For the last two years Eurex has been heavily engaged with understanding how MiFID II will impact its business and how to address these new regulatory hurdles. Eurex was also determined to understand how the new regulatory regime would affect its members so that it might be able to use its existing expertise to solve not only its own compliance requirements, but also those of its members by providing genuinely innovative solutions. To this end, MiFID II has become a catalyst for change, presenting not only challenges around compliance but opportunities as well.
One of the more onerous legislative challenges is around member investment firms having to comply with Best Execution. This requires that Brokers, or indeed any firm with clients, must be able to demonstrate that they have taken all ‘sufficient steps’ to achieve the best result for clients. This ultimately requires the collection, collation and even synchronisation of not only prices, but also taking into consideration cost, speed and likelihood of execution, size and indeed ANY other considerations. None of these requirements seems impossible, but once these requirements are applied to existing Off-Book price formation processes then the scale of the problem looks almost insurmountable. Especially when one considers the collection of this information around price formation is required even if no trade occurs, but simply intended.
Off-Book Status Quo
Currently, non-electronic off book price formation is a combination of voice, chat and a collection of hand written quote and trade blotters on the desks. For Eurex products such as Fixed Income Options the price formation process is one hundred percent voice and chat.
“…currently the broker receives the call from the client, and the voice broker decides which market maker to contact. So the way it chooses to execute the order and the information it shares can vary enormously and produce potential for confusion and non-compliance to the firms execution policies even if it is not done maliciously,” said Randolf Roth, member of the Eurex Executive Board.
This is because voice brokering, despite it being a predominantly relationship-driven business, has become inherent with inefficiencies and problems, despite its obvious strengths around the putting together of more complex strategies, and the speed of initial dissemination of requests.
Roth believes that the new regulatory regime will significantly change the brokering models among banks, interdealer brokers and market makers. A significant portion of brokering will become electronified as a means to prove best execution without the huge infrastructure overheads required from some suggested telco offerings or administrative solutions.
“To prove best execution, it requires records of all details leading to a trade being executed. It is therefore much easier doing this electronically rather on the phone where all the data collection and collation is automated,” Roth added. “The regulators see the value in the general brokering model by creating the organised trading facility (OTF) category, but nonetheless brokering will become more electronic.”
As interdealer broker (IDBs) look to set up under the OTF or Multi-Lateral Trading Facility (MTF) status, they will begin to adopt exchange-like characteristics when facilitating the trading of OTC derivatives, including ETD products.
”Any new solution should not just be about assisting in the BestEx compliance proof, but rather to improve the process as a whole for industry participants. Ultimately, the goal should be to further improve liquidity, to benefit all market participants.”
Improving the process, improving the business
Whilst an innovative electronic solution seems an obvious solution for the practical proof of BestEx, and the storage of this data that can be accessed in a timely and efficient manner, it is not simply enough to help members solve this problem alone.
One of the strengths of voice will always be the speed that a simple strategy can be disseminated to potential market makers. However, whilst an electronic solution may not be as efficient at this specific point in the workflow, it is much better at understanding, collating and disseminating back to the broker the ensuing responses. Voice has always focused on three, perhaps five market makers to build a price surface from client orders. Much of the reason for this is simply that to ‘deal’ (negotiate) with more than this amount becomes simply unmanageable from a practical perspective. MiFID II will make this even harder as all the responses need to be seen to have been understood and compared. Ultimately an electronic solution will encourage the inclusion of more market makers, and resulting in a much more diverse landscape which can only be good for the whole industry.
Electronification also lends itself to more streamlined STP processes, reducing errors, and decreasing the time it takes to enter arranged orders into the exchanges trade entry services such as TES for Eurex. It will effectively be no more time consuming to deal against ten market makers, as it would be to deal against one.
“In the future, we envisage a three tier model for off-book price formation. A significant share of off-book transactions will be negotiated via electronic platforms due to the ease to prove Best Execution. For more complex requests, an element of voice and human interaction will still be required to meet client demand. Finally, chat based systems will continue to be used to some degree, although I expect their share to decrease,” Roth commented.
It seems clear in the evolution of the off book business that MiFID II will become the catalyst for the electronification of the business. However; having spent an enormous amount of time discussing potential electronic solutions with members, Eurex observes that right now for some asset classes such as Fixed Income there are no existing electronic platforms that come close to replicating the finer aspects of the voice and chat process. Investment firms wait with the hope that a platform will emerge, capable of replicating all the best aspects of the existing voice processes whilst solving other important problems around efficiency, and of course, assisting that firm to be MiFID II compliant. No small challenge, but one that Randolf Roth believes Eurex has moved a large step closer to solving.