Regulators around the world have turned up the spotlight on the quality of trade execution. The global financial crisis accelerated change in trading’s technology and market structure, leaving financial authorities facing increasing pressure in strengthening and extending best execution regulations. This is due to a number of trends which developed after 2008, including renewed activism on the part of fund boards and plan sponsors to ensure that investors are receiving the most favorable terms when investment managers trade securities on their behalf.
There has been a clear trend in recent years to provide a more explicit definition of best execution for fixed income trading in order to maximize value for the fiduciary. In the US, FINRA developed guidelines for corporate bonds back in 2008 and the MSRB proposed a set of best execution requirements for municipal bonds in 2013. More recently, regulation in Europe put forward by the EU’s Markets in Financial Instruments Directive 2 (Mifid 2) has been a key driver in the greater focus on best execution. In order to protect the original asset owner, Mifid 2 aims to establish a “safer, sounder, more transparent and responsible financial system in the EU.”
Mifid 1, which came into force in 2007, focused exclusively on equities. A key provision in Mifid 2 is a requirement for investment firms to have best execution policies in place throughout the trading process and across all asset classes including equities, derivatives and fixed income. However, the Mifid 2 requirements faced substantial criticism. Concerns have been raised by a number of industry practitioners that the execution quality criteria merely overlay an equity template of best execution onto the very different market structures of over the counter (OTC) instruments.
It should be stressed that Mifid 2 is not only an issue for firms in the EU. The interconnections among today’s financial markets make this a global issue. There is a strong possibility that global bond fund managers will adopt policies that adhere to the strictest regulatory regime rather than apply differing policies across various markets. In short, managers don’t want the headache and risk of trying to comply with multiple standards.
In order to comply, fund managers will be required to report a policy and process of best execution to their fund clients and regulators. Reporting requirements will focus on quality of execution including cost, price, speed, size and likelihood of execution and settlement. In addition, managers are obliged to make public, for each year, the top five trading venues for each class of financial instrument. The provision also mandates that managers maintain order execution policies, which are customised based on class of financial instrument and contain details of factors used in choosing a trading venue.
One of the greatest challenges presented by Mifid 2’s best execution proposal lies with securities that trade mostly OTC, and in particular, fixed income instruments. Mifid 2 requires investment firms to check “fairness of price” with the help of market data for price estimation and comparison with similar instruments.
The regulatory emphasis on quality of execution has stimulated even greater interest in transaction cost analysis (TCA) as fund managers look to demonstrate best value trading across asset classes. Historically, the OTC nature of fixed income products has left industry participants skeptical about the ability to accurately measure bond trading performance. The crucial issue has been the difficulty in obtaining a high quality benchmark price that can be used as a comparable to measure the performance of trades. The problem is especially acute for less liquid securities, such as emerging market instruments, which can be the riskier part of an overall portfolio.
Given the importance of evidence-based fund management, global bond managers need a compliance tool to report to their clients and the regulators. Many market participants are turning to TCA to monitor trades and ensure they are receiving the best prices, fulfilling regulatory requirements, and satisfying client questions on quality of execution. The demand for transparency and the ‘equitization’ of the fixed income industry has created a shift in focus by investment firms to provide best execution analysis to their plan sponsor clients as well as address questions and concerns from their board of directors.
How are the buyside and sellside managers adapting to the transition? Adopting TCA tools will help them comply with Mifid 2’s best execution rule. Advancements in TCA platforms can provide actionable insight to enhance trading execution, compliance and management reporting capabilities.
Henry Yegerman is a Director at Markit
