MiFID II/MiFIR: Best Execution. A Framework for Implementation

Transcription

1 MiFID II/MiFIR: Best Execution A Framework for Implementation September 30, 2016

2 CONTENTS 1 Introduction 1 2 Best Execution according to the MiFID Review 3 Execution Quality Reports 3 4 Changes to the Trading Work ow How the Relationship with the Client will change 7 6 e Importance of Record-keeping 7 7 Implementation Framework 8 8 How Synechron can help 11

3 Best Execution - A Framework for Implementation 1 Introduction It is di cult to assess the e ectiveness of new concepts or new ways of working imposed by regulation until the reaction of the market that can be gauged. ere is a constant tug-of-war between regulators thinking up new rules and concepts, and the nancial services industry trying to nd a way around them. It may hit the pause button at times, but it seldom ends. MiFID I de nes best execution as 'the best possible outcome for the client'. is represented a move away from the equation: best execution = best price. It also introduced the concept of multiple venues and gave clients the possibility or opportunity to query a nancial institution's quality of execution for ve years after the actual transaction took place. e changes to best execution introduced by the MiFID Review are partly due to market reaction to the Best Execution rules after MiFID I and partly to the extension of the scope to non-equity instruments. It will be interesting to see how the market reacts to them and to all the other new concepts introduced by MiFID II/MiFIR after the planned introduction in January is paper looks at the changes in the concept of Best Execution and what needs to be considered when devising an implementation strategy. 1

4 Figure 1 below represents a high level representation of MiFID ows. Distribution Network/ Advisors Product Governance (**) Research & (++) Inducements Admission to trading Stored by the trading venue to be made available on request Client Order Investment Firm Order Execution Trading Venue Order Book Pre-Trade tr. Post-Trade tr. Exec. Quality Report (Yearly) Exec. Quality Report (Quarterly) Client details Transaction Reporting Recordkeeping Home Competent Authority Stored by the investment rm to be made available on request Figure. 1 (**) Client to investment rm - Direct contact or direct enquiry Investment rm to client - Marketing, promotion of services and/or cross-selling (++) is is a relationship between buy-side and sell-side. erefore, it involves two investment rms. is chart does not include commodity trading. 2

5 Best Execution - A Framework for Implementation Total Cost of Transaction Choice of multiple execution venues Figure 2 - Principles of Best Exection 2 Best Execution according to the MiFID Review MiFID II/MiFIR moves away from the best possible outcome for the client and introduces four pillars to the concept of Best Execution: a) Price b) Total Cost of Execution c) Speed of Execution As in the time elapsed between the execution venue receiving the order to be executed and the actual execution taking place. d) Likelihood of Execution how likely is it that the order will be executed in that venue. Best Execution will be determined by most advantageous combination of those four factors. When a trader has to choose from multiple execution venues it will not be just about price. Moreover, once a year a nancial institution will have to report to its clients how it has monitored all the factors ensuring Best Execution (Execution Quality Report for Financial Institution). e MiFID Review also includes two reports that aim to demonstrate the quality of the execution. ey are both called execution quality reports but have di erent layouts. One is the responsibility of the execution venue and sent quarterly to their members / clients while the other is aimed at the clients of a nancial institution and is an annual summary. ese two reports have to be prepared by ISIN code and they show execution information for the top ve execution venues used to trade the instrument with that speci c ISIN code. is is an indirect check that multiple execution venues use whenever possible. Execution Quality Reports will be discussed in Section 3 below. 3

