Clash of the Titans: Best EX and Transparency Collide Under MiFID II
By George Bollenbacher, Capital Markets Advisors
Originally published on TABB Forum
MiFID II includes both pre-trade transparency and best execution requirements. While commendable, though, these goals may create a very difficult situation for both customers and dealers: If regulators focus on pre-trade transparency, best execution will probably suffer; if they focus on best execution, transparency will probably suffer.
In the rather picaresque story of MiFID II, it often looks as if each requirement has had its own wandering life, evolving independently of everything else in the story. Every once in a while, though, two of these monsters meet unexpectedly, and everyone cowers behind cover, waiting for the fight to the finish. Thus it is with pre-trade transparency and best execution.
Pre-Trade Transparency First
So let’s look at transparency first. Article 3 of MiFIR requires market-makers to “make public current bid and offer prices and the depth of trading interests at those prices … for different types of trading systems including order-book, quote-driven, hybrid and periodic auction trading systems.”
Of course, different instruments trade on different kinds of markets, so we should be mostly concerned with instruments that don’t trade on central limit order books (CLOBs), such as bonds, since CLOB bids and offers are public already. The first thing to understand is that bonds can trade one of two ways: on an ECN, called an organized trading facility (OTF) in MiFID, or direct with a market-maker, which is called a systematic internalizer (SI). In the current world, most ECNs or OTC market-makers operate in a request-for-quote (RFQ) world, where dealer bids and offers are only available upon request.
The general interpretation of the rule language (and there is very little clarification in the various technical standards) is that any quote, bid or offer given by a market-maker to a customer must be available to and actionable by everyone, including other market-makers. (As an aside, ESMA was told early on that this interpretation would likely double the market spreads in affected bonds.)
It has been the long-time practice in all principal markets, including bonds, for market-makers to adjust their bids and offers to reflect their relationship with the counterparty; customers that show the dealer a good flow of business get better markets than occasional customers or competitors. It’s a way of rewarding loyalty in what is essentially an adversarial marketplace.
The pre-trade transparency rule tosses this practice on its head. Except that the practice won’t go away; it will just morph. The expectation is that dealers and customers will evolve a new way of communicating, particularly about off-the-run trades. Instead of asking, “What will you pay for $10,000,000 of this bond?” the customer will say something like, “What do you think I could sell this bond for?”
The dealer, instead of saying, “I’ll pay 98.26,” will say something like, “I think you could get 98.26, if you made a firm offering.” Suppose the customer were to ask, “Will you pay 98.26?” If the dealer responds positively, he has to show that bid to his competitors. Thus the customer must offer at 98.26, and then the dealer can execute without exposing a bid.
Some Implications
Of course, this practice doesn’t apply to CLOBs, such as equities or futures, but it will definitely affect OTC markets and any RFQ ECNs. In Europe, where the trading obligation doesn’t apply to fixed income, that is the market that will be most affected. Even in this market, though, customers who don’t have a relationship with a particular dealer will be shown the same price the dealer would show his competitors. It is only the good customer/dealer relationship that will be impacted.
The first implication is that the trading process will become significantly more cumbersome and time consuming. With everyone going through a language ritual, it will definitely take longer to execute a trade. The second implication is that the buy side is now setting the price instead of the dealer. In off-the-run issues that is a definite change.
Now for Best Execution
And it is in the customer’s setting of the trade price that we encounter the conflict with best execution. Article 27 of MiFID II says, “Member States shall require that investment firms take all sufficient steps to obtain, when executing orders, the best possible result for their clients,” given all the applicable parameters. This requirement applies to both dealers and asset managers, so the buy side now has a positive obligation to obtain the best execution on customer orders.
But the dealer is unable to give the customer his best price, if that price is better than the dealer would show his competitors. The price he suggests may be the best the dealer would do, but there is no guarantee that the dealer would execute there until the customer makes a firm bid or offer. And there is no guarantee that any particular dealer’s quoted price is the best in the market, so the customer may have to go through the same linguistic dance with several dealers, never knowing which one to make a firm bid or offer to.
So we can see that two separate requirements, each perhaps commendable in its own right, will combine to produce a very difficult situation for both customers and dealers. As a result, how this all plays out will depend on how the regulators enforce the rules. If they focus on pre-trade transparency, best execution will probably suffer. If they focus on best execution, transparency will probably suffer. And, if they choose to concentrate on both? Then everyone suffers.