Concept
The mandate for best execution under the Markets in Financial Instruments Directive II (MiFID II) establishes a uniform principle ▴ investment firms must secure the most favorable outcome for their clients when executing orders. This core obligation, however, refracts into a spectrum of complex, asset-specific requirements upon implementation. The operational pathways for achieving and demonstrating best execution for equities diverge significantly from those for non-equity instruments, such as bonds, derivatives, and structured products. This distinction is a direct consequence of the fundamental structural dissimilarities between the markets in which these assets trade.
Equity markets are characterized by a high degree of centralization and transparency. Trading predominantly occurs on regulated markets or multilateral trading facilities (MTFs), where a continuous flow of lit order book data and post-trade information is available. This environment facilitates a relatively straightforward, quantitative assessment of execution quality against observable benchmarks. The availability of a consolidated tape, which aggregates trade data, further enhances a firm’s ability to benchmark its performance.
Conversely, non-equity markets are frequently decentralized, opaque, and dominated by over-the-counter (OTC) transactions. Liquidity in these markets is often fragmented and episodic. Price discovery is a more challenging endeavor, relying heavily on request-for-quote (RFQ) protocols and bilateral negotiations rather than a central limit order book.
The absence of continuous, publicly available pricing data for many non-equity instruments means that a simple comparison to a market-wide reference price is often impossible. The directive acknowledges these inherent market realities, leading to a more qualitative and principles-based approach for non-equities, where the firm’s process and judgment play a more prominent role in satisfying the regulatory requirements.
The Genesis of a Bifurcated Standard
MiFID II evolved from its predecessor, MiFID I, with a clear intention to extend the reach and rigor of best execution across all asset classes. While MiFID I established the foundational principles, its practical application was heavily skewed towards the equities world, where data was abundant. The updated directive sought to rectify this by explicitly bringing non-equity instruments into a more robust compliance framework. The result is a system where the overarching objective remains the same, but the methodology for achieving it is bifurcated.
For equities, the path is illuminated by data and quantitative metrics. For non-equities, the journey requires navigating a landscape of fragmented liquidity and qualitative judgment, demanding a different set of tools, strategies, and documentation to prove that “all sufficient steps” were taken to achieve the best possible result for the client.
Defining the Scope of Application
The application of these differentiated requirements hinges on the classification of the financial instrument. MiFID II provides clear delineations for what constitutes an equity versus a non-equity instrument, with specific sub-categories for equity-like instruments, bonds, derivatives, and structured finance products. This classification is the critical first step for any firm in designing its order execution policy, as it dictates which set of rules and evidential standards will apply to a given trade. The directive’s expansion to cover a wider universe of instruments reflects the regulators’ intent to enhance investor protection and market integrity across the entirety of the European financial landscape.
Strategy
Developing a robust best execution strategy under MiFID II requires a nuanced understanding that a single, monolithic policy is insufficient. The strategic framework must be bifurcated, with distinct approaches for equities and non-equities that reflect the profound differences in their market structures, liquidity profiles, and available data. The core of this strategic differentiation lies in how a firm defines, prioritizes, and evidences the various execution factors for each asset class.
The relative importance of each execution factor is not static; it shifts depending on the specific characteristics of the client, the order, the instrument, and the execution venue.
Comparative Weighting of Execution Factors
MiFID II outlines a set of execution factors that firms must consider when executing a client order. These include price, costs, speed, likelihood of execution and settlement, size, and nature of the order. While all factors are relevant to every trade, their relative importance shifts dramatically between equities and non-equities.
For liquid equities traded on a regulated market, the ‘total consideration’ ▴ the combination of the execution price and explicit costs ▴ is typically the paramount factor. The high degree of transparency and competition among venues makes price the most readily comparable and critical element. Speed and likelihood of execution are also important, but often in the context of capturing a specific, visible price before it moves.
For an illiquid corporate bond or a complex OTC derivative, the hierarchy of factors changes. The likelihood of execution becomes a primary consideration. Sourcing liquidity for a large block of an infrequently traded bond may be the single most challenging aspect of the trade.
In this context, a firm might justifiably prioritize securing a counterparty to complete the trade at a reasonable price, even if that price is not the absolute best that might theoretically be achievable with more time or at a smaller size. The nature and size of the order, therefore, take on a much greater significance in the strategic calculus for non-equities.
