MiFID II for Hedge Funds: Best Execution

December 14, 2017

MiFID II will have broad repercussions when it comes into effect at the beginning of next year – impacting every sector and market participant in the financial services industry. Although hedge funds may, at one time, have been subject to a lighter regulatory touch, that can no longer be expected.

Hedge fund managers have not only been under increasing direct scrutiny (through initiatives such as AIFMD), they have also been subject to a growing number of broader rule changes (such as MiFID II), which do little to distinguish between different types of investment firm.

Our research has highlighted twenty key areas of MiFID II that are relevant to hedge funds. Best execution, the subject of this blog, is just one of those.

Does MiFID II best execution really apply to hedge funds? 

The simple answer is yes. Yet there are some who still like to argue the fact, so we wanted to quickly address a couple of those arguments.

When it comes to hedge funds, the importance of performance-based compensation means the interests of managers tend to be well aligned with investors. As my American colleagues would say, hedge fund managers have a lot of ‘skin in the game’ – which means they naturally seek out best execution. So why would regulators subject them to the same yardstick as other market participants?

Unfortunately, while we may agree with the logic of such an argument, it makes no difference to the obligations that funds face. Not only will best execution have to be sought, it will also have to be demonstrated in a more quantitative and public fashion. That means having systems and processes in place to monitor and manage the quality of execution one attains. For hedge funds, it also means maintaining records and publishing the top five destinations (brokers) for their order flow.

Another argument questioning the importance of MiFID II centres around Brexit. Given that MiFID II is a European initiative and Britain has begun the process of separating itself from the European Union, some may be hoping that all these burdensome obligations will be unwound before long – so why bother going through the effort of complying?

Sadly, we would perceive such logic as flawed. The FCA has been a leading advocate of best execution obligations. It has taken a significant role in shaping MiFID II. Even in advance of the new rules coming into effect, it has underscored its views that investment managers are failing to ensure effective oversight of best execution. Furthermore, the advantages of maintaining regulatory equivalence means we see little chance of MiFID II rules being repealed post-Brexit.

What do we need to do? 

Once we accept MiFID II will not simply go away, and rather, needs to be addressed with some urgency, then the first step is to make sure everyone is aware of their obligations come January. Firms thinking tactically about their requirements will simply view compliance as a tick box exercise. However, we believe this should be more than a compliance task. When new regulations drive changes to market structure and processes, there are always opportunities to review existing workflows, and get the whole organisation thinking strategically about the future. That means understanding how MiFID II will impact the broader market, and how to position yourself in view of those changes.

Getting More Quantitative 

For those that remember best execution obligations brought about by the first round of MiFID in 2007, the requirements were policy-based and less prescriptive. Fast forward ten years and the sequel to MIFID takes a more quantitative view. As such, both trading venues and the firms routing order flow to those venues will need to publish a lot of data regarding execution quality and their preferred execution venues, respectively.

The data required is incredibly detailed. Venues will need to break out a wide range of statistics, not only relating to price, but also factors that might influence the quality and likelihood of execution – such as market depth, average trade size, number of market makers, cancelled or unfilled orders, number of trading halts etc. Meanwhile, investment firms will be forced to publish a table of their top five execution venues (for each category of asset classes), alongside numerous other disclosures designed to shed light on any potential conflicts.

Warning: given that the first round of best ex data disclosures are set for April of next year—covering trades conducted over the course of this year—firms should already have started their internal data collection efforts.

A Complex Matrix 

Were all of this new data focused on a single asset class, it would be a challenge in itself. However, the fact that MiFID II obligations are cross-asset makes it a much more complex conundrum.

Firms that are active across many asset classes will therefore face a significant headache in either publishing and/or aggregating and making sense of all newly available datasets. While the regulation states that the data needs to be provided in a machine readable format, that doesn’t necessarily mean it will be easy to consolidate, normalise and analyse.

Even assuming that this technical task can be outsourced, sourcing best execution will still pose unique difficulties within each asset class. Some markets have an abundance of data with which to benchmark execution quality. Others are opaque by contrast given their inherent lack of liquidity. Typically, best execution will already be easier to achieve in liquid markets, while at the less liquid end of the scale one may rely more on qualitative insights. Even with more data available, the ability to piece all of it together, derive insights and combine qualitative and relationship-based assessments will not be simple.

All of these assessments will also have to be made on a dynamic basis. Just as with investments, past performance in execution quality may not be a guarantee of future performance. So execution practices and policies will have to be reviewed, monitored and adjusted in response to new information becoming available.

In tandem with best execution, the unbundling of research services will add to the complexity of the new landscape post-MiFID II. As firms begin assessing their execution services through a more quantitative lens, they will need to do the same for research services.

One might assume that service un-bundling and greater transparency would innately be of benefit to consumers of those services. But things may not be that straight forward. Our next blog will look specifically at the changes that lie ahead in the landscape for research provision and the steps hedge funds will need to take.