Why demonstrating OTC fixed income best execution may require trade reconstruction under MiFID II

This article was written by Janos Renz-Hotz and Gary Stone. It appeared first on the Bloomberg Terminal.

In this series of blogs, we will discuss how MiFID II impacts the best execution process, in particular for OTC fixed income instruments, and how trade reconstruction capabilities will be crucial for firms to reach optimal results.

In our last post, we discussed how the FCA, in their May 2017 update “Investment managers still failing to ensure effective oversight of best execution,” noted that “most firms had failed to take on board the findings of [a] thematic review”, pointing to a lack of effective monitoring capability to identify best execution failures or poor client outcomes.

In a recent press article, it was suggested that regulators are “agnostic” as to whether firms use TCA or not, and that its use is not a requirement under MiFID II. While the term “transaction cost analysis” is not specifically cited in the regulation, using quantitative methods to demonstrate conformance with disclosed order execution policies, and delivering client (best execution) outcomes is required. And, quantitative methods are certainly needed to identify client outcome outliers that need further investigation, in order to conform with the FCA’s requirement for feedback loops to improve the execution processes.

Fixed income execution

In our last post, we proposed “dynamic trade optimization” as a basis for firms to adopt a holistic approach to the execution process.  Trade management analysis is a critical component because it compares actual execution results with execution benchmarks to identify poor client outcomes. This is well developed for equities and less sophisticated for OTC trading, particularly in fixed income.

For OTC fixed income trading, because of the preponderance of “block” trading, a compliance benchmark could be derived from an observed actionable indication of interest, an executed price or an independent “evaluated price.” Firms can set a “tolerance band” to identify execution outliers (poor results) or identify trends that need to be investigated.

Price fairness and execution evaluation comparison benchmarks are an area of technological innovation. In some situations, price fairness and execution benchmarks may not be “tradable prices”. But they can be considered as compliance proxy prices that can enable firms to form a robust, systematic process to evaluate execution results. It’s all about having a source to identify areas of poor performance that need to be analysed.

Why trade reconstruction capabilities matter

A best execution compliance program initiates a virtuous cycle between the setting of tolerance levels, the monitoring and trend investigation and the feedback into the execution process. In OTC fixed income trading, Bloomberg Valuation (BVAL) prices can be used as a compliance benchmark in Bloomberg’s BTCA tolerance analysis to systematically assist clients in evaluating “price fairness”, and identifying areas for compliance professionals to perform further investigation. Because of the heavy reliance on voice or electronic market color, and trade details communications in OTC fixed income trading, trade reconstruction is a critical component to the investigatory part of OTC trade management analysis.

Towards best execution trade-event reconstruction

Especially for fixed income, various combinations of voice, chat or message are employed as part of the trading process. Even asking for “market color” can be a source of information leakage and have adverse impact on prices. As part of the pre-trade execution process, the FCA probably would argue that it needs to be monitored. Moreover, Europe’s market structure is going to be extremely fluid with the introduction of new trading venues and the pre/post-trade transparency regime which will impact the (best) execution process.

Once execution outliers are identified, combining structured market data, news and other static information with unstructured voice and electronic communications data is an efficient way to gain a holistic view of execution, check the fairness of prices and identify deficiencies in process and technology that may need to be adjusted/corrected – especially as EU market structure evolves.

Trade reconstruction methods, such as the one provided by Bloomberg Vault, provides investigators with an easy to use workflow to gain that view. They can help document findings and work with execution decision makers on adjustments on future orders. In fact investment decision makers should be involved in these discussions, not only because the solution to poor execution results may include a change in the investment selection process, but also because the portfolio managers, in selecting assets, may in fact be the source of information leakage resulting in sub-par execution.

Although MiFID II focuses on the execution process, the ultimate feedback loop could be one where pre-trade indications of potential execution results is factored into the investment selection process. These are all demonstrable actions which seek to continually improve investor (client) results.

Bloomberg supports firms with their MiFID II best execution requirements through BTCA, which delivers transparent, broker-neutral transaction cost analysis across multiple asset classes.  BVault enables firms to combine structured and unstructured communications data for trade reconstruction. For more information, type <BTCA> GO and <BVLT> GO on your Bloomberg terminal or check our website.

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