You may have read the last few blogs I’ve written about MiFID II, all of which dealt with aspects that were relatively technical. This time I’d like to look at something which is quite well understood by the market but its implications (and potential opportunities) are much less well known.
Best execution is not a new concept. It was originally introduced in MiFID I and applied only to the equities market. It arguably didn’t go far enough as it effectively ensured only that a best execution policy was in place, not what that policy was.
Now it’s extended to cover all asset classes and strengthened to ensure that the intended outcome is actually realised. This is set to be one of the more complicated parts of MiFID II to implement. The gargantuan task of connecting to multiple venues, ensuring and demonstrating quality of execution fills many in the markets with dread. This is accentuated by not having a central reference point, such as a consolidated tape, against which to benchmark.
Unpacking the complexity
The actual steps needed to be taken to comply are not complicated to set out:
1. Participants need an accurate, timely view of the market
2. They then need to employ analytics to be able to trade effectively – e.g. smart order routers, algos and data
3. Next they need access to the infrastructure to be able to participate and execute quickly in any market they need
4. Finally they need to be able to prove that the trade was executed correctly
While this sounds relatively simple, in practice things are quite different.
How can you get an accurate and, more importantly, a complete view of the market at any given time? How would a single participant go about connecting to sufficient liquidity venues to ensure it always has access to the best execution terms? How do you then prove that – at that point in time – the trade you executed was the best one for your client taking into account commissions, pricing and timing on a global scale? Moreover, what will it cost and how long will it take to get the various pieces of the jigsaw puzzle in place?
First things first
Ensuring a complete and accurate market view and connecting to sufficient liquidity venues present the most immediate infrastructure challenges.
As yet it’s unclear how many venues a participant would need to connect to in order to be confident that they have visibility of the best price in the market. Clearly for some asset classes that number will be larger than for others but the cost and time outlay could be high. Once those connections are in place, a participant would need to subscribe to a commensurate number of market data feeds in order to gain a complete picture of the market. Obtaining an accurate picture is a different matter and depends entirely on the latency of these market data feeds.
Once the connections, the data feeds and analytics required are in place, attention then has to be turned to proving best execution. This presents a completely different set of problems. In order to prove best execution, historical data needs to be analysed to show that a specific trade couldn’t have been done with more favourable terms to the client. Initially it might seem that if you have gone through the set-up process correctly and can rely on having a complete and accurate view of the market that this would be simple to prove. Under MiFID II, however, penalties for non-compliance are severe and the only way of unequivocally proving best execution would be against something like a consolidated tape. As this doesn’t yet exist in Europe, ensuring the set up phase is right becomes doubly important.
Considering that this needs to be done for each asset class covered by the directive, the scope and scale of change is truly staggering.
Tapping in to the network effect
There may be an alternative to building everything from scratch. Financial extranets are widely used and have the fundamental properties needed to help firms comply with best execution regulations efficiently by ensuring they can reach required destinations on time. Extranets have established connections to multiple liquidity venues, the access to market data and the ability to reach analytics and algorithmic providers needed to trade. Due to the ecosystem potential of extranets’ nature a complete market view is relatively simple to get, and depending on the level of latency, an accurate one is possible too.
With foresight, there is even the potential for extranets to be a trade and transaction reporting conduit by bringing APAs onto the ecosystem.
Thus, best execution requirements cease to be a compliance burden and, managed correctly, could even become a competitive advantage. The firm that can guarantee best execution at a higher percentage of the time than its competitors will stand to gain sizeable market share. Clearly compliance will be a challenge but solutions already exist which could make it much less of one.