Philip Yarrow, the chief executive of Winterflood Securities gives his views in the Financial Times on how MiFID II’s next seismic shift will impact trading and discusses how firms must demonstrate effective broker selection procedures and best execution policy to consistently deliver good outcomes for customers.

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How MiFID II’s second seismic shift is reshaping the trading landscape

New European market rules known as Mifid II have not given us a single Big Bang moment. Instead, they have set off a series of seismic impacts currently reshaping the investment trading landscape. The first shift of this expansive regulation was the requirement to unbundle payments for research and execution. This measure swiftly dismantled a deeply ingrained culture where sell-side banks and brokers provided research to the buyside investment management firms to attract order flow in return.

Investment firms must now demonstrate effective broker selection procedures and a best execution policy, which consistently delivers good outcomes for customers, independent of research services.
Another Mifid II shift has also been quietly set in motion — a challenge of greater complexity: how to ensure transparency around liquidity and best execution.

The reporting requirements of Regulatory Technical Standards 28 (RTS 28) pack a punch. From April 2018, investment firms have been required to publish on websites — in a machine-readable format — annual information on their top five trading venues via RTS 28 reports. These reports will also offer unique insight into the venue choices of investment firms and therefore an indication of the liquidity offered by execution venues and other liquidity providers, such as market makers.

The key question is whether investment firms can access all the available liquidity. Ultimately, it is diversity in liquidity sources that ensures suitable price discovery and reduces market impact.
Retail investors are one such source of vital liquidity. Currently, retail investors account for up to 28 per cent of the UK market in the smaller, less-liquid stocks and even the more liquid FTSE 100 index has more than 5 per cent of daily value traded by retail investors.

Moreover, individual holders of UK equities only account for approximately 12 per cent of ownership, versus 54 per cent in the US. This gap is anticipated to narrow with the increased introduction of fintech, micro investing platforms and UK pension freedoms.
Trading desks should seek to interact directly with this additional liquidity.

Alongside tapping deeper pools of additional liquidity, buyside firms must approach best execution not just as a process, but as a core philosophy. Buyside asset managers must answer the questions Mifid II and RTS 28 pose: do current broking processes benchmark across multiple venues? Are they accessing all meaningful sources of available liquidity? What are they doing to ensure this?

Mifid II requires investment firms to evidence that they have taken ‘all sufficient steps’ to obtain the best possible results for clients when executing orders. It is no surprise that a great number of investment firms are choosing to outsource dealing to industry specialists in order to control their costs and focus on their core business.
Additionally, buyside investors should question if counterparties are a source of liquidity in all market conditions or only there in ‘fair-weather’. Can the traders help to reduce the market impact of larger orders and achieve high-quality execution?

In a world where execution services are increasingly commoditised, can they differentiate and tap into wider sources of liquidity? Can the market maker consolidate both institutional and retail flows from a diverse client base? Finally, are firms accessing this liquidity directly, or is it accessible only via a costly ‘dog-legged’ approach through multiple brokers?

These are some of the many questions still requiring answers.

As the requirements for best execution grows, there will be a natural gravitational pull towards those firms that can offer varied sources of liquidity. Mifid II best execution regulation has a long way to go to achieve its aims — but collaborating to improve efficiencies can help the industry rise to this regulatory challenge.

Philip Yarrow is chief executive of Winterflood Securities, a UK market maker for retail brokers and institutional investors