Best execution policy under MiFID adopts a multi-faceted approach that addresses, amongst other things, quality of execution, trading conditions extended to clients and the counterparty selection process. It also provides directions and guidelines on how best execution can be achieved.
The execution policy, set forth in MiFID II rests on several main pillars and I will briefly describe my findings on these below.
MiFID II main pillars
How many counterparties should a broker have - 1 or 5?
The broker may use a single counterparty as long as, by using this counterparty, the broker is able to deliver consistently best execution to its clients (Please note that this order execution should be supported by relevant data and internal analysis). If the broker is not able to consistently achieve best execution for its clients through one venue, then they should deploy multiple liquidity providers and report the top five counterparties by volume on an annual basis (see point #2).
“Investment firms transmitting or placing orders with other entities for execution may select a single entity for execution only where they are able to show that this allows them to obtain the best possible result for their clients on a consistent basis and where they can reasonably expect that the selected entity will enable them to obtain results for clients that are at least as good as the results that they reasonably could expect from using alternative entities for execution. This reasonable expectation should be supported by relevant data published in accordance with Article 27 of Directive 2014/65/EC or by internal analysis conducted by these investment firms.”
Reporting the top five trade-executing venues by volume
Under this best execution criteria rule, if a broker sends its order flow to other parties for execution, it should produce an annual report disclosing its top five counterparties based on the volume of client trades executed. The company should also be able to provide such statistics upon a reasonable request from the client.
“Article 64 Best execution criteria (Articles 27(1) and 24(1) of Directive 2014/65/EU)
In particular, when the investment firm select other firms to provide order execution services, it shall summarize and make public, on an annual basis, for each class of financial instruments, the top five investment firms in terms of trading volumes where it transmitted or placed client orders for execution in the preceding year and information on the quality of execution obtained.
Upon reasonable request from a client, investment firms shall provide its clients or potential clients with information about entities where the orders are transmitted or placed for execution.”
Document counterparty selection process
Brokers will be required to, both, create and retain a summary of their counterparty selection process as well as their criteria for defining best execution policy for their clients.
“a summary of the selection process for execution venues, execution strategies employed, the procedures and process used to analyze the quality of execution obtained and how the firms monitor and verify that the best possible results were obtained for clients.”
Conduct extensive due diligence on all potential counterparties, taking into consideration the industry expertise and market reputation of the counterparty in question
Apart from obvious considerations in selecting a liquidity provider, such as pricing and execution, market practices, business model and other trading conditions, brokers should also evaluate intangibles like domain expertise and market reputation.
“In particular, Member States shall require investment firms to take into account the expertise and market reputation of the third party as well as any legal requirements related to the holding of those financial instruments that could adversely affect clients’ rights
Speed, likelihood of execution and settlement, the size and nature of the order, market impact and any other implicit transaction costs may be given precedence over the immediate price and cost consideration only insofar as they are instrumental in delivering the best possible result in terms of the total consideration to the retail client.”
Emphasis on Best Execution on a consistent basis
MiFID II is now forcing brokers to take into consideration the multiple factors impacting trade execution, not just the price, by focusing the emphasis on the consistency of the overall client experience.
“least establish the process by which it determines the relative importance of these factors, so that it can deliver the best possible result to its clients. In order to give effect to that policy, an investment firm should select the execution venues that enable it to obtain on a consistent basis the best possible result for the execution of client orders”.
Collecting Market data
In order to prove best execution practices, brokerage firms will need to gather relevant market data to verify OTC prices, offered to clients, against the interbank market benchmark.
“As best execution obligations apply to all financial instruments, irrespective of whether they are traded on trading venues or OTC, investment firms should gather relevant market data in order to check whether the OTC price offered for a client is fair and delivers on best execution obligation.”
While the number of changes to requirements might seem overwhelming, in my opinion a lot of these can be addressed by working with reputable and experienced partners, those that are experienced and can cover these new requirements from all angles and, in turn, provide the fair and completely transparent execution for traders.
For some guidelines on the appropriate questions to ask a potential liquidity provider during the due diligence process, please click here.
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