What Constitutes a Good-Faith Effort to Obtain Market Quotations in an Illiquid Market? ▴ Question

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Concept

The question of what constitutes a good-faith effort to obtain market quotations in an illiquid market is a foundational challenge in institutional finance. It moves directly to the core of the buy-side trader’s fiduciary duty. The answer is an auditable, systematic process designed to overcome informational asymmetry. In liquid markets, price is a readily available commodity.

In illiquid markets, price is a manufactured good. It must be constructed, piece by piece, through a deliberate and defensible protocol. The good-faith effort is the blueprint for that construction. It is the operational manifestation of a firm’s commitment to achieving the best possible outcome for a client under adverse structural conditions.

This process is predicated on a single, powerful idea the price discovery in the absence of a central, continuous order book is a search problem. The objective is to design and execute a search that is as comprehensive as reasonably possible given the specific constraints of the security, the market conditions, and the size of the order. The “good-faith” component is not about subjective intent; it is about the objective, demonstrable quality of that search.

It is measured by the system’s design, the diligence of its execution, and the integrity of its documentation. A regulator, an auditor, or a client should be able to reconstruct the trader’s actions and conclude that the methodology was sound, even if the outcome was suboptimal due to market conditions beyond the trader’s control.

A good-faith effort is measured by the objective, demonstrable quality of the price discovery process.

At its heart, this operational challenge requires a shift in mindset. One must move from passively observing a market price to actively soliciting indications of interest from a curated network of potential liquidity providers. This is the domain of the Request for Quote (RFQ) protocol, a structured dialogue designed to function where the public market fails. The system must be built to handle the inherent difficulties of this environment, specifically the risk of information leakage.

Every potential counterparty that is queried represents a potential source of adverse selection. If the search for liquidity is not managed with precision, the act of searching itself can move the market against the order. Therefore, a good-faith effort is also a discreet one, balancing the need for broad solicitation with the imperative to protect the client’s intentions.

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Defining the Operational Standard

The operational standard for a good-faith effort is built on three pillars documentation, diligence, and dynamic adaptation. Each component is essential for constructing a defensible framework that can withstand scrutiny. These pillars transform an abstract legal concept into a concrete set of institutional behaviors and technological systems.

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Pillar One Documentation

Documentation is the bedrock of a good-faith effort. It provides the verifiable evidence that a structured process was followed. Without a detailed audit trail, any claim of a diligent search is merely an assertion. The documentation protocol must be systematic and contemporaneous, capturing not just the quotes that were received, but also the efforts that yielded no response.

This is particularly important in illiquid markets where a “no-bid” is a frequent and meaningful data point. It confirms the scarcity of liquidity and justifies the final execution price, whatever it may be.

The system must log key data points for every inquiry:

Counterparty Selection The rationale for which dealers or market makers were included in the RFQ process. This should be based on established counterparty lists, historical performance, and known specialization in the specific asset class.
Timestamping The precise time each RFQ was sent, when each response was received, and when the final trade was executed. This creates a clear timeline of the price discovery process.
Quote Details All terms of any received quotations, including price, size, and any specific conditions or contingencies. This includes quotes that were not ultimately acted upon.
Unresponsive Inquiries A record of all counterparties that were solicited but did not provide a quotation. This is crucial evidence of the market’s illiquidity.

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Pillar Two Diligence

Diligence refers to the thoroughness and intelligence of the search for liquidity. It is a qualitative measure of the effort expended. In an illiquid market, simply querying the same two or three dealers for every trade is insufficient. A diligent process involves a more thoughtful and expansive approach.

It requires the trading desk to maintain and regularly review its network of potential counterparties, understanding their individual strengths and appetites. The process must be demonstrably robust, showing that the trader explored multiple avenues to find the best available terms for the client.