A Tale of Two Asset Classes
The strategic divergence is best illustrated through a comparative table that outlines how a firm might approach the execution factors for each asset class.
| Execution Factor | Strategic Approach for Equities | Strategic Approach for Non-Equities (e.g. Corporate Bonds) |
|---|---|---|
| Price | Paramount importance. Assessed against public benchmarks (e.g. VWAP, TWAP) and consolidated tape data. Smart order routers (SORs) are used to algorithmically scan multiple lit and dark venues for the best available price. | High importance, but assessed within the context of available liquidity. Price discovery is achieved through RFQs to multiple dealers. The “best” price is the most competitive quote received from a reliable counterparty capable of handling the order’s size. |
| Costs | Primarily explicit costs (e.g. exchange fees, broker commissions). These are transparent and easily quantifiable. Minimizing these costs is a key objective. | Costs are often implicit and embedded within the bid-ask spread. The dealer’s spread reflects liquidity risk and other factors. The focus is on achieving a fair “all-in” price rather than isolating explicit fees. |
| Speed | High importance, particularly for algorithmic strategies seeking to capture fleeting prices. Low-latency connectivity to venues is critical. | Lower importance. The process of soliciting quotes and negotiating a trade can be manual and time-consuming. The priority is finding a willing counterparty over immediate execution. |
| Likelihood of Execution | Generally high for liquid stocks. The primary risk is price movement (slippage), not failure to execute. For illiquid stocks, this factor gains importance. | A critical, often primary, factor. For large or illiquid positions, the ability to complete the trade at all is a major success criterion. The strategy focuses on identifying pockets of liquidity. |
| Size and Nature | Algorithmic strategies (e.g. VWAP, Iceberg orders) are used to manage the market impact of large orders. The nature of the order (e.g. market, limit) dictates the execution logic. | The size of the order is a dominant constraint. A large order may need to be worked over time or placed with a dealer known to have an appetite for that specific type of risk. The bilateral, negotiated nature of the trade is central. |
The Role of Technology and Data Analytics
The strategic implementation of best execution is heavily reliant on technology. For equities, this means sophisticated Smart Order Routers (SORs) and algorithmic trading engines that can process vast amounts of market data in real-time to optimize execution across multiple venues. Transaction Cost Analysis (TCA) is a mature discipline, with established benchmarks and analytical models to assess execution quality.
For non-equities, the technological requirements are different. While electronic trading platforms and RFQ systems are increasingly common, the process is less automated. The technology must support the capture and analysis of unstructured data, such as dealer quotes, response times, and the rationale for counterparty selection. TCA for non-equities is a more complex and developing field.
It often involves creating custom benchmarks based on historical data, evaluated pricing services, or the range of quotes received for a specific trade. The strategic focus is on building a defensible audit trail that demonstrates a consistent and thoughtful process, even in the absence of a single, definitive market price.
Reporting and Transparency Obligations
MiFID II introduced stringent reporting requirements to enhance transparency, detailed in Regulatory Technical Standards (RTS) 27 and 28. These reports are a key part of a firm’s best execution strategy, as they force a systematic review of execution quality.
- RTS 27 ▴ This report is produced by execution venues (including market makers and systematic internalisers). It provides detailed quarterly data on execution quality for each financial instrument, covering aspects like price, costs, and likelihood of execution. The granularity of RTS 27 data is much higher for equities due to the nature of the available information.
- RTS 28 ▴ This report is produced annually by investment firms. It requires them to publish a summary of their analysis of the top five execution venues used for each class of financial instrument, along with a qualitative assessment of the execution quality obtained. A core part of the strategy here is to provide a clear narrative, especially for non-equity asset classes, explaining why certain venues were chosen and how the execution factors were balanced to achieve the best result for clients.
Execution
The execution of a MiFID II-compliant best execution framework moves beyond strategic planning into the realm of operational protocols, technological integration, and rigorous, evidence-based analysis. The core challenge in execution is translating the high-level principles of the directive into a tangible, auditable, and repeatable process that functions effectively across the distinct ecosystems of equities and non-equities. This requires a granular approach to policy design, data management, and quantitative assessment.
The Operational Playbook for a Differentiated Framework
A firm’s order execution policy is the central document that governs its approach. To be effective, this policy must be a living document, not a static compliance checkbox. It must detail the specific procedures for different asset classes.
- Instrument Classification ▴ The process begins with the unambiguous classification of every financial instrument into a defined category (e.g. liquid equity, illiquid equity, government bond, corporate bond, OTC derivative). This classification triggers the specific execution protocol to be followed.
- Venue and Counterparty Management ▴ The firm must maintain and regularly review a list of approved execution venues and counterparties for each instrument class.
- For equities, this involves evaluating regulated markets, MTFs, and systematic internalisers based on quantitative metrics from RTS 27 reports and the firm’s own TCA.
- For non-equities, the process includes assessing the creditworthiness, reliability, and historical pricing competitiveness of OTC counterparties. The rationale for including or excluding a dealer from an RFQ process must be documented.
- Pre-Trade Analysis ▴ Before an order is placed, a documented analysis must occur.
- For an equity order, this may be an automated process where an SOR assesses liquidity and pricing across all connected venues.
- For a non-equity order, this is a more deliberative process. The trader must determine the appropriate number of dealers to include in the RFQ (typically at least three for a competitive process) and document the reasons for their selection based on the size and nature of the order.
- Post-Trade Monitoring and Review ▴ This is the critical evidence-gathering phase. The firm must systematically monitor the effectiveness of its execution arrangements and policies. This involves a regular, formal review process to identify and remedy any deficiencies.
Quantitative Modeling and Data Analysis
The evidentiary burden of MiFID II necessitates a robust quantitative approach. However, the models and data used for equities are fundamentally different from those applied to non-equities. Transaction Cost Analysis (TCA) provides a clear example of this divergence.
