Justifying Brokers In An Unbundled World


By Ian Mawdsley, Head of ETI Trading EMEA, Thomson Reuters

Brokerages will face tighter scrutiny from the buy-side after MiFID II, and will find new ways to add value.

As the effective date of Markets in Financial Instruments Directive (MiFID) II nears, the implications of its mandate to unbundle services are getting clearer. MiFID II aims to provide a level of transparency around certain practices in the financial markets, particularly the use of broker commissions. In practice, the regulation asks: What does the payment facilitate and who should really be paying?

Until now, a variety of services have been bundled into simple “pay-as-you-go” commission payments. Research, corporate access and technology services are in these bundles by default. The payments have been used, however, to provide clients with office space and furniture. Ultimately, though, commission costs were passed on to the end-investors – the people who MiFID II protects.

MiFID II requires firms to pay for research either in cash or through research payment accounts (RPAs). Order management and execution management systems technology must be paid for through a direct arrangement between a buy-side firm and a vendor.

This is a crucial difference from MiFID I, in which guidelines about how dealing commissions could be used were provided by National Competent Authorities (NCAs), but were not included in the overall European Union directive. In turn, the trading community largely misinterpreted or perhaps even ignored those guidelines as brokers subsidized the costs of vendor services as part of their distribution, effectively inducing clients to trade with them.

So, what do these distinctions about which types of services may be or may not be paid for with broker commissions mean for brokers? Adhering to broker scorecards is becoming more of a challenge. The RTS 28 technical standards in MiFID II obligate buy-side firms to report on why they chose a certain broker as their execution channel – and to explain why in both quantitative and qualitative terms.

Quantitative analysis
In a quantitative selection process, transaction cost analysis (TCA) is the key driver. TCA should be inherent in best execution analysis (BXA). The RTS 27 best execution provision in MiFID II requires venues and executing counterparties to achieve more granular reporting detail. This will vastly improve the depth and quality of data. By analysing historical trade patterns, buy-side firms can determine where they will get the best execution of certain orders.

Proving best execution is not as simple as looking at how a trade has performed in the past and replicating the instructions. Firms must account for current market conditions and the executing party’s goals. Is immediate execution required? Does deeper liquidity need to be sourced? What type of benchmarks will be used?

The buy-side can access about 1,500 broker algorithms to execute trades on just short of 600 venues. Choosing among these algorithms for thousands of trades will be arduous. The obvious way to address this problem is some form of automation, likely including basic machine learning capability.

Using software to perform pre-trade analysis of executions will present the trader with one or more ways to place the orders with brokers. This will not only ease the trader’s broker and algo selection, it will also help compliance officers show that their firms used a systematic approach to best execution.

When trades prove to be small compared to a stock’s average daily volume (ADV), the buy-side may automate execution through a rules-based order router, allowing traders to focus more on transactions that are larger or more complex to complete. Broker selection can easily be randomized to distribute resources equally across numerous broker counterparts.

Qualitative analysis
Qualitative selection processes are obviously broader and harder to measure, but these are no less important to defining the relationship between the buy- and sell-sides. First and foremost, access to liquidity is a large factor in determining which brokers will make the list. Whether they access lit or dark venues, some brokers may choose to act as systematic internalizers (SIs), using their own risk capital to act as a one-stop solution for filling large block trades.

Secondly, access to quality and reliable executions, coupled with the appropriate investment in the associated technologies, will be a must. MiFID II will undoubtedly increase electronic traffic. The performance of sell-side legacy systems may be important for determining where order flow is directed.

Finally, the high-touch desk will also continue to play a part, acting more like an execution consultant than like a sales trader who uses the outdated ‘fill-and-bill’ method. As the markets become more fragmented and the technology offerings more complex, someone will still need to be there to hold the hand of the buy-side trader.

However buy-side firms figure out compensation of brokers for their services, the value brokers provide – even in a changed compliance climate – cannot be denied.

(These views represent the views of Ian Mawdsley and not those of Thomson Reuters.)

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