Latest FMSB Paper Looks at Execution Quality in FICC Markets

The FICC Markets Standards Board (FMSB) has released a fourth, and what it says is its last spotlight review, this one studying the challenges in measuring execution quality and how different participants assess it.

FMSB acknowledges the increased focus on best execution and transaction cost analysis (TCA) by market participants and regulators and says that as a result measuring and evidencing trade execution quality has become “critical to client servicing as well as to demonstrating ongoing compliance with investor protection regulations”.

It observes that a firm’s ability to do this well depends heavily on the quality of data available and while the various regulatory requirements for measuring execution quality vary by jurisdiction and asset class, wholesale fixed income, currencies and commodities (FICC) markets face specific challenges in achieving high standards of transparency, openness and fairness.

FMSB spotlight reviews seek to highlight key issues facing market participants, this latest paper, authored by FMSB’s Rupak Ghose, explores the root cause of the challenges around best execution, highlights the progress made in regulation and market participants’ practices with regard to data reporting and best execution, and sets out key points of focus for firms navigating “difficult waters”.

The review notes that effective measurement of execution quality rests crucially upon the observability of relevant high-quality data sources. It adds that increased electronic trading and post-trade regulatory reporting requirements have substantially increased the amount of data available, however, the vast majority of FICC instruments continue to trade episodically, without adequate penetration by CLOBs (central limit order books) and, even where there is regular trading activity, there may be a limited amount of real-time public market data due to the OTC nature of the activity.

FMSB says that the growth of disclosed liquidity channels with pre-trade trade axes can be a valuable source of data for measuring execution quality, but warns that while post-trade regulatory reporting requirements have led to a growth in the amount of data that is available, much of that data is derived from small trade sizes while block liquidity may vary significantly.

Looking at the various approaches around the globe, FMSB observes “significant inconsistencies” and says there is a continuing debate amongst market participants and regulators about the benefits of increased real time reporting and dissemination of this market data. “This is particularly relevant in less liquid securities, where there is a balance between ensuring transparency and liquidity,” the paper states.

Stressing the importance of reliable data, the review says ensuring that data is fit for purpose involves checking for its accuracy, robustness and timeliness as well as how it is aggregated and analysed. Much of the new data ecosystem that has emerged in
recent years has not been optimised because of a lack of data quality and standardisation, it continues, saying, “This is particularly evident in the context of the Markets in Financial Instruments Directive (MiFID II)1 where a less prescriptive approach to post-trade reporting of OTC transactions has led to inconsistencies in the disclosures provided by market participants, which has in turn impacted their usefulness to the competent authorities.”

Looking at the focus on best execution and TCA by both market participants and regulators, FMSB says the growing shift of liquidity risk to the buy-side over the last decade has increased its desire to ensure adequate liquidity sources across all types of market conditions. “Creating a rigid one-size-fits-all set of requirements is not suitable given differences in the application of best execution factors and TCA principles across asset classes, geographies and firms, and the variability in data availability,” the review states. “However, there may be benefits to agreeing broad best practice, including due diligence as to how execution quality is measured, with a view to better fulfilling regulatory requirements and driving greater efficiencies.”

In laying out some key inputs to a best execution policy, the review acknowledges that achieving a one-size-fits-all set of requirements for best execution and TCA is impossible given the fundamental differences across asset classes, geographies, firms’ business models, and the lack of wide availability of key data points. It adds, however, there are opportunities to agree principles of best practice in broad terms regarding the due diligence of how execution quality is measured; fulfilling regulatory requirements while driving greater efficiencies. “A broader approach to establish standardised models and processes rather than specific obligations related to an individual trade could be crucial to building trust between buy-side clients and market makers over the fairness and effectiveness of FICC markets,” it states.

The review continues by observing that designing best practice focused on the measurement of execution quality must strike a fine balance between being detailed enough to improve consistency in how market participants engage with each other while not being so prescriptive that it harms liquidity. It also needs to be able to cater for the huge diversity of FICC markets, in terms of the amount of trading activity and data available, product complexity, unique market structure of individual asset classes and market segments.
It is also crucial for individual market participants to dedicate time and resource to this area, the review states, adding that ensuring observability of data through the appropriate use of public data sources, such as electronic trading platforms and post- trade reporting, consensus and evaluated pricing and internal historical databases, is “foundational”. Moreover, it adds, this observed data must reflect the ‘real’ available liquidity for the relevant market participant and in the right size. It must also pass the reliability test which incorporates the need for robust processes to ensure that data is not stale or erroneous, and that there is proper timestamping and labelling of data. It also observes there is a limited public consensus on the data inputs and processes that should be included in best execution assessments.

“This Spotlight Review…suggests that there may be benefits to agreeing broad best practices for measuring execution quality, both to better fulfil regulatory requirements and to achieve greater operational and cost efficiency,” says Mark Yallop, chair of FMSB. “Drawing on themes already identified in earlier Spotlight Reviews, this study highlights the importance of ensuring good quality data – from the broadest, most reliable and most appropriate sources – in order to measure the quality of trade execution.”

Ghose adds, “The series of four market structure Spotlight Reviews focused on emerging themes such as model risk in algorithmic trading, the critical role of data management, the changing surveillance environment and processes around measuring execution quality. A common theme throughout this series is the increasing importance of data quality and technology advancements, such as machine learning, in shaping the financial market landscape. Ensuring that governance and industry best practice keeps up with the rapid evolution of these trends is more important than ever in today’s complex financial system.”

Colin Lambert

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