THE CHANGING FACE OF TCA.

Sabine Toulson, Managing Director, LiquidMetrix examines the impact of regulation on trading at both the macro and micro level, and predicts the trajectory of TCA under the new European regulations.

After many years of deliberation, discussion and informed guesswork, judgement day will soon be upon us. In Europe, we now have pretty firm outlines for the scope of the updated MiFID II/MiFIR and MAR/MAD II regulations with hard implementation dates in the next 18 months. The impact of these new regulations and directives is likely to be significant.

On a purely practical level there will be an array of new reporting requirements and procedures associated with trading that will need to be implemented. Both buy- and sellside firms will need to update their systems and processes in time for the July 3rd 2016 (MAR / MAD II) and January 3rd 2017 (MiFIR/MiFID II) go-live dates.

However, the medium term technical challenges brought about by the new regulations are unlikely to stop there as the implementation is quite likely to alter the market microstructure itself. As an example, and foretaste, the imminent imposition of limits on ‘Dark’ trading (the 4% / 8% caps) and the demise of Broker Crossing Networks (BCNs) are most likely the driving factor behind a number of recent innovations in European equity markets. Examples include: London Stock Exchange’s new intraday auction, BATS Europe’s new continuous intraday periodic auctions, Turquoise’s Block Discovery service and the proposed new Dark Pool, Plato. These changes are already throwing up new opportunities and obligations for investment firms to consider.

One could argue that the most significant practical impact to trading firms – especially sellsides – from the MiFID I regulations adopted in 2007, was not only the immediate new direct reporting/process requirements that went live in 2007, but also the fact that the new regulations heralded lit market fragmentation, starting a technological arms race of Smart Order Routers / HFT market making / Dark Pools / BCNS and so on. Keeping up with these rapid changes in trading microstructures brought about by the new regulations required significant investments by firms in the years following MiFID I implementation. The real sting was in the tail.

It will be interesting to see what impact MiFID II will have on the market microstructure of, for example, fixed income trading. It may well be that the immediate requirements imposed by the new regulations are the start, not the end, of larger changes to the technologies and processes used to trade these markets.

Let’s consider the areas of the new regulations that are likely to impact TCA, best execution and reporting.

Extension to more asset classes

One of the biggest changes in MiFID II is that a number of the more onerous requirements related to Best Execution monitoring and pre- and post-trade reporting, that were previously limited to equity instruments, are now extended to other asset classes; most significantly perhaps fixed income and listed derivatives.

This will be challenging. One of the more persistent complaints following MiFID I implementation was that the lack of an official ‘consolidated tape’ (such as NBBO in the US) made monitoring best execution difficult for firms. In fact, the situation was not really so bad. All the ingredients required to make your own ‘EBBO’ tape were available (market data feeds from exchanges / reporting venues) so the challenge was more of a technical nature to gather this data and stitch it together (or asking someone else, whether a market data supplier or TCA firm, to do it for you).

However, if we now consider best execution for fixed income trading, the problems of a lack of an EBBO tape in equities look pretty small by comparison. For many fixed income instruments, instead of deep public, lit order books with firm prices, we have less formalised, quote-driven trading. Also there are many (by equity standards) illiquid instruments that trade alongside relatively liquid ‘similar’ instruments.

So, when we try to assess a fair benchmark price to measure fixed income best execution:

• Do we use all quotes visible in the market, or only private, firm quotes? Can we add volumes from multiple quotes or assume only one quote from one venue / provider is ‘valid’. And how do we assess the time validity of quotes if they are not explicitly stated?
• If there is a trade today in an instrument that last traded three weeks ago and for which we only have very wide indicative quotes for today, do we use the firm traded price of three weeks ago or do we use the more recent private or non-firm quotes? Alternatively, do we use a model that takes the firm price of three weeks ago, adjusted by the implied price change due to market wide yield curve movements in the meantime?

Of course TCA firms like ourselves are currently busy sourcing data and coming up with solutions to the questions above. But it’s most likely the case that methodologies for best execution are going to evolve significantly, not least because as mentioned above, the regulations themselves may well alter the style of trading and the types of market data that will be freely available for these asset classes post-2017.

