Mifid II has not given us a single ‘Big Bang’ moment.
Instead, it has set off a series of seismic impacts that are reshaping the investment trading landscape.
The first tectonic shift of this expansive regulation was the requirement to unbundle payments for research and execution. This measure swiftly dismantled a deeply engrained culture where brokers provided research to the buy-side to attract order flow from them in return.
Now, due to Mifid II, buy-side asset managers are no longer permitted to engage firms for trading purposes with the sole intention of receiving investment research.
This regulation has added a new dimension to the investment value chain and ultimately benefits the end investor. Flow must beget flow, liquidity should attract liquidity and those firms with the ‘contra-trade’ must be sought out by those wishing to transact in order to achieve ‘best-execution’.
Wave of reform
Investment firms cannot choose an execution broker based on research provided or simply because they have long-standing relationships.
They must demonstrate effective broker selection procedures and a best execution policy, which consistently delivers good outcomes for their customers.
Investment firms will favour a ‘best of breed’ approach in selecting specialist brokers for execution services and a different group for their research requirements.
While attributing a value to investment research has been the focus of intense scrutiny, another Mifid II seismic shift has been quietly set in motion.
This is a challenge of greater complexity: how to ensure transparency around liquidity and best execution.
The reporting requirements of Regulatory Technical Standards 28 (RTS 28) pack a punch, and are set to unleash a further wave of reform for the industry’s buy-side.
Indeed, RTS 28 is aimed at all investment firms tasked with executing client order flow and has been created to enable the public and investors to evaluate the quality of a firm’s execution arrangements by requiring the publication of key information about where a firm has executed client orders.
This is an immediate concern for financial firms and investment managers in particular. From April 2018, investment firms are now required to publish on their websites (and in a machine-readable format, no less) annual information on their top five trading venues via RTS 28 reports.
These reports will also offer unique insight into the venue choices of investment firms and therefore an indication of the liquidity offered by execution venues and other liquidity providers, such as market-makers.
Tapping additional liquidity
The truth is, we are living in an increasingly commoditised trading world where pricing points are often converging to the same levels.
An execution broker offering their services to an asset manager is bound to peddle that they can reach various execution venues, managed trading services and ‘hidden liquidity’ but the real question is, are they accessing all the liquidity available to them? Ultimately, it is diversity in liquidity sources that ensures suitable price discovery and reduces market impact.
Retail investors are one such source of vital additional liquidity, executing their business via market-makers.
This order flow can be directly accessed as a liquidity source by investment firms who have dealing relationships with these market making firms.
Currently, retail investors account for up to 28% of the UK market in the smaller, less liquid stocks and even the more liquid FTSE 100 index has over 5% of its daily value traded by retail investors.
Moreover, individual holders of UK equities only account for circa 12% ownership versus 54% proportionally in the US. This gap is anticipated to narrow with the increased introduction of fintech, micro investing platforms and pension freedoms in the UK.
Trading desks should seek to interact directly with this additional liquidity, not least because they are now obliged to demonstrate that they are doing so.
Delivering best execution
Alongside tapping deeper pools of additional liquidity, buy-side firms must approach best execution not just as a process, but as a core philosophy – one which encompasses arrangements and procedures designed to secure the best outcomes for clients with pre- and post-trade monitoring to assess ongoing effectiveness, and with clear and concise reporting to deliver confidence, trust and transparency.
By this measure, best execution must lie at the heart of any investment firm. For buy-side asset managers, the question is whether they can answer the questions Mifid II and RTS 28 pose: Do current broking processes benchmark across multiple venues? Are they accessing all sources of liquidity available? What are they doing to ensure that they are?
Mifid II requires investment firms to evidence that they have taken ‘all sufficient steps’ to obtain the best possible results for the client when executing orders.
It’s no surprise that a great number of investment firms are choosing to outsource their dealing function to industry specialists in order that they can remain focused on their core businesses.
Additionally, buy-side investors must question if their counterparties are a source of liquidity in all market conditions or if they are only there in ‘fair-weather’.
Can their traders help to reduce the market impact of larger orders and achieve high quality execution? And in a world where execution services are increasingly commoditised, can they access market makers to tap into wider sources of liquidity?
Does that market maker have the ability to consolidate both institutional and retail flow from a diverse client base? Is liquidity provision available in all market conditions or does it seem to just disappear when the screens go red? Furthermore, are firms accessing this liquidity directly or is it accessible only via a costly ‘dog-legged’ approach via multiple brokers?
Ben Jowett is head of business development at Winterflood Securities.