The absence of a continuous, public price feed for most non-equity instruments makes traditional, benchmark-based TCA challenging, requiring a more creative and process-oriented analytical approach.
Comparative Transaction Cost Analysis
The following table presents a simplified, hypothetical TCA report for two trades ▴ a €5 million purchase of a liquid equity and a €5 million purchase of an investment-grade corporate bond. It highlights the different data points and analytical methodologies involved.
| Metric | Equity Trade (Liquid Stock on Regulated Market) | Non-Equity Trade (Corporate Bond via RFQ) |
|---|---|---|
| Order Size | €5,000,000 | €5,000,000 (Nominal) |
| Execution Venue(s) | MTF Alpha (60%), Dark Pool Beta (40%) | Dealer Gamma (Winning Quote) |
| Primary Benchmark | Arrival Price (Price at time of order receipt) | Quote Mid-Point (Mid-point of best bid/offer from RFQ) |
| Arrival Price / Quote Mid | €50.00 | 101.50 |
| Average Execution Price | €50.05 | 101.60 |
| Slippage vs. Benchmark (bps) | +10 bps ((€50.05 – €50.00) / €50.00) | +9.85 bps ((101.60 – 101.50) / 101.50) |
| Explicit Costs (Commissions/Fees) | €1,500 (3 bps) | €0 (Implicit in spread) |
| Total Cost (Slippage + Explicit) | 13 bps | ~9.85 bps (Implicit) |
| Supporting Evidence | Full order book data, consolidated tape records, SOR execution logs. | RFQ logs showing quotes from Dealer Alpha (101.65), Dealer Beta (101.70), and Dealer Gamma (101.60). Timestamped communication records. |
| Key Analytical Question | Did the algorithmic strategy and venue selection minimize market impact and slippage against a verifiable public benchmark? | Did the RFQ process produce a competitive price, and was the choice of winning dealer justifiable based on the quotes received and the need to secure execution? |
System Integration and Technological Architecture
Compliance with these divergent requirements is impossible without the appropriate technological infrastructure. A firm’s Order Management System (OMS) and Execution Management System (EMS) must be configured to handle both types of workflows seamlessly.
For equities, the system requires low-latency connectivity to a multitude of trading venues, sophisticated algorithmic trading capabilities, and a data pipeline capable of capturing and processing high-frequency market data for TCA. The FIX protocol is the standard for communication, with well-defined message types for order routing and execution reporting.
For non-equities, the architecture must support multi-dealer RFQ platforms and capture the associated data. This includes not just the quotes themselves, but also metadata such as response times and reasons for declining to quote. The system must have robust case management and audit trail capabilities to store unstructured data, such as chat logs or emails, that form part of the execution record. While FIX is also used, there may be a greater need for custom integrations or API connections to various dealer platforms and pricing services.
References
- European Securities and Markets Authority. (2017). MiFID II and MiFIR. ESMA.
- Financial Conduct Authority. (2017). Markets in Financial Instruments Directive II Implementation. FCA.
- Lehalle, C. A. & Laruelle, S. (2013). Market Microstructure in Practice. World Scientific Publishing.
- Investopedia. (2023). Best Execution Rule ▴ What it is, Requirements and FAQ.
- Macfarlanes LLP. (2017). MiFID II for private equity firms.
- Planet Compliance. (2018). In a nutshell ▴ Best Execution under MiFID II/MiFIR.
- Gresham House Asset Management. (2020). Best execution | MiFID II.
- Harris, L. (2003). Trading and Exchanges ▴ Market Microstructure for Practitioners. Oxford University Press.
Reflection
Calibrating the Execution Framework
The assimilation of MiFID II’s bifurcated best execution requirements compels a fundamental review of a firm’s internal systems. It is an exercise in moving from a compliance-driven mandate to a source of strategic advantage. The regulations provide a blueprint, but the ultimate architecture of the execution framework is a proprietary construction.
It reflects the firm’s specific client base, its risk appetite, and its technological capabilities. The central question for any institution is not merely whether it is compliant, but whether its execution policy is an integrated component of its performance-generating machinery.
Beyond the Mandate a System of Intelligence
Viewing these requirements as a mere regulatory burden is a strategic miscalculation. The data captured, the processes defined, and the analyses conducted form a powerful, proprietary intelligence layer. For equities, this intelligence reveals the subtle behaviors of algorithms and the true cost of liquidity across different venues.
For non-equities, it builds an invaluable map of counterparty behavior and liquidity pockets in opaque markets. A truly effective system does not just satisfy the regulator; it provides the firm’s traders and portfolio managers with a measurable edge, transforming a defensive compliance posture into an offensive tool for enhancing client outcomes.
Glossary
Non-Equity Instruments
Best Execution
Execution Quality
Consolidated Tape
Rfq
Non-Equities
Asset Classes
Equities
Order Execution Policy
Financial Instrument
Execution Factors
Mifid Ii
Corporate Bond
Transaction Cost Analysis
Tca
Rts 27
Rts 28
Sor
