The following was contributed by Tom Healey, Founder-Director of FINXIS
In ICMA’s MiFID II Consolidated Tape Task Force Report, published in April 2020,[i] the Task Force made it clear that while MiFID II accomplished many goals it failed to achieve the market transparency that regulators had envisioned. This statement echoed comments by Steven Maijoor, ESMA Chair, when he said: “Transparency is important to ensure that markets are fair, sound and efficient. However, after nearly two years of operating under MIFID II, we are still lacking a reliable view of liquidity across the EU.”[ii] By most measures, MiFID II cost the industry over $2 billion, but it’s still a regulation trying to reach its goals.
The industry pointed to the lack of quality aggregated data as one of the major reasons MiFID II did not achieve its transparency objectives, and data costs actually escalated for many firms that needed data to comply with best execution policies. Anyone trying to access MiFID II APA data and RTS27/28 reports published by investment firms discovered how difficult it was to locate, access, and aggregate data across venues, dealers, and service providers. Given the expectation that trading would move to exchanges, MTFs, and OTFs, it was probably a little surprising that over 80% of the participants in the Task Force said MiFID II had no impact on their trade execution processes.
After years of researching the need, impact, and cost of a consolidated tape (“CT”) for the European equity markets, ESMA finally seems ready to move forward for both equities and non-equity products. The objective appears clearer now than before: aggregate MiFID Level I data and make it available to the market in a standardized machine readable format that market participants can consume for a reasonable fee.
One of the key benefits as noted by the Task Force is reaching more accurate assessments of execution quality. The report states: “A post-trade CT can be used for transaction cost analysis and best execution assessments, as it provides a neutral and reliable source of current market trading activity against which to reference execution quality. Evidencing best execution is also generally a compliance requirement, where again the existence of a CT could support observance.” So, will a CT just assist with best execution analysis or can it also improve execution? While a CT will provide the market with a better and more consistent data set that increases post-trade transparency, it’s impact on pre-trade decision making for best execution, especially in the corporate bond market where only a small portion of bonds are actually being traded on a daily basis, is less clear.
The Task Force understood the challenges to both achieving best execution and proving it when it noted: “Mandatory consumption of post-trade execution data does not equal ‘best execution’. Proving best execution (or ‘achieving the best possible result for customers when executing their orders via execution venues or OTC’) should not be overly simplified to observing just post-trade pricing. The best execution process is a complex matrix of pre-trade decision making and tools and much more than execution ‘prices.’”
Under MiFID I, Article 21, Best Execution, firms are required to “take all reasonable steps to obtain, when executing orders, the best possible result for their clients…” and demonstrate to clients when requested, that their order was within its execution policy. But, under MiFID II, best execution is more complicated. MiFID II now requires firms to take all “sufficient” steps instead of just “reasonable” steps, and added additional reporting requirements for firms to publish quarterly execution quality reports (RTS27) and annual top five execution venues (RTS28). It seems that RTS27/28 reports were even less useful than APA data. Over 90% of the respondents indicated the public’s interest in viewing RTS27/28 reports as low, very low, and of no interest at all. This was likely not because clients don’t care, but more because they had little interest in sorting through the data and trying to figure out how it relates to the trades they did three months or a year ago.
As a model of comparison, the Task Force considered many aspects of the U.S. TRACE system including covered asset classes, reporting frequency, governance, and rollout. The benefits of TRACE are evident and supported in many studies that show a significant reduction in transaction costs.
Whether TRACE is a good comparison to the E.U. or not is debatable, especially because of differences in market structure and how TRACE was introduced to the U.S. market. In an article from “The Desk” by Lynn Strongin Dodds,[iii] Joe Grochan of MarketAxess makes the point that “…TRACE segmented the release of information by market, while MiFID II is segmented by liquidity classifications. This is an important difference because firms tend to be structured by market. ‘From a cost benefit point of view, firms would prefer 100% of one market versus 5% of all markets.'”
Practitioners of best execution analysis prefer to view best execution as a framework of policies, rules, and processes that are affected by market structure and data. Whether an order received best execution cannot be measured against a single price or process, and a firm’s best execution performance cannot be evaluated based on a single order. It is essential to analyze pre- and post-trade market conditions to understand all the options available to a trader when executing an order if the firm is to determine if that trader took sufficient steps to get the best execution. While individual actions on a specific order may violate internal compliance requirements, they may not break the firm’s published best execution policy, which is harder to prove and in most cases exempts the firm from guaranteeing best execution on any specific order.
In “The Law and Economics of Best Execution,”[iv] Macey and O’Hara propose that given the contractual nature of best execution and no explicit contract (assuming the client did not direct the dealer where and how to execute), if the firm can’t analyze every aspect of how the dealer executed the order ex ante, then the client is entitled to the “hypothetical bargain,” the execution that both parties would have agreed upon if both parties had access to the same information.
