Best Execution Under MiFID II and the Role of Transaction Cost Analysis in the Fixed Income Markets

Fixed income markets are undergoing significant change, both in market structure and liquidity. Impending regulatory reform coupled with an increased focus on greater transparency and efficiency around trading costs are driving demand for performance measurement tools that help investment firms evaluate the quality of their execution and prove best execution, such as Transaction Cost Analysis.

In our latest regulatory-focused webinar, our experts provided an overview of best execution requirements under MiFID II, and explained how Tradeweb’s TCA tools can help the buy-side remain compliant post January 3, 2018.

FCA Thematic Review – 2014 and 2017

The UK’s Financial Conduct Authority (FCA) appears to be leading the charge on best execution. The regulator expects all firms to be aware of enhancements to best execution monitoring, and assess whether they are suitable and proportionate for their business model. Its 2014 Thematic Review generally outlined good practice, but also indicated that the industry struggled to implement best execution requirements.

Little progress has been made since then, according to similar analysis published in March 2017, which showed that investment managers are still failing to ensure effective oversight of best execution. To the FCA’s disappointment, “the pace of change in improving client outcomes in best execution was slow, with few firms having a cohesive strategy for improving client outcomes.”

On the fixed income side, the review found that best execution monitoring was less sophisticated than in equity trading, and that some firms had been known to be more proactive in meeting their obligations than others. The FCA intends to revisit best execution this year, and has stated it will consider appropriate action, if “firms are still not fulfilling their best execution obligations.”

The FCA’s lead on best execution does not preclude other local regulators from taking charge in the future. As the MiFID II dawn breaks, senior managers are being held increasingly more accountable, while the structure of the market is changing. For example, pre-trade price transparency may increase participation, and pre-trade security price data can support compliance with best execution regulation therefore investment firms need to be aware of the new tools available. 

Best execution concept enhanced under MiFID II

Originally introduced under the first Markets in Financial Instruments Directive in 2007, best execution requirements are not a new concept. However, the regulatory reform’s second instalment both enhances and strengthens these obligations by introducing a higher bar for compliance.

Specifically, MiFID investment firms will be required to take all sufficient and not just reasonable steps to obtain the best possible result for their clients. To achieve best execution, firms must now take into account a series of factors including “price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to execution.”

One key aspect of the new rules is that best execution focuses on best possible overall results on a consistent basis, and not just on best price for an individual trade. This will likely involve strengthening of front-office accountability and controls systems to ensure that investment firms’ detection capabilities are able to identify any potential deficiencies.

In order to identify circumstances under which changes or improvements may be appropriate, firms are not only required to monitor execution quality obtained, but also the quality and appropriateness of their execution arrangements and policies on an ex-ante and ex-post basis.

A good example of ex-ante monitoring is ensuring the design and review process of policies is appropriate, while taking into account new services or products offered by the firm. Ex-post monitoring is establishing whether a firm has correctly applied its execution policy, and if client instructions and preferences are effectively passed along the entire execution chain, when using smart order routers or any other means of execution.

It’s also important to note that best execution goes beyond MiFID II – across jurisdictions, regulations, and products. It does not stop at best price and needs to be viewed as a process, i.e. analysing performance over long time horizons and individual transactions.

RTS 27 / RTS 28 reports

MiFID II places unprecedented emphasis on ‘fairness’ and ‘market data’ for OTC products – a distinct departure from its predecessor – which highlights the need to formalise and place rigor around best execution in the OTC space.

Article 64.4 stipulates that investment firms must check ‘fairness’ of price proposed to the client “by gathering market data used in the estimation of the price of such products and, where possible, by comparing with similar or comparable products.” Hence, for fixed income and FX OTC products, it is prudent that firms have access to pre-trade TCA analysis tools that allow them to analyse the fair price for the underlying product or currency.

As of next year, SIs and trading venues – that is RMs, MTFs and OTFs – will need to make quarterly reports available to the public containing data relating to the quality of execution of transactions on that venue. That data will consist of price, costs, speed and likelihood of execution for individual financial instruments. According to the most recent guidelines issued by ESMA, the pan-European securities regulator, the first such report is expected to be published in June 2018, reflecting quality of execution during the first quarter of 2018.

By 30th April 2018, MiFID investment firms will also need to publish an annual report providing information on the top 5 execution venues by trading volumes, where they transacted client orders. 

The Tradeweb TCA approach 

When the original best execution requirements came into force in 2007, Tradeweb developed a series of spreadsheet-based reporting tools to help both traders and compliance officers monitor best execution policies. These tools leveraged data sources available on Tradeweb to provide a series of exception reports for clients to incorporate into their internal processes.

As best execution policies under MiFID I changed, these reports were adapted accordingly. Over time, it became clear that buy-side execution desks were looking for a mechanism that not only helps them satisfy their fiduciary and regulatory obligations, but also enables them to trade more effectively and, as a result, to provide a better, more cost-effective service to their own clients.

Following a series of meetings with our most active clients in early 2014, when the full impact of MiFID II was still unclear, it became apparent that a transposition of an equity-based methodology into the fixed income world would be of limited use. For example, the creation of a volume-weighted average price benchmark would not be relevant in a market where the number of securities is substantially greater, and where many participants trade no more than once or twice a day over a greater range of liquidity conditions.

