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Regulatory intelligence

Tightening up on transaction cost analysis

An industry-wide focus on best execution and Transaction Cost Analysis (TCA), driven by Markets in Financial Instruments Directive II (MiFID II) and wider industry changes, should lead to a more informed buy-side.

Best execution is a well-worn concept in wholesale financial markets, and its pursuit is one of the common objectives that unites trading desks across asset classes. But with changes in market structure and regulation, as well as the increasing sophistication of asset managers and the technology available to them, best execution is a rapidly evolving discipline that is fast reshaping trading practices.

Historically, a mandate for best execution was fulfilled simply by requesting multiple quotes from competing dealers and then trading on the cheapest one. But it is now widely recognised to encompass more than just best price. According to the EU’s recast MiFID II, factors that should be taken into account extend to cost and speed of execution, as well as likelihood of execution and settlement, and size of transaction.

Sophisticated TCA is needed to properly review such factors in a timely manner and to present the necessary analysis to traders with the frequency and accuracy they require. As the focus on best execution has become more widespread in recent years, TCA has advanced a great deal. While it started out in equities, it is now being much more widely used in OTC asset classes.

“There has been a real step change in recent years as more firms seek to record and monitor a systematic process of best execution. Whereas previously, many firms had a best execution policy that often wasn’t actively implemented or monitored, it has become a far more proactive and effective process,” says Pete Eggleston, co-founder and director at BestX, an independent FX TCA provider founded in 2016.

But while MiFID II will play a role in the evolution of TCA in the future, practitioners are not seeking best execution purely because it is required by regulation. The broader impact of bank balance sheet pressures and the fragmentation of liquidity are also playing their part in increasing scrutiny of sell-side execution practices.

With the weight of heightened capital requirements slashing banks’ risk appetite, asset managers can no longer rely on their dealers to take the execution risk for large block trades. That means firms have to be much savvier about how they execute their orders at minimum cost, which in turn means they need a more detailed and real-time view of execution options, often on a pre-trade basis.

John Cooley, head of FX Buy-Side Trading at Thomson Reuters, says, “Across FX and fixed income, there has been a steady decline in dealer inventory and the number of dealers that will take on large block positions has diminished. This requires asset managers to be more aware of where the underlying sources of liquidity are and the costs of taking on block execution risk.”

The proliferation in the number of trading venues and protocols across OTC asset classes further amplifies the case for robust TCA. Whereas dealers and large platforms used to operate the market’s largest liquidity hubs, which made execution decisions relatively straightforward, liquidity now tends to be distributed

around a larger number of banks, non-banks and trading platforms, which requires a more informed approach to execution decision making. This dynamic is particularly prevalent in FX.

“Clients are looking to improve best execution across the board and this is not just a European trend driven by MiFID II,” says Matt Thomas, head of e-Commerce Operations at Credit Suisse. “In particular, pre-trade analytics are in great demand in FX because the market is so fragmented and there is a need for better monitoring to improve pre-trade decision making.”

With the weight of heightened capital requirements slashing banks’ risk appetite, asset managers can no longer rely on their dealers to take the execution risk for large block trades.

Regulation has also led to stronger regional divisions, thereby adding to the fragmentation, with US firms having to abide by the provisions of the Dodd-Frank Act while their European counterparts concentrate on MiFID II. Advanced TCA is being tailored to these rulebooks, so that market participants can use the analysis to determine how best execution can be achieved in a way that is compliant with the regulations.

“In OTC markets, the buy-side used to rely on dealers to tell them where the market was and to hold the execution risk on their behalf, so best execution could be achieved by calling a few dealers and relying on relationships to secure the best price,” says Cooley. “With less dealer inventory and more execution choices, firms now need their own understanding of factors such as market impact and how liquidity may change depending on the time of day or the instrument traded.”

With MiFID II set to be implemented in January 2018, European market participants face intense pressure to get their execution analysis right. While the original MiFID rules, implemented in 2007, already set a focus on best execution, MiFID II raises the bar, requiring that investment firms take “all sufficient steps” rather than “all reasonable steps” to obtain the best possible result for their clients when executing orders.

As preparation for MiFID II advances, the pursuit of best execution and use of TCA remain at the forefront of the industry agenda. While OTC markets have certainly lagged behind equities in the past, TCA is gradually becoming more advanced and widely used across FX and fixed income.

That change in language may appear to be fairly minor, but the European Securities and Markets Authority has fleshed out what is required under MiFID II in more detail, and the requirements are onerous. For example, firms will need to strengthen accountability and systems in the front office to identify deficiencies in execution, as well as monitoring execution arrangements closely on an ongoing basis.

John Mason, head of Regulatory and Market Structure Propositions at Thomson Reuters, says, “We have seen fairly limited pursuit of best execution outside equities in the past, and the capabilities have often been poor in FX, fixed income and OTC derivatives. That is changing now as MiFID II requires best execution across asset classes so we should see more detailed analysis of trades and greater use of electronic trading.”

As preparation for MiFID II advances, the pursuit of best execution and use of TCA remain at the forefront of the industry agenda. While OTC markets have certainly lagged behind equities in the past, TCA is gradually becoming more advanced and widely used across FX and fixed income.

One of the challenges is that data in non-exchange- traded markets is less readily available to use as a benchmark for analysis, and that has inhibited the development of TCA in the past. But new providers such as BestX have sourced reliable data from independent sources and built successful offerings based on conflict- free, timely analysis of trades.

“We look at best execution very broadly and measure many different elements of FX execution, and we also allow users to generate reports at whatever frequency they require, including in real time,” says Eggleston. “That is very valuable, because many clients haven’t previously been able to generate the immediate independent analysis they need.”

Other TCA providers will surely play catch-up as the pressure from MiFID II and other drivers of best execution continues to build, but they will need to overcome the natural barriers that have long prevented TCA from penetrating the OTC markets.

“You need to start with strong data that is ideally aggregated from multiple contributors, and because the size of OTC transactions varies much more than in equities, this must be taken into account when evaluating the cost of execution or market impact. Otherwise, the wrong conclusions may be drawn,” says Cooley.

Beyond TCA, the prevailing winds may also drive increased use of algorithmic execution tools, which have long been a feature of electronic markets but have enjoyed only limited adoption in some asset classes. Algo strategies come in many different varieties, but they offer the benefit of a clearly defined and transparent execution methodology, backed by scientific and quantitative analysis to demonstrate the results they can deliver.

While many dealers have invested heavily in research and development in the algo space, it is yet to fully pay off as adoption remains piecemeal. Regulators are putting in place greater constraints to ensure algos are properly marketed and distributed, which could constrain the pace of adoption in the near term.

“Regulators have some concerns about the use of algos, and MiFID II introduces new conformance requirements to make sure they are fully tested and the necessary circuit breakers are in place,” says Mason. “A distinction must be drawn between controlled algos that execute orders systematically over a certain time period and more aggressive strategies that may need closer scrutiny.”

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