Assessing ‘Best Ex’ in Fixed Income

AxeTrading looks at what is arguably MiFID II’s thorniest component.

Best Execution: Finding an answer to fixed income’s technology problem
By Mark Watters, Director at AxeTrading

Mark Watters, AxeTrading

MiFID II is finally a reality, and many institutions still aren’t prepared to comply with what is arguably its most notorious component – fixed income best execution.

There have been a wide range of responses to solving this mandate, but it’s become abundantly clear that applying technology built for other asset classes simply won’t do for fixed income.

I’ve been involved in fixed income electronic trading for over two decades, and it’s evident to me and others that the ongoing electronification of markets is creating two distinct groups of institutions – those who are prepared for the future, and those whose technology will hold their business back.

In fixed income, the lack of a centralized trading venue or exchange, far greater number of instruments available for trading, and generally lower trading frequency per-instrument all raise challenges that can’t be solved by simply importing functionalities designed for equity markets.

While features aren’t portable, concepts like the execution management system (EMS) can be tailored to fit the unique shape of fixed income’s market structure, rather than taken off the rack and clumsily applied, and offer the same transformative benefits.

EMS: Keeping compliance under control

In the late 90s, direct-market-access platforms primarily used for day trading were plucked from the reaches of retail, upgraded and purpose-built for equity trading on electronic markets.

It became clear that exchange traded instruments like equities and low latency trading technologies were not only compatible, but seemed engineered for the purpose. Matching engines, algorithmic trading and predictive technology have allowed equities to fly at the quite literal speed of light.

While most fixed income trading won’t likely reach that pace anytime soon, the technology lag, the market structure “bear in the corner”, is now in clear view as the countdown to MiFID II and best execution nears midnight.

At its core, MiFID II’s best execution standard requires firms to take “all sufficient steps” to account for price, cost, speed, likelihood of execution and settlement, size and other relevant factors to achieve the best possible result for their clients, instead of the old standard of “all reasonable steps.”

In equity markets, despite their own unique challenges, this standard is relatively clear.

In fixed income, however, to make defensible judgments as to what is ‘best execution’ requires evaluation of all available, relevant sources of liquidity and pricing. This may include aggregation and comparison of email and voice quotes, platform and exchange prices and countless other data threads and streams, in order to form a sufficiently thorough assessment of the market before execution.

Proving ‘best execution’ is even more challenging – many of these quotes may not be ‘firm’ or even executable. To accurately demonstrate best execution, traders must take account of this, and then provide end-to-end tracking of why each step in an execution was taken.

That’s where a fixed income EMS becomes invaluable.

Instead of relying on traders to check and register a wide range of pricing sources from different systems including on-screen quotes, voice and chat messages, before deciding to execute, having an EMS that integrates the firm’s internal systems with multiple trading venues (OTC, exchanges, MTFs, OTFs and SEFs), and data sources into a single application to help facilitate fixed income best execution strengthens regulatory compliance to defend both the trader and institution.

With this set of tools to gather all available pre-trade information and enable an accurate reconstitution of variables at each decision point, institutions will have the standard, defined process that is critical to demonstrate ongoing compliance.

Not all doom and gloom

Despite the short runway left for institutions to leap forward with MiFID compliance, a fixed income execution management system isn’t a pipedream that’s years away. It’s a reality today

As the buy-side takes on more of a role in liquidity provision, and are now reputed to hold over 90% of all outstanding bond issuance, a well-designed fixed income EMS can turn the pressure of best execution compliance into advantage by enabling traders to act as a price-maker where it may be appropriate to do so, in the new and evolving market structure.

The technology and market expertise exist and are in-production, leaving only one question for institutions to answer: “Are you a leader, or left behind?”

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