6 3 Execution Quality Reports We start with Execution Quality Reports as they dictate a large part of the implementation requirement for Best Execution and for an even larger part of data capture requirements. 3.1 Execution Quality Reports for Execution Venues ese reports need to be compiled by Trading Venues [Regulated Markets (RM), Multiple Trading Facilities (MTF), Organised Trading Facilities (OTF)], Systematic Internalisers (SI), Market Makers, Liquidity Providers and other execution venues. Although a sell side company is considered the execution venue by a buy-side rm, a sell-side company does not necessarily have to prepare an Execution Quality Report unless it is an OTF, an SI, a market maker or a liquidity provider. e report consists of nine tables that are supposed to provide the clients / members of a speci c execution venue with details of how orders have been executed. ey are: 1. Type of execution venue 2. Type of nancial instrument 3. Intraday price information 4. Daily information 5. Costs information 6. Likelihood of execution information 7. Likelihood of execution (additional information for continuous auction order book and continuous quote driven execution venues) 8. Information related to continuous auction order book and continuous quote driven execution venues (other than likelihood of execution) 9. An order transmitted for execution under Request For Quote (RFQ) method may need additional information. is report is sent quarterly to nancial institutions. Everything is reported by execution venue and nancial instrument. 4

7 Best Execution - A Framework for Implementation 3.2 Execution Quality Report for Financial Institution is report is due once a year to all clients of a nancial institution. It is one of the reports that has to be provided by every nancial institution engaged in trading nancial instruments on behalf of clients. is is reported by asset class. It is less detailed then the previous report. It has three separate tables that report the volume of trades and number of orders for the top ve execution venues by class of instrument. 1. Orders executed on behalf of professional clients 2. Orders executed on behalf of retail clients 3. Orders executed as part of Security Financing Transactions e classes of instruments are de ned by ESMA as - (a) Equities Receipts Shares & Depositary i. Tick size liquidity bands 5 and 6 (from 2000 trades per day) ii. Tick size liquidity bands 3 and 4 (from 80 to 1999 trades per day) iii. Tick size liquidity band 1 and 2 (from 0 to 79 trades per day) (b) Debt Instruments i. Bonds ii. Money Markets (c) Interest Rate Derivatives i. Futures and options admitted to trading on a trading venue ii. Swaps, forwards and other interest rates derivatives (d) Credit Derivatives i. Futures and options admitted to trading on a trading venue ii. Other credit derivatives (e) Currency Derivatives i. Futures and options admitted to trading on a trading venue ii. Swaps, forwards, and other currency derivatives (f) Structured Finance Instruments (g) Equity Derivatives i. Options and Futures admitted to trading on a trading venue ii. Swaps and other equity derivatives (h) Securitised Derivatives i. Warrants and Certi cate Derivatives ii. Other securitised derivatives (i) Commodity Derivatives and Emission Allowances Derivatives i. Options and Futures admitted to trading on a trading venue ii. Other commodities derivatives and emission allowances derivatives (j) Contracts for di erences (k) Exchange traded products (Exchange traded funds, exchange traded notes and exchange traded commodities) (l) Emission allowances (m) Other instruments Last but not the least, an actual report that should include: 1) an explanation of the relative importance the rm gave to the execution factors of price, costs, speed, likelihood of execution or any other consideration including qualitative factors when assessing the quality of execution; 2) a description of any close links, con icts of interests and common ownerships with respect to any execution venues used to execute orders; 3) a description of any speci c arrangements with any execution venues regarding payments made or received, discounts, rebates or nonmonetary bene ts received; 4) an explanation of the factors that led to a change in the list of execution venues listed in the rm s execution policy, if such a change occurred; 5) an explanation of how order execution di ers according to client categorisation, where the rm treats categories of clients di erently and where it may a ect the order execution arrangements; 6) an explanation of whether other criteria were given precedence over immediate price and cost when executing retail client orders and how these other criteria were instrumental in delivering the best possible result in terms of the total consideration to the client; 7) an explanation of how the investment rm has used any data or tools relating to the quality of execution, including the venue Execution Quality Report; 8) where applicable, an explanation of how the investment rm has used output of a consolidated tape provider. ¹ Liquidity Provider is a very vague term. It is likely that the European Commission has kept it intentionally vague to 'future proof' MiFID II and MiFIR. It is possible that this concept will be clari ed in the Question and Answer papers usually published after the directive and the regulations are all nalised and the approval process is completed. ² e other reports is a daily transaction report. Orders record have to be kept available in case the National Competent Authority requests them so, in a way, this is also another report associated to trading nancial instruments on behalf of clients. 5