Elements of a diligent process include:

Sufficient Number of Counterparties The process should involve soliciting quotes from a reasonable number of market participants. While there is no magic number, the effort should reflect the nature of the security. For a truly esoteric instrument, contacting the three known market makers might be sufficient. For a security that is merely thinly traded, a broader search is warranted.
Diverse Counterparty Types The search should not be limited to a single type of counterparty. A diligent process might involve contacting traditional dealers, specialized electronic liquidity providers, and other buy-side institutions that may have an offsetting interest.
Consideration of Different Venues Where applicable, the process should consider different execution venues. This could include crossing networks or other off-exchange platforms that might offer a source of liquidity.

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Pillar Three Dynamic Adaptation

The market is not a static entity, and a good-faith effort must reflect this reality. A process that was sufficient yesterday may be inadequate today. Dynamic adaptation means that the firm’s protocols for sourcing liquidity must be responsive to changing market conditions, new technologies, and evolving regulatory expectations. This requires a continuous feedback loop where the results of post-trade analysis inform and refine the pre-trade strategy.

For example, if a particular dealer consistently provides non-competitive quotes, the system should adapt, perhaps by down-weighting them in future RFQ processes. Conversely, if a new electronic platform emerges as a reliable source of liquidity, it should be integrated into the firm’s workflow.

This adaptive principle also extends to the specific circumstances of each trade. A good-faith effort for a small order in a slightly illiquid bond will look very different from the effort required for a large block of a distressed corporate security. The system must allow for this level of tailored execution, enabling the trader to adjust the breadth and intensity of the search based on the specific risk parameters of the order.

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Strategy

Developing a strategy for obtaining market quotations in an illiquid market is an exercise in system design. It requires moving beyond a simple checklist and constructing a robust, multi-layered framework for price discovery. The core objective is to maximize the probability of finding the most favorable terms for a client while minimizing the market impact caused by the search itself. This is a delicate balance.

A search that is too narrow may fail to uncover the best price, while a search that is too broad may signal the trader’s intentions to the market, leading to adverse price movements. The optimal strategy is therefore a system of tiered and intelligent inquiry.

The foundation of this strategy is the segmentation of both the securities and the counterparties. All illiquid assets are not the same. A corporate bond that trades by appointment is fundamentally different from a distressed security or a complex, multi-leg derivative. The first step is to create a liquidity classification system.

This allows the firm to apply a pre-defined, yet flexible, protocol based on the known characteristics of the instrument. For instance, a “Level 1” illiquid asset might require a standard RFQ to a list of five to seven core dealers, while a “Level 3” esoteric asset might trigger a more intensive, manual process involving phone calls to a small, specialized group of counterparties.

The optimal strategy for price discovery in illiquid markets is a system of tiered and intelligent inquiry.

This classification system provides a baseline, but the strategy must also be dynamic. Real-time market intelligence is a critical input. This includes monitoring any available public data, news flow related to the issuer, and general market sentiment. This intelligence layer informs the trader’s decision on when and how to approach the market.

A strategy built for a stable market environment may be entirely inappropriate during a period of high volatility. The ability to adjust the protocol in response to changing conditions is a hallmark of a sophisticated approach.

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Architecting the Inquiry Process

The inquiry process itself must be architected to manage the flow of information. The most common tool for this is the Request for Quote (RFQ) system, but how that system is used defines the strategy. A tiered approach to the RFQ process is often the most effective. This involves a sequence of inquiries, starting with a small, trusted group of counterparties and expanding outward as necessary.

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Tier 1 High-Trust Counterparties

The first tier of inquiry should be directed to a small group of high-trust counterparties. These are typically market makers with whom the firm has a strong relationship and who have a proven track record of providing competitive quotes without leaking information. The initial RFQ to this group serves two purposes. First, it provides a quick, initial benchmark for the price.

Second, it does so with the lowest possible risk of information leakage. In some cases, the quotes from this initial tier may be sufficient to satisfy the firm’s best execution requirements, and the process can conclude there.