Clients’ TCA wish list also included the ability to:

• Ensure real-time access via a secure web-based portal
• Calculate a discrete transaction cost for every trade
• Aggregate and customise analysis that caters to specific execution objectives
• Drill down into specific clusters or individual trades to identify areas of improvement or concern
• Undertake all the above using a series of validated and trusted measures

Initially, client demand centred on a post-trade tool feeding pre-trade functionality as a second stage. The base premise of Tradeweb’s post-trade TCA offering is based on two core components:

• First, in order to calculate an accurate transaction cost for each and every trade executed on the platform, we needed to provide a valid reference price, in this case Tradeweb’s real-time proprietary composite. This live bid-offer spread is updated in real time using price feeds from up to 50 liquidity providers across the platform. Using this reference price, we were able to derive transaction costs for 99.8% of cash bond transactions in Europe during the first quarter of this year.

• And second, the nature of electronic executions means that all specifics of the trade, including timestamps and contextual information, can be used to offer deeper analysis into trading activity.

How the Tradeweb TCA tool works

The Tradeweb TCA module is housed within InSite, our dedicated online MIS tool, and can be accessed directly from the Tradeweb Viewer. It is updated in real time as executions take place. All cash and European credit instruments are in scope, which translates to approximately 15,000 bonds in European spread marks and another 3,500 bonds in G10 rates markets.

Users of the applications can view cash and basis point transaction costs, as well as transaction profits or savings for groups of securities. They are also able to determine different views and samples of trading data, whether this relates to specific timeframes, funds or traders.

However, the cash transaction cost can be imprecise when it comes to evaluating execution quality.   Once individual transaction costs are calculated, they need to be taken into context of the relative level of liquidity of the specific security. For example, identical transaction costs for a 10-year Bund vs. a peripheral inflation-linked instrument have different implications.

To address this, we provide a second step of analysis that allows clients to monitor these execution costs, not just in absolute terms, but as a percentage of the bid-offer spread. Using this measure, users can effectively compare relative performance, not only across different sectors, but also through a number of other variables, including the time of day, size, and trading protocol among others. As we add additional execution options on the platform, our TCA tool is updated to take these into account.

A third level of analysis uses this same percentage of bid-offer spread measure to provide comparison against a peer group. Delivered within the same interface, customers are able to derive, on a quarterly basis, those areas where they outperform or underperform vs. their peer group.

Again, users can benefit from the various views and filters to cut and slice data for a more granular understanding affecting relative execution costs. Within each dataset, minimum sample sizes apply to ensure the relevance of the analysis.

A trading venue-agnostic tool

One of the key pieces of feedback we received over the last year was that, although the TCA functionality worked well for orders traded electronically, the market lacked a solution covering all activity, regardless of execution venue.

We have addressed this requirement in two ways:

• First, by integrating our process trade functionality directly into the TCA tool. As a result, terms negotiated off venue and then processed on the MTF are seamlessly included in the analysis.

• Second, by allowing customers to upload trades executed off Tradeweb. As with process trades, these transactions can be included in the generic TCA interface, but remain clearly identifiable to facilitate separate analysis.

The compliance application

Whilst the development of TCA initially focused on the trading application, it has become increasingly important to tailor analysis to compliance functions. This means the ability to undertake a systematic review of trades that fall outside of best execution policies and adapt accordingly. The Trade manager function within the Tradeweb TCA tool has been built to specifically cater to this function and the requirements of compliance teams.

More specifically, users can drill down on each dataset within the application to return a list of all transactions within the sample. From here, trades can be annotated and exported into their own systems accordingly. Within the Interface, compliance officers at investment firms are able to both search for observations falling outside certain parameters, such as not trading at the best price or outside the Tradeweb composite, or configure and save rules based on their defined best execution policies. This in turn alerts users to outliers warranting further investigation.

Expanding the TCA capability

We believe the processes of pre- and post-trade analysis to be linked with the process of execution itself. The aim is to combine historical post-trade analysis and overlay this with real-time data, to determine the optimal strategy for execution desks.

Before deploying our pre-trade TCA tool, product enhancements will involve these two main areas:

• Expansion of asset class coverage beyond cash bonds to include interest rate and credit default swaps, and ETFs, by the end of the year. The development of the IRS and CDS modules also allows us to leverage some of the post-trade SEF data available through the swaps data repositories, in order to provide additional metrics and context for each trade.  This will mean not only having a benchmark at the point of trade, but also the ability to compare to execution in the same contract in the wider market.

• When MiFID II arrives next year, these additional pre-and post-trade data sources will be incorporated into the post –trade TCA tool to offer additional colour and context.   

At Tradeweb, we are already developing a series of pre-trade liquidity monitors that will combine historical execution activity including historical trades, transaction costs and hit rates with real-time axes, pricing and additional liquidity measures to deliver in one place all the information required by execution desks.

For example, traders looking to buy or sell a specific credit security will be able to overlay historical trading activity from across the whole of his desk with associated transaction costs, composite pricing and customised axes sent from dealers’ inventory. They will then be able to determine not only how and when to execute, but also what the expected target price should be.

And as with post-trade TCA, we will be providing additional context surrounding executions in the wider market, so that these execution decisions can be informed based on the availability of post-trade transparency.

The use of data to aid, inform, justify and refine the trading process will become increasingly important, as the transparency threshold is lowered and trading desks have more data at their disposal. We believe that electronic trading platforms are well placed to provide this kind of analysis.

Meeting the new best execution obligation

The developments in the pre-trade analysis of our TCA tool will address the best execution monitoring requirements under MiFID II. And more broadly, for fixed income and certain OTC products it will be necessary for firms to have access to pre-trade TCA analysis tools that allow them to analyse the fair price of the underlying product. MiFID II may seem to present a best execution challenge, but also provides an opportunity where firms can differentiate themselves in providing excellence in execution and client service.

As a world leader in building and operating electronic OTC marketplaces for nearly 20 years, Tradeweb has both the required market expertise and quality of data to offer compliance officers more data to review, audit and adapt best execution policies.