8 4 Changes to the Trading Work ow MiFID II/MiFIR has de ned best execution in a considerably more detailed way. is implies some changes to the trading work ow. e following is a high level overview of those changes according to the relevant nancial instrument. 4.1 Equity Trades Equity trades are already subject to MiFID I Best Execution rules. It might look like an evolution, but it is actually more like a 'revolution'. Changes to the rules means that a vague 'best possible outcome for the client' has been changed to a set of very speci c criteria (see Section 2 above). ose criteria and the requirements for the 'Execution Quality Report' means that, as a minimum, a front o ce system would have to show quotes and total transaction costs for at least ve venues and ideally, give an indication of the other two criteria: speed of execution and likelihood of execution. Once a year, any 'special relationship' with the execution venue will also have to be reported. Examples of this relationship could be: 1) Ownership 2) Inducement received by the execution venues (e.g. free research, some forms of corporate entertainment) 3) e need to reach certain targets to secure volume discounts Whilst only quotes and total transaction cost may appear on a front o ce system, the other information is also relevant. Data received by the execution venues and provided in their quality report (see Section 3.1 above) should also nd its way to the trader that is deciding how to execute an order. e main change, however, will be in executing large trades and executing trades in a way that does not immediately a ect the price. Dark trading and block trading will have to be executed in the environment of an exchange and are subject to limitations (e.g. double cap in negotiated trades). 4.2 Bonds Bonds deserve a section of their own because they are the only instrument not subject to the 'obligation to trade on exchange' if they are 'liquidy enough'. Also, there is still a lot of bond voice trading and this needs to be re-assessed not just for Best Execution purposes. Reporting, record-keeping and Best Execution requirements necessitate information capture and precise date and time stamps. is could be unnecessarily complex to achieve in a voice trading environment. e same considerations discussed above for Equities also apply. 6