Some studies note that TRACE lowered transaction costs by up to 50%, but while CT, like TRACE, will provide more transparency it is not a guarantee of best execution. As an example, TRACE wasn’t able to provide sufficient transparency to eliminate the disadvantages that some traders experience. In a 2015 study by O’Hara, Wang, and Zhou,[v] well after TRACE was implemented, their data analysis of U.S. insurance companies’ trading in bonds showed that, “for the same bond, same day and same dealer, less active traders receive worse executions than active traders, paying 0.49% more for buys and receiving 1.78% less for sells.” Which begs the question, as the authors pointed out, if essentially the same trades are not getting essentially the same execution quality, then what exactly does best execution in the fixed-income market mean?
The other important impact that TRACE has on the market is the availability of larger and more complete data sets that are now widely used for research and analytics. Availability of enhanced TRACE data that includes buy-sell indicators, size, and client type is still delayed by 18 months. Clients may never have the same access to the real-time pre- and post-trade data that the dealers have, but the buy-side can level the playing field using reference prices, fair value marks, and analytics that benchmark and compare dealers’ executions.
A recent study by Guo, Lehalle, and Xu[vi] set out to establish a benchmark for TCA in bond trading for retail investors. Their analysis used enhanced TRACE data and regression analysis to identify price impact asymmetry between buys and sells. With a more consistent data set and more powerful analytics tools clients will be able to construct their own TCA benchmarks and gain greater leverage when selecting dealers. Many studies have proposed standardized benchmarks and while this may sound good it may limit dealers’ ability to change and innovate their processes. The LSE said it best, “The current flexibility for investment firms to determine their best execution policies allows them to identify and interact with the most suitable source of liquidity to fulfil these aims, looking across the range of best execution factors, which include not only price, but also elements such as volume, fees and efficiency.”i
Where best execution will improve the most is when it becomes a competitive strategy for dealers. Regulation and compliance are one thing, but business performance is something else, as the airline industry knows all too well. Departure delays and passenger rights define wide boundaries, but passengers and the airlines know that actual performance matters the most. As Shapiro pointed out in “Best Execution: Life After Compliance,”[vii] “Merely satisfying the rules and not taking advantage of the information they provide is not doing your company justice. Firms have an opportunity to use the data developed to enhance their internal performance measures, marketing, and sales efforts, and to expand their competitive and industry-related analysis. If firms are not actively questioning their performance versus their competitors today, they will shortly when they realize that clients and competitors are using their lack of knowledge against them.”
Beyond lower transaction costs and improved transparency, what might the impact of a consolidated tape be? After TRACE was introduced one study noted that some dealers’ revenue dropped by 30%. Lynn Strongin Dodds articleiii, also pointed to a 2013 Massachusetts Institute of Technology study, The Effects of Mandatory Transparency in Financial Market Design, found that trading activity in the U.S. corporate bond market was reduced, especially among already illiquid high yield bonds. They reported a 41.3% slide based on volume/issue size, against 15.2% across all bonds. Other criticisms include the steady migration to agency from principal trading since its inception.
If the impact that TRACE has had on the U.S. corporate bond markets is an indication, the European market CT will have significant changes coming: 1) The additional transparency afforded by the CT will significantly reduce overall transaction costs; 2) Industry profits will decline and many smaller tier 2 and 3 dealers will not be able to survive; and 3) Corporate bond desks will reduce trader and sales head counts as even more trading will move to an agency/riskless model.
From the perspective of improving best execution, a common data set with analytical benchmarks should give investors a better tool when comparing dealers and execution platforms. The data and analytics required to comply with best execution are well suited to redefine a firm’s strategy to lower costs, improve processes, and gain market share. Forward looking firms should prepare for the potential shock to their business and build new strategies to deal with the wave of market challenges ahead.
Tom Healey is the Founder-Director of FINXIS LLC, a boutique research and consulting firm based in New York.
[i] “EU Consolidated Tape for Bond Markets Final report for the European Commission”. ICMA MiFID II Consolidated Tape Taskforce, April 2020.
[ii] “ESMA Recommends Real-Time Consolidated Tape for Equity”. ESMA News, 5 December 2019.
[iii] “The Utopia of the Consolidated Fixed Income Tape.” Lynn Strongin Dodds, The Desk, 21 March 2018.
[iv] “The Law and Economics of Best Execution”, Jonathan R. Macey and Maureen O’Hara, Journal of Financial Intermediation, 7 October 1996.
[v] “The Best Execution of Corporate Bonds”, Maureen O’Hara, Yihui Wang, Xing Zhou, The Journal of Trading, October 2015.
[vi] “Stylized Facts on Price Formation on Corporate Bonds and Best Execution Analysis”. Xin Guo, Charles-Albert Lehalle, Renyuan Xu, March 21, 2019.
[vii] “Best Execution: Life After Compliance”, Alan Shapiro, Transaction Performance, Spring 2002.
The views represented in this commentary are those of its author and do not reflect the opinion of Traders Magazine, Markets Media Group or its staff. Traders Magazine welcomes reader feedback on this column and on all issues relevant to the institutional trading community.