By Howard Moore
MiFID II, the revised iteration of the Markets in Financial Instruments Directive, came into force in January 2018. Although a European directive, MiFID II applies to all firms that trade in European markets, and thus has a global reach. It is meant to incorporate new market practices, many made possible by advances in technology, as well as to hold investment managers accountable to best execution standards, and to clarify trading and investing costs by separating trade execution and securities research. Buy-side firms must demonstrate that they have taken “sufficient” steps to achieve best execution, as opposed to the merely “reasonable” steps mandated previously.
While MiFID II and other financial regulations established best execution standards and enforce accountability, the market – particularly the buy side – has demanded less opacity and greater control all along. “One of our major areas of focus is best execution,” says Tyler Gellasch, executive director of the Healthy Markets Association, which was formed in 2015 to advocate on behalf of the buy side on market structure issues. “We’ve been working with FINRA over the past couple of years to encourage brokers to deliver improved execution quality and provide more effective monitoring tools and enforcement mechanisms,” he says. The Healthy Markets Association will soon release the third edition of its report “Better Best Execution,” which details best execution practices for investment advisors and what they should expect from their brokers.
At the heart of best execution is venue analysis, which not only helps to determine venues and optimize their priority, but also to demonstrate the execution standard has been met under MiFID II and the proposed SEC enhanced order transparency rules. Technology now allows buy-side traders to engage in meaningful conversations with their counterparties using detailed and unbiased reversion, fill rate, and hit rate data, which allows for detailed venue performance analysis, so traders can measure and rationalize order handling protocols accurately. Further, on the most innovative venue analysis tools, a venue’s performance is not treated as an absolute. Instead, performance can be evaluated and prioritized based on the intent of the trade, whether it’s passive, aggressive, or seeking block liquidity.
Confusion as markets evolved
As the market’s structure evolved over time, it had become increasingly complex and fragmented, with hundreds of different order types and tiers, and insufficient documentation. Alternative trading systems (ATS), like dark pools, emerged that could accommodate trading strategies enabled by technology that generated, routed, and executed orders at a high-frequency based on an algorithm. “Venue fragmentation played a huge role in the market’s confusion – as prior internalization of orders by some ATS’s – bred an air of distrust,” says Joe Wald, CEO of Clearpool Group, a trading technology provider, noting that were many conflicts of interest, some real and intentional, others perceived.
However, ATS are registered as broker-dealers and aren’t subject to the same level of disclosure as exchanges. The SEC established Regulation ATS, which requires disclosure of some material facts and trading statistics, 20 years ago, but there has been little guidance since, despite the growth of algorithmic trading in both volume and sophistication. What specific disclosures are required remain open to interpretation. Some venues post their Form ATS and even share more granular data about operations, subscribers, and trading statistics on their websites. Some provide information only to their subscribers – and others don’t provide any.
This impairs the ability to compare various market centers (including registered exchanges) accurately and allows abusive practices, like trading ahead of – or against – subscribers’ orders, sending them to other market centers without notification, using order information inappropriately, issuing misleading information, and more. When the SEC and other regulators started to levy fines for nondisclosure and other abuses, the industry – especially the buy side –began to take notice.
“When we organized The Healthy Markets Association, ATS disclosure was at the top of the agenda,” says Gellasch. Early on, the association released “The Dark Side of the Pools,” a report that reviewed the significant regulatory actions at that time and offered recommendations on how best to navigate the various complexities of working with dark pools and other venues. In 2016, Healthy Markets proposed to the SEC that ATS operators provide increasingly detailed and enhanced public disclosures, and it released a due diligence questionnaire that helped investment advisors, asset owners, and even broker-dealers to understand potential conflicts of interest and how to improve working relationships among the market’s constituents.
Market behavior changing for the better
“We’re seeing market behavior changing, merely by asking the questions,” says Gellasch. As a result of the attention, some ATS have voluntarily enhanced their disclosures – some publicly – just because some of their clients asked for more information. “That’s the power of the buy-side order flow,” he says. Regulators are taking notice as well. “Just by highlighting some of these interests and concerns, they have appeared on the SEC’s and FINRA’s agendas.”
In addition to mandating new standards of best execution, MiFID II has separated trade execution services from securities research, and asset management firms must now divulge what they pay for each service. This marks a significant break from the traditional institutional trading market practice of offering one bundled with the other, and letting its clients figure out the relative value of each. “Those brokers who can differentiate their research franchise and trade execution services as superior, but separate, products have the best chance to maintain both sides of the business,” says Wald. From the sell side’s perspective, both have to be better. Over the past year, asset managers debated what they were willing to spend on research, and sell-side firms have been strengthening each service to preserve, if not increase, market share.
Now there are tools that empower market participants and demystify a complicated market, providing a deeper level of analysis of venue performance. “When developing Venue Analysis, our aim was to give traders the tools to analyze venues and determine which were best suited for inclusion in their routing protocol based on the goal of the trade,” says Wald. By doing so, a deeper, collaborative level of communication between the buy side and the sell side has formed. “There are two parties who want to do the right thing for each other in a very complex and fragmented market structure. Having the right toolset to analyze venues lets the buy side and sell side see eye-to-eye and work together to inform, demonstrate, and validate execution protocols – for the first time.”