9 Best Execution - A Framework for Implementation 4.3 All other Financial Instruments Equity-like instruments (e.g. ETFs) and Derivatives will be subject to Best Execution under MiFID II. ey will be subject to an 'obligation to trade on exchange' if they are liquid. We shall have to wait to assess how the markets respond to MiFID II to see how many of those can be traded on multiple exchanges and therefore how pragmatically relevant some of the 'choices' will be. ey may run the risk of providing a choice from only one possibility and therefore hardly a choice at all. One must remember, however, that any institution currently operating an electronic platform to trade a speci c nancial instrument (other than shares) may end up having to register as an Organised Trading Facility and therefore becoming a trading venue. is does provide a choice. In any case, trades are subject to Best Execution and record-keeping. Reporting requirements will also provide an idea of what needs to be captured and when. ese instruments belong to asset classes that are also subject to EMIR rules. EMIR reporting requirements are di erent in format and logic. 4.4 Transmitted Orders Firms that pass their order on for execution to another broker will have an opportunity to discuss their relationship with the broker. Although the details of the order are simply passed on for execution to another broker there is an interesting 'dance' of responsibilities and liabilities. For instance, A client instructs Broker A to buy an OTC contract that is being traded at the London Metal Exchange (LME) and Broker A is not a member of the LME, they pass on (transmit) the trade to Broker B for execution. Broker B does not have a relationship with the ultimate client so they rely on Broker A to send all the necessary information on the order. MiFID has a list of essential information to be transmitted. Broker A is the client of Broker B, but retains the liability for the accuracy of data because Broker B simply has to pass on the information received and then reports back with the information integrated into the execution details. Broker B has duties of Best Execution for Broker A. Broker A is only liable for the accuracy of the data and for the ultimate relationship with the client. is can be slightly more complex if Broker A is in a di erent jurisdiction. In relation to implementing MiFID the basic principles are as described above. 5 How the Relationship with the Client will change What changes in the interaction between Client and Firm? interaction with the client will have to change, because : 1) It will not be enough to show a list of venues. A minimum of ve will need to be supplied. At the end of the year the client will have to be advised of the relevant importance of each venue and the monitoring methods for the quality of execution. 2) e scope has been extended beyond cash equities. A client sending orders for bonds and derivatives will now have to go through an onboarding process that includes a suitability test. e Execution Quality Report (see section 3.2 above) could represent an interesting moment for interaction with the client because it also has to be sent to those with an 'execution only' relationship. Clients now will have one opportunity a year to discuss the quality of execution. Clients that used rms just to execute their nonequity orders will have to undergo a 'suitability assessment' before any of their orders can be executed. e 6 e Importance of Record-keeping One of the basic principle of Best Execution according to MiFID II/MiFIR is that a client has up to ve years from the date of execution to question the 'quality' of a speci c transaction. e requirements to keep the information relating to the trade and 'the environment of the trade' for ve years makes it possible to discuss a trade up to ve years after it happened and re-assess its quality. e de nition of Best Execution based on the criteria discussed in section 2 makes it easier to go through this exercise than the vague de nition of 'best possible outcome for the client' of MiFID I. e extension of the scope to non-equity under MiFID II/MiFIR means that information on the underlying instruments will also have to be kept depending on what is traded. is produces a higher level of complexity than storing the environment of the trade of a cash instrument (shares and bonds). is and the clear de nition of Best Execution are the two main reason why a MiFID I record-keeping solution cannot just be 'transported' into a MiFID II environment. A radical review of the record-keeping process is essential. 7

10 7 Implementation Framework One of the basic principle of Best Execution does not exist in isolation. You will end up looking at your front o ce system, your data landscape, your reporting, and also how you are managing technology risk. All of this will either in uence or be in uenced by the choices you make. Building the framework to implement best execution depends on the nancial instruments traded on behalf of clients, how they are traded, whether the institution is a market maker, has sought authorisation to operate as a Systematic Internaliser (SI), an Organised Trading Facility (OTF), and, last but not least, where they trade. Synechron has developed a consolidated approach to tailor any regulatory change to the speci cs of a nancial institution. 7.1 Synechron ICAL Method You need to take a step back and de ne the high level environment of any regulatory change project before you start examining any detail. For instance, implementing Best Execution has to start from client classi cation. Financial rms that do not deal in equities may not have classi ed their clients according to the requirements of MiFID I ( ey did not have to); those that deal in equity may have to review their classi cation in the light of changes to criteria introduced by MiFID II/MiFIR. In any case, the environment of any regulatory change project depend on four factors : 1) Instrument traded 2) Clients How are they classi ed? Where are they based? How do you communicate with them (do you receive their orders electronically, through phone calls, etc.) 3) Authorisation - Are you authorised (or do you plan to apply for authorisation) as a trading platform (MTF, OTF) or a Systematic Internaliser (SI) for each asset class you trade? Are you a market maker in a speci c instrument? is will have implications on how you execute your trades, what other regulatory obligations you might have and the shape of the work ows associated with the execution of an order to trade a nancial instrument on behalf of a client. 4) Location Are you going to execute your trades on or o exchange? If on exchange, is it in the MiFID area ( e Single Market in Financial Services SMF?) Do you trade in a way that does not a ect immediate price formation (e.g. block trading or negotiated trades)? 8