Venue and broker reporting and best execution (RTS 6 and RTS 7)

There are two major new pre- and post-trade market quality / best execution reporting requirements:

• For venues (and possibly some other liquidity providers) there will be a requirement (RTS 6) to publish on a quarterly basis an instrument level, daily breakdown of trading volumes and market quality (spreads, market depths, IOC fill rates, etc.) of all activity occurring on their venue.
• For investment firms that execute client orders to publish annual summaries of the top five venues, or trading destinations (i.e. brokers) split by each class of financial instrument (RTS 7), including information on the quality of execution obtained. Details to be provided will include execution costs/incentives and also passive/aggressive or liquidity adding/removing ratios of orders sent to venues. Investment firms will now also be required to update their order execution policies to “explain clearly, in sufficient detail and in a way that can be easily understood by clients, how orders will be executed by the investment firm” (MiFID II Article 27), and be able to demonstrate that they have executed orders in accordance with their policy.

Firms will be expected to produce the above information on a regular basis (quarterly for RTS 6, yearly for RTS 7) in a fixed format and the information must be made feely and publicly accessible.

There is an immediate and obvious impact to venues and brokers who will need to put processes to create these reports into place. An interesting related question is how should the rest of the market then be using this information as part of their own best execution due diligence? In principle, the RTS 6 reports provide a lot of detailed daily instrument level information on execution quality (albeit on a delayed basis). So what weight, if any, should firms be taking from this RTS 6 data when selecting which trading venues they should use? The RTS 7 reports give some useful detail on venue preferences and best execution policies of brokers, but how might buysides use this data in their broker selection decisions? From a TCA perspective is this data actually useful and if so how should it be used?

More generally, the requirement to clearly explain best execution policies to clients and to follow “all sufficient steps” (MiFID II Article 27) to achieve best possible results for clients is likely to lead to investment firms moving beyond ‘tick box TCA’ and towards providing a coherent, well thought out and quantifiable approach to all aspects of execution quality (see Figure 1).

Starting from parent level TCA analysis pre MiFID I, TCA has expanded to incorporate all aspects of execution quality over multiple venues and asset classes.

What does this mean for TCA?

If we wind the clock back to before MiFID I, TCA was a relatively simple exercise based on parent order analysis (usually limited to equity markets) with some standard top-level benchmarks such as Implementation Shortfall (IS) and VWAP giving general guidance on relative implicit costs of trading.

Post MiFID I, LiquidMetrix often makes the case that the additional complexity of trading due to lit venue fragmentation, algos and the emergence of HFTs and dark pools meant that to get a proper sense of execution quality, TCA really required drilling down into the micro level: our ‘Pyramid’ view of TCA.

Many of the high profile perceived ‘problems’ related to equity trading – such as HFT gaming and toxic dark pools – in recent years were largely invisible to standard top-level TCA analysis. To properly address concerns about such activities one needed to go beyond the basics. Some of the changes in MiFID II (for instance the new emphasis on venue/fill level reporting) are playing catch-up with the way equity markets currently work.

Possibly the most significant changes in MiFID II are the extensions to other asset classes. This presents an immediate set of challenges in acquiring market data sources to properly benchmark and assess best execution. As the trading microstructures of some of these new markets are very different to cash equities it will also mean thinking more deeply about how to define best execution for these asset classes.

As always, the temptation is to try and come up with a single set of measures common across asset classes. But as we saw with equity trading in Europe post MiFID I, if the underlying market structure and dynamics change then any effective best execution monitoring must be able to adapt to reflect these changes. So trying to simply copy ‘equity TCA’ methods to other asset classes may lead to inappropriate or worse, misleading, analysis of execution quality.

So be prepared for TCA methods to initially ‘fragment‘ for a period of time as the most appropriate methods of measuring execution quality in different markets evolve.

Of course, in the longer term, it is possible that the trading ecosystems of different asset classes might start to converge (we see some evidence of this in equity/FX markets) and a single set of TCA methods may work for all asset classes again. But in the short term, we think care needs to be taken not to try to force square pegs into round holes.

In summary, over recent years TCA has evolved rapidly to stay relevant to today’s markets. In the coming years that speed of evolution is only likely to increase.

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