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Tier 2 Broad Market Sweep

If the quotes from the first tier are not competitive, or if only a small number of counterparties respond, the strategy moves to the second tier. This involves a broader sweep of the market, sending RFQs to a larger list of potential liquidity providers. This is where electronic RFQ platforms are most valuable, as they allow for efficient, simultaneous communication with a wide range of dealers.

The risk of information leakage is higher in this tier, but it is a calculated risk, taken only after the more discreet options have been explored. The key is to control the process, ensuring that all counterparties are queried at the same time to prevent any one dealer from having an informational advantage.

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Tier 3 Non-Traditional Liquidity

For the most challenging securities, a third tier of inquiry may be necessary. This involves looking for liquidity in non-traditional places. This could mean contacting other buy-side institutions to see if they have an offsetting interest, a practice often facilitated by specialized crossing networks or blotter-scraping technology.

It could also involve more manual, voice-based negotiation with counterparties who specialize in “work-up” orders, where a price is agreed upon for a small initial quantity, with the understanding that more can be done at that price over time. This tier requires the highest level of skill and discretion from the trader.

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Comparative Analysis of Quotation Strategies

The choice of strategy has direct implications for execution quality. The following table provides a comparative analysis of different approaches to obtaining quotations in an illiquid market, highlighting the trade-offs between speed, information leakage, and the potential for price improvement.

Strategy	Description	Risk Of Information Leakage	Potential For Price Improvement	Best For
Sequential Voice RFQ	Calling dealers one by one to request a quote.	High	Low to Medium	Highly sensitive orders where the trader needs to provide color to the dealer.
Simultaneous Electronic RFQ	Using a platform to send a single RFQ to multiple dealers at once.	Medium	High	Standard illiquid securities where competitive tension is desirable.
Tiered RFQ	A hybrid approach, starting with a small group and expanding as needed.	Low to Medium	High	Most situations, as it provides a balance of discretion and competitive pressure.
All-to-All Trading	Using a platform that allows all participants to see and respond to orders.	Medium to High	Medium	Securities where buy-side to buy-side liquidity may be significant.

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Execution

The execution of a good-faith effort to obtain market quotations in an illiquid market is where strategy becomes practice. It is the precise, moment-to-moment application of the firm’s established protocols. This is a high-stakes procedure where the quality of the outcome is a direct function of the quality of the process. The focus is on creating a complete, unimpeachable record of a diligent and systematic search for liquidity.

This record is the firm’s ultimate defense against any future challenge to its execution quality. Every step must be deliberate, and every decision must be documented.

The execution phase begins the moment a portfolio manager’s order arrives at the trading desk. The first action is to classify the order according to the firm’s liquidity matrix. This classification determines the specific execution protocol that will be followed. The trader must then conduct a pre-trade analysis.

This involves reviewing any available market data, however sparse, to establish a reasonable price range. This could include recent trade prints, indicative levels from pricing services, or even prices of comparable securities. This pre-trade analysis is not about finding the “true” price; it is about establishing a baseline against which the solicited quotes can be judged. This entire analysis must be logged in the firm’s order management system (OMS).

A complete and unimpeachable record is the ultimate defense of execution quality.

With the pre-trade analysis complete, the trader initiates the quotation process according to the chosen strategy. If using a tiered RFQ approach, the first wave of inquiries is sent to the high-trust group of counterparties. The system must automatically log which counterparties were contacted and the exact time of the request. As responses arrive, they are also logged, creating a real-time picture of the emerging market for the security.

The trader must then make a critical decision should they execute based on the initial responses, or should they proceed to a wider inquiry? This decision must be based on a clear set of criteria, such as the number of responses received, the competitiveness of the quotes, and the size of the order relative to the quoted depth.

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The Documentation Imperative a Procedural Guide

The core of the execution process is the creation of a detailed audit trail. This is not simply a matter of compliance; it is a vital tool for risk management and performance analysis. The following procedural guide outlines the essential steps for documenting a good-faith effort in an illiquid market.