11 Best Execution - A Framework for Implementation 7.2 Generic Best Execution work ow Client Order Choice of venue Execution Reporting Classi cation Suitability Check if instrument admitted to trading Check if obligation to trade on exchange Directed Order? Large in scale or negotiated trade? OTC O -Venue On Venue O Venue OTC Voice Auction Execution Venue, execution quality report (Quarterly) Investment Firm, execution quality report (Yearly) Record-keeping (*) Only Best Execution related reports and record-keeping activities are included in this diagram Figure 3 - Generic Best Execution Work ow Synechron ICAL approach can be used to tailor this work ow, for instance: 1) Clients: a. Client classi cation - Financial institutions that deal in Cash equities will have to review the principles they use as MiFID II/MiFIR slightly changes the criteria to classify a client as professional and introduces a sub-group of professional clients that will not be allowed to transact high-risk nancial instruments (e.g. local authority or pension fund). Investment rms that transact any other nancial instruments (and not in cash equities) will have to classify their clients for their rst time. b. At the moment, a suitability assessment has to happen only for clients of cash equities. It will have to be applied to clients dealing in bonds and any other nancial instruments. 2) Orders: a. Check if the instrument is admitted to trading - ESMA has a database of all instruments admitted to trading on an exchange. b. Check if there is an obligation to trade on exchange - ere is an obligation to trade on exchange liquid instruments that are admitted to trading on exchange. Bonds are the only exceptions. e database mentioned in point (a) above includes a 'liquid' ag. If an instrument is not considered liquid, there is no obligation to trade on exchange. c. Directed orders are basically 'execution only'. If the investment company simply receives the order and sends it to the execution venue chosen by the client without any adjustment, change or any action on the order itself, that order is not subject to best execution. d. Large in scale or negotiated trades - (Block trades or principal crossing) ese trades enjoy an exemption from post trade transparency and have to happen in the environment of an organised exchange (RM, MTF or OTF). 3) Choice of venue: a. Traded to be executed on exchange - One of the basic principles introduced by MiFID is the choice of execution venues for any given order. e 'best' execution venue will be the one where the best combination of the four 'pillars' of Best Execution can be achieved. is is a process that will have to be described as part of the annual Execution Quality Report that rms will have to send to their clients. erefore it is important to have a process in place to review the execution venues available on the market and monitor how each broker or trader chooses the execution venue for each trade. b. Traded to be executed o -venue - Illiquid instruments can be traded o venue and bonds can be traded o venue. Large in scale trades and negotiated trades may enjoy a posttrade transparency exemption. c. OTC Instruments not admitted to trading and ad-hoc contracts created to meet a client's speci c needs will be traded OTC. 4) Execution: 5) Reporting (See also section 3 above): a. Venue Execution Quality Report - is is a quarterly report for execution venues, in other words Organised Exchanges (RM, MTF, OTF and SI), market makers and liquidity providers. It is a report for organised exchanges and speci c sell side companies. It must be sent to client/members once a quarter. b. Firm Execution Quality Report Annual report that every regulated investment rm has to send to its clients. 9

