Given the lengthy run-up and imminent implementation date of MiFID II, the legislation due to overhaul European financial markets, one would expect participants to be more or less fully prepared by now. However, recent research by Liquidnet in May 2017 showed that of the 55 global asset management firms interviewed, only 6% said that their best execution policies were ready for the more rigorous standards of MiFID II. With investment managers under pressure to prove and provide an audit trail of best execution, the industry is currently contemplating how the regulatory fall-out will shape up in reality. One definite trend is the continued fragmentation of the marketplace and the impact this has on where and how liquidity is formed.
The origins of MiFID II legislation came about as a reaction to the 2008 financial crisis with deep concern from governments about how the chain of events was played out at the time by different market players. Now regulators are attempting to bring the industry under more control by forcing a much greater level of transparency, making markets more efficient to better serve the end-customer.
Firstly, firms need to demonstrate the value of services that are provided and the procurement of those services in terms of research costs and unbundling. The focus is very much on excellence in all areas, and around genuinely disaggregating the decision to buy services, such as investment research, from the decision to trade and execute orders based on proven execution performance. In terms of the regulators’ efforts to unbundle research costs, the sourcing of liquidity is therefore expected to change because the separation of research costs from trading will ultimately alter the way in which liquidity is formed in the market. The sell-side will see bundled orders disappear from January 2018, leading to the question of where liquidity will be formed in the new environment once execution and research consumption are detached from one another.
Secondly, excellence will also need to be sought in terms of pure execution. ‘Best execution’ is not just about best price, it’s how you execute, where you execute, why you execute there, and ultimately, how much money you are saving. And like so many things nowadays, the achievement of best execution and improved execution performance will essentially be reliant on the successful management of data, and lots of it. While transaction cost analysis (TCA) has been around for a long time, the reality is that new requirements for best execution processes now need to be in place, as well as audit procedures to actually demonstrate those processes have been followed; a new phenomenon for the buy-side in particular.
Due to fragmentation in the marketplace as a result of unbundling, asset managers are having to face a multitude of challenges in terms of not only ensuring regulatory compliance with the eventual MiFID II environment, but also in the effective sourcing of liquidity.
For the buy-side, liquidity is ideally formed in safe places where like-minded investors are happy to rest similar-sized indications to trade with minimal information leakage or market signals. The moment a trader starts touching the lit markets using either an algorithm or a traditional broker, is the moment the price starts to move against him or her. The first place that institutions will look to execute an order is in a pool of natural liquidity, such as those found in a buy-side to buy-side trading network.
And it is when the safe environment of a crossing network is paired with additional innovative tools, that the buy-side can be provided with more control than ever before over their trading decisions. These tools have come on in leaps and bounds due to technological innovation, at Liquidnet for example, intelligent and anonymous search tools within a dark pool have been created for genuine past contras to bring them into the market. This effectively allows the buy-side to become their own sales traders, rather than losing control through price or information leakage that occurs once an order is sent through more traditional means. Another Liquidnet innovation is the creation of sets of algorithms geared towards the buy-side trader searching for block liquidity with minimal market impact, where a parent block can rest conditionally in the dark pool as well as in alternate conditional venues to increase chances of execution.
Data-driven decision making
Technology can also help institutions achieve more control over best execution by providing them with the data sets they need to help decide their trading strategies. Platforms have been developed that are able to sort through massive amounts of market data and deliver real-time, relevant information at both a portfolio level and an order-by-order level. In essence, these dashboards are able to display a whole series of relevant and correlated events so that buy-side traders are able to make decisions about how to best access the market and where to execute orders, based on information right in front of them.
Furthermore, best execution as prescribed by MiFID II is not just about having a process, but also about demonstrating how and why the processes worked. These technological innovations go a long way towards helping prove best execution because of an automatically generated audit trail of decision-making processes.
There are still many unanswered questions surrounding the actual implementation of MiFID II, but what is clear is institutional investors are in a position to take back more control in a bid for transparency and for the ultimate benefit of the end investor. Buy-side traders are now on the look out for innovative tools that can tie the sourcing of liquidity into execution processes using intelligent data analytics they need to make good decisions, as well as easily track all decision-making steps in between. Indeed, robust use of data and analytics can evidence where true opportunities lie not only to regulators, but also to clients. Across the globe, forward-thinking firms looking to differentiate themselves are not sitting still in their efforts to deliver practical solutions; best execution is not just necessary, but good for business.
Mark Pumfrey, head of EMEA at Liquidnet