Order Ingestion and Classification Upon receiving an order, the system should automatically tag it with a unique identifier. The trader then classifies the security based on the firm’s liquidity framework (e.g. Tier 1, 2, or 3 illiquid). This classification dictates the minimum number of counterparties to be contacted.
Pre-Trade Price Benchmark The trader documents the pre-trade price analysis. This should include the sources used (e.g. Bloomberg BVAL, recent TRACE prints, comparable bond analysis) and the resulting price target or range. This is a critical step in demonstrating that the final execution price was reasonable.
Counterparty Selection and RFQ Dispatch The trader selects the counterparties for the RFQ process. The system should record the list of selected counterparties and the rationale for their inclusion (e.g. “core dealer,” “specialist in sector”). The RFQ is then dispatched, with the system logging the precise time.
Response Logging and Analysis All responses, including both quotes and “no-bids,” are logged automatically by the system as they are received. The trader analyzes the responses, comparing them to the pre-trade benchmark and to each other. The spread between the best bid and the best offer is a key data point to record.
Execution and Rationale If a trade is executed, the system records the execution price, size, counterparty, and time. The trader must then add a comment documenting the rationale for the execution. For example “Executed with Counterparty B as they provided the best offer, which was within our pre-trade target range.”
Post-Trade Analysis After the trade is complete, a post-trade analysis should be performed. This involves comparing the execution price to various benchmarks to calculate performance metrics like slippage. This data feeds back into the system to refine future counterparty selection and trading strategies.

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Illustrative Execution Log

The following table provides a simplified example of what an execution log might look like for a single trade in an illiquid corporate bond. This log serves as the primary evidence of the good-faith effort.

Timestamp (UTC)	Action	Details	Trader Notes
14:30:01	Order Received	Buy 500M XYZ Corp 4.5% 2035	Order classified as Tier 2 illiquid.
14:32:15	Pre-Trade Analysis	BVAL ▴ 98.50, Last Trace ▴ 98.25 (3 days ago)	Target price set at 98.50 or better.
14:35:05	RFQ Sent (Tier 1)	Sent to Dealers A, B, C	Initial inquiry to core relationship dealers.
14:35:45	Response Received	Dealer A ▴ No Bid	Market appears thin.
14:36:02	Response Received	Dealer B ▴ Offer 500M @ 98.75	Quote is 25 cents above target.
14:36:10	Response Received	Dealer C ▴ Offer 300M @ 98.80	Quote is smaller and higher than Dealer B.
14:38:00	RFQ Sent (Tier 2)	Sent to Dealers D, E, F, G	Expanding search for price improvement.
14:39:30	Response Received	Dealer E ▴ Offer 500M @ 98.65	Best offer received so far.
14:39:55	Execution	Bought 500M @ 98.65 from Dealer E	Executed at best price after two-tiered search.

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References

Harris, Larry. “Trading and Exchanges Market Microstructure for Practitioners.” Oxford University Press, 2003.
O’Hara, Maureen. “Market Microstructure Theory.” Blackwell Publishers, 1995.
U.S. Securities and Exchange Commission. “Release No. 34-54165; File No. SR-NASD-2004-183.” 2006.
Financial Industry Regulatory Authority. “Regulatory Notice 15-46 Best Execution and Interpositioning.” 2015.
Keim, Donald B. and Ananth Madhavan. “The upstairs market for large-block transactions ▴ analysis and measurement of price effects.” The Review of Financial Studies, vol. 9, no. 1, 1996, pp. 1-36.

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Reflection

The architecture of a good-faith effort is a reflection of a firm’s core operational philosophy. It reveals how the institution perceives risk, values diligence, and systematizes its duties to its clients. The frameworks and procedures discussed here provide the necessary components, but the ultimate effectiveness of the system depends on its integration into the firm’s culture.

Is the pursuit of best execution viewed as a compliance burden or as a source of competitive advantage? A truly robust process is one that is constantly being questioned, refined, and improved, driven by a deep understanding that in the complex terrain of illiquid markets, a superior process is the only reliable path to a superior outcome.