Analysing execution quality for over-the-counter (OTC) trades can be challenging. The absence of immediate comparable pricing information, coupled with an overall lack of transparency, is usually cited as one of the main factors towards the low adoption of transaction cost analysis (TCA) among market practitioners. MiFID II will change this picture, as it requires instruments traded both on- and off- market to be subject to best execution obligations. In fact, the list of instrument categories subject to best execution obligations under MiFID II includes many securities where OTC trading is either the main or exclusive form of trading, including:
- debt instruments (including bonds and money market instruments)
- interest rate derivatives (including futures and options, swaps and forwards)
- credit derivatives (including futures and options)
- currency derivatives (including futures and options, swaps and forwards)
- structured finance instruments
- equity derivatives (including swaps, futures and options)
- securitized derivatives (including warrants and certificates derivatives)
- commodity derivatives (including futures and options)
- contracts for difference
- exchange traded products (including exchange traded funds, exchange traded notes and exchange traded commodities)
- emission allowances
Fair value versus execution prices
One of the key challenges when demonstrating best execution on OTC instruments is gathering market data. Investment firms need market data to demonstrate the fairness of prices for their trades. The data needs required for such comparisons vary according to the instrument category being analysed, but typically include inputs required for price estimation and / or comparisons with prices from similar instruments.
Fair value estimation does not necessarily give the best price available for each transaction but provides a baseline to measure whether a given price is reasonable. This allows investment firms to demonstrate that their pricing provides the best possible results over time, even if not on every transaction.
Incorporating fair value estimates into best execution
Once you have access to fair value estimates, then the next step is to incorporate these measurements into your best execution process. One approach is to gather as many data sources as possible; historical data and estimated values should be used in parallel if available. This allows you to create tolerance levels against which you can compare your trades and be confident that they have fallen within an acceptable range. Keep in mind that a single trade outside an acceptable range may not necessarily represent the overall execution performance for an instrument category for an investment firm. The collective of all trades and how they stack up against the range of selected benchmarks provides an accurate picture as to how well a firm has been able to meet its order execution objectives, which under MiFID II will have to be set on its order execution policy by instrument category and client type.
Execution methodology as a measure of best execution
OTC instruments are traded extensively using the request for quote (RFQ) mechanism. While fair value or contributed prices can provide a proxy for independent benchmarking in the absence of a published tick stream, the RFQ mechanism delivers actionable prices that can be used to demonstrate best execution. Being able to capture all competing quotes from counterparties allows the measurement of price improvement against the next best quote. Measuring the spread of all quoted prices provides an illustration of RFQ competitiveness as well as promoting transparency by ensuring a minimum number of quotes are received (as defined by the order execution policy).
As MiFID II approaches, market practitioners will need to pay close attention to the processes outlined above in order to ensure that OTC instruments fall in line with best execution obligations.
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