12 7.3 Framework for Implementation Software Data Best Execution Implementation Framework Work ows Governance & Strategy Figure 4 - Components of a framework to implement Best Execution Governance and strategic choices Do you operate a trading platform where clients can trade? If that is the case, you may seek authorisation to become an Organised Trading Facility for that speci c asset class or nancial instrument. Do you operate a proprietory desk? If that is the case, you may seek authorisation to become a Systematic Internaliser for that speci c nancial instrument. Are you a market maker? Do you meet the criteria to be considered a 'liquidity provider'? Do you execute your client's orders in venues outside the Single Market in Financial Service area? (MiFID II/MiFIR applies to the EU and the EEA). e answers to all those questions bear some in uences on what you have to implement and not just in terms of best execution. Your reporting obligations are also a ected. A buy-side company has a slightly less complex issue as the questions listed above are not relevant to them, but in any case they will have to review their client classi cation processes and make sure that they have a process to monitor the component of Best Execution for the annual Execution Quality report to their clients Data e execution of nancial trades carries regulatory obligations. Normally, one talks about 'orders' before the trade is executed and 'transactions' after the trade is executed. A consolidated approach to data analysis will consider all the reporting and processing obligations associated to the life of an order, so looking at: Data included in the order Recordkeeping obligation for an execution venue (they will also dictate the information you have to receive from a client). Data to include in a transaction report (daily reporting. Not part of best execution but, again, they will dictate the information you have to receive from a client). Data to include in a post-trade transparency report (if relevant, you will have established that using Synechron's ICAL approach). Data that allows you to prepare one or both of the execution quality reports (depending whether you are an execution venue). It is better to take a consolidated approach to this data analysis. e regulator requirements are fairly detailed. ere are a number of static or reference data elds that are common to all those reports and also feature in other regulatory requirements Work ows You need to de ne the following work ows : Any ow to capture the data item you have established you need to capture. How are you going to allow traders to choose between trading venues? Where will you display the information? How are you going to monitor the market to establish whether new venues execution venues are becoming available? How are you going to monitor the component of best execution? Section 3.2 gives you an idea of the annual report you have to attach to the Execution Quality Report that you have to send to your clients once a year. How are you going to ensure that you have the work ow in place to be able to provide this information? Will your front o ce system be able to accommodate the additional detail required? Will your trading platform be able to capture the information that is required for your best execution compliance?³ Software Essentially a change/build/buy choice. In reality, you need to assess the solution that minimises the technology risk. is is not just for the sake of minimising operational risk or building a secure environment. If you are an execution venue, you have to report every three months any downtime. is has to be included in your execution quality report. You may want to look at any legacy system that provides input to your front and/or middle o ce system and assess its level of documentation, reliability, etc. You may end up including those in your implementation e ort. Actually, as you are looking at that issue you might just consider the information that needs to be captured for other reporting requirements such as transaction reporting and post-trade transparency (if relevant to you). 10

13 Best Execution - A Framework for Implementation 8 How Synechron can help Our Subject Matter Experts (SMEs) can assist in choosing the appropriate response and solutions to regulatory requirements. e impact of regulation can have far-reaching consequences and at a minimum requires the translation of requirements into a comprehensive project plan. We provide the sta and expertise needed to implement & integrate changes into the business. Regulatory Advisory Service Create Regulatory Strategy & Programme for your organisation Provide regulatory research, analysis & white papers Apply regulatory Intelligence / Accelerators Inform of Regulatory events & announcements Create Regulatory Playbook for your organisation Assist in providing targeted decisions Produce Board level reports Create regulatory timelines Our Regulatory Advisory Service provides a comprehensive review of all the new regulations a ecting our clients. We take a step back and look at all your regulation related obligations and their relevant timelines. We then consider your current business and its strategy for the future. We may suggest changes to that strategy depending on any new factors introduced by the regulation(s) considered. Analyse the target Translate into approach Implement the solution Embed & ne tune Advisory Advise programme board on overall strategic direction as well as speci c issues and risks Program Management Manage the program: Plan & monitor completion of deliverables and meeting the milestones. Ensure stakeholder buy-in and report to Steerco Project Support: Produce reports, support the programme, monitor issues, risks, actions Impact & Business analysis Data gathering, impact assessment, and reponsible for workstream deliverables Business change Rollout planning, business readiness, communication, work instructions, process ows Technology change Technical design, advise on technical and infrastructural matters, development, testing Training Ensure that the organisation understands the key requirements of the regulation by conducting workshops, regulatory updates and insights, implications to di erent areas of the business Quality Assurance Review Review and assess the quality of project management deliverables relating to the new regulation. Identify and raise any loopholes in the project Fast track your regulatory change Regulation Analysis Governance Rules Impact Identi cation Regulatory ICAL* Reporting Implications Synechron Consolidated Reporting Framework (CRR) Strategy *(ICAL: Instruments, Channels, Authorisations, Locations) 11

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