firm relies on to meet its obligations. For an OTF, this includes its own system but may also involve accessing liquidity from other venues. The firm must justify why these venues consistently lead to the best possible results.
• Fair Pricing for OTC Instruments When dealing with instruments that do not have a public price, such as certain OTC derivatives, the policy must outline the process for ensuring the price is fair. This typically involves gathering market data from various sources and using it to construct a benchmark price against which the execution is measured.
• Policy Review and Governance The strategy must include a formal process for reviewing the execution policy and arrangements at least annually, or whenever a material change occurs that could affect the firm’s ability to deliver best execution.

Discretionary Matching Vs Automated Systems

The strategic challenge for an OTF is to demonstrate that its discretionary model provides a superior outcome for certain types of trades compared to purely automated systems like MTFs or Regulated Markets. The table below outlines how the application of best execution principles differs between these models.

Monitoring and Demonstrating Compliance

A strategy is incomplete without a robust monitoring component. The OTF operator must continuously collect and analyze data to verify the effectiveness of its execution arrangements. This involves tracking key metrics related to execution quality and comparing them against relevant benchmarks.

The firm must be able to demonstrate to regulators, and upon request to clients, that it has followed its policy and achieved the best possible result. This data-driven approach is what transforms the subjective nature of discretion into an objective and verifiable process.

Effective monitoring requires the systematic capture of trade data and its analysis against the promises made in the execution policy.

This continuous feedback loop allows the firm to identify any deficiencies in its policies or arrangements and make necessary corrections. It is the mechanism that ensures the strategic goals outlined in the policy are being met in the real world of trading.

Execution

The execution of best execution obligations for a discretionary OTF is a deeply operational and data-intensive process. It requires a specific technological and procedural architecture designed to capture, justify, and report on every discretionary decision. The entire workflow, from order receipt to post-trade analysis, must be structured to produce a clear audit trail that demonstrates compliance with the firm’s execution policy and MiFID II regulations.

At the heart of this process is the executing broker, who must operate within a predefined set of parameters. Their discretion is guided by the firm’s policy but applied to the specific context of each order. This requires not only market expertise but also a systematic approach to documenting the rationale behind their actions. The supporting infrastructure must provide them with the necessary data to make informed decisions and the tools to record those decisions effectively.

Procedural Workflow for Discretionary Execution

An OTF operator must implement a clear, step-by-step procedure for handling client orders. This workflow ensures that all necessary checks and justifications are completed at each stage of the order’s lifecycle.

1. Order Reception and Analysis Upon receiving a client order, the system and the executing broker analyze its characteristics against the execution policy. This includes identifying the client type, order size, and instrument complexity to determine the relative importance of the execution factors.
2. Pre-Trade Justification Before exercising discretion, the broker must have a clear rationale. If they decide to hold an order rather than execute it immediately, they must document why. For example, they might record that they are seeking to avoid negative market impact or are waiting for a specific liquidity event.
3. Exercise of Discretion The broker makes a decision, such as matching the order with a specific counterparty, retracting it from the system, or negotiating a price. This action is time-stamped and recorded in the system.
4. Execution and Confirmation Once the trade is executed, the details are recorded, and a confirmation is sent to the client. This confirmation should contain sufficient detail for the client to understand how the order was handled.
5. Post-Trade Monitoring and Reporting The data from the trade is fed into the firm’s monitoring system. It is analyzed against the benchmarks defined in the execution policy to assess the quality of the execution. This data will also be used to compile regulatory reports, such as the RTS 27 and RTS 28 reports.

Data Infrastructure and Quantitative Analysis

To support this workflow, the OTF operator needs a sophisticated data infrastructure. This system must capture a wide range of data points for each order and execution. This data is the raw material for the quantitative analysis required to monitor and demonstrate best execution.

The ability to demonstrate compliance rests entirely on the quality and granularity of the data collected at every stage of the trade lifecycle.

The table below details the critical data points that must be captured and analyzed to ensure a robust execution monitoring framework. This data forms the basis for both internal reviews and external regulatory reporting.

How Is the Fairness of a Price Assessed?

For many instruments traded on OTFs, particularly OTC derivatives, there is no single, publicly available price. In these cases, the operator has a specific obligation to check the fairness of the price proposed to the client. This is a critical execution function that relies on gathering and synthesizing market data. The process typically involves collecting pricing information from a variety of sources, which could include other dealers, data vendors, or internal pricing models.

This data is used to construct a fair value range for the instrument. The final execution price is then compared against this range to ensure it is fair and meets the best execution standard. This entire process, including the data sources used and the valuation methodology, must be documented and auditable.

Reflection

The regulatory framework governing discretionary OTFs forces a fundamental re-evaluation of how execution quality is measured and achieved. The obligations move beyond simple compliance and compel an operator to build a truly intelligent execution system. The question for any market participant is how their own operational architecture interacts with such venues. Understanding the depth of an OTF’s obligations is the first step toward strategically leveraging its capabilities.

Considering Your Own Framework

Does your firm’s process for venue selection account for the qualitative difference between discretionary and automated execution? How do you measure the value of a broker’s discretion in securing liquidity for a difficult-to-trade instrument? The answers to these questions define the sophistication of your own execution strategy.

The data and transparency mandated by MiFID II provide the tools to perform this analysis. The ultimate advantage lies with those who can integrate this understanding into their own systems, transforming a regulatory requirement into a source of competitive edge.