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Trading

Another MiFID II impact: Best execution of derivatives

Over-the-counter activity seen ripe for transaction cost analysis

Bloomberg’s Mike Googe

Add derivatives transaction cost analysis — measurement of best execution — to the list of services that could grow with the advent of MiFID II in January.

Required disclosure of trade execution data under the European Union's Markets in Financial Instruments Directive II, effective Jan. 3, has transaction cost analysis providers saying they expect more institutional investors — pension funds, endowments and foundations, and their money managers — to seek third-party help in reporting best-execution data.

Some TCA firms are adding to their existing equity and fixed-income analysis services by developing capabilities in listed options, asset-backed securities, interest-rate swaps and other asset classes traded over the counter.

At Bloomberg LP, its BTCA transaction cost analysis business has created a beta program for OTC and swaps TCA that's offered to a small number of clients. "Our focus is to introduce this in time for MiFID II" in January, said Mike Googe, global head, post-trade transaction cost analysis at Bloomberg in London.

"The drivers (of transaction cost analysis in derivatives) are twofold," Mr. Googe said. "Yes, there are regulatory requirements for a wider group of asset classes, but ultimately, asset owners and stakeholders are more interested now in how they define execution quality and how they protect their alpha."

Mr. Googe said the growth in derivatives TCA is expected to mirror the growth Bloomberg has seen in fixed-income TCA, which began four years ago and now accounts for half of Bloomberg's business in terms of the number of clients.

Abel/Noser Corp., New York, which added fixed-income transaction cost analysis earlier this year, is looking at applying TCA to asset-backed and mortgage-backed securities. "We're thinking about this every day," said Ted Morgan, Abel/Noser CEO. He said listed options also could be "an accessible asset class for us" in the next year or two given the availability of data on price discovery and liquidity.

Mr. Morgan said Abel/Noser's over-the-counter bond trading analytics can be applied to derivatives transaction cost analysis. "OTC bond trades are something our product covers well, in depth, using all three of our fixed-income measurement methodologies — liquidity, quote and spread-to-benchmark," which measures the spread of a security with its corresponding or similarly behaving benchmark or index, Mr. Morgan said. "This could be useful to many firms trading derivatives, even if those derivatives are not directly covered by our product.

"It's early days, but the 100-year trend is that equity blazed the trail on transparency, and fixed income and others will follow. The more transparency there is, that makes TCA — and price discovery — a lot easier," Mr. Morgan said.

Dash Financial Technologies, a Chicago-based TCA provider, has seen an uptick in interest in the firm's listed options analysis over the past year. "There are a few key points that make TCA difficult to calculate, but there are ways to handle it and meet each client's needs," said Ben Londergan, Dash Financial president.

"There are 15 venues to execute equity options in the U.S.," Mr. Londergan said. "Then there are different ways to place orders and execute orders. That complexity lends itself to meet the more specific needs of each investor. Computation might be simple, or it might be a complex algorithm. It depends on the investor."

Mr. Morgan at Abel/Noser said there are elements required in standard equity TCA — market data to measure trade efficiencies like average price, settlement price, peer benchmarking capabilities and liquidity measurement — that are harder to replicate with over-the-counter trade analysis.

"You'll face the same challenges" in derivatives as in fixed income and other strategies traded over the counter, Bloomberg's Mr. Googe added. "When it comes to fixed income, or anything over the counter, because of the nature of how the market is traded it's entrenched in voice and messaging," he said. "In these cases, it's not so much the opportunity cost measured through the entire trading cycle, as is the case with equities, but about whether you got the best deal at the time of the trade. And that can be measured. OTC trades have unique contracts and settlements. We can represent that. You wouldn't directly benchmark apples and oranges. We liken this to contextual data."

However, disclosure requirements under MiFID II could create a new source of data that doesn't exist now for derivatives TCA, said Thomas Lehrkinder, senior analyst at TABB Group LLC, New York. "TCA is growing in use for a variety of things," he said, "but it's going into things they can't yet go into because the data's not there. They'll get there eventually, but they're not at that stage yet with over-the-counter trades, especially for OTC derivatives. That's where MiFID II comes in, to have that data posted. So regulation will drive this, not the market."

Gauging interest

Mr. Googe said that while he couldn't say how much interest in derivatives TCA is coming from pension funds, endowments and foundations, "generally speaking, it's fair to say that the more sophisticated and forward-thinking an organization is, the more ahead they are on TCA."

Dash Financial's Mr. Londergan said he'd be surprised if asset owners responsible for investments aren't looking at over-the-counter trade analysis. "I'd be shocked" if investment committees aren't using this TCA, he said. "As someone who's run a proprietary trading firm, some of the first questions you ask (a money manager) is, 'Have you backtested it? Can you execute with the same or better alpha as another manager?' I can see this being very important for them."

However, selling TCA to some institutions that have large percentages of investments in derivatives could be difficult, based on the views of David Long, senior vice president and chief investment officer, asset/liability modeling, derivatives and fixed income at the C$70.4 billion ($57.7 billion) Healthcare of Ontario Pension Plan, Toronto. As of Dec. 31, HOOPP had a total notional value of C$294 billion in foreign exchange forwards, futures, options and interest-rate, equity and credit default swaps, according to the pension fund's annual report.

"Generally, I am not a fan of TCA, or for that matter, separating portfolio management from trading," Mr. Long said. "Everything will cost money to trade. Whether the cost is worth it is dependent on several factors. For example, how much risk is there in waiting for a better price? Is there an opportunity that could be lost by waiting? Should you do less of a good trade because you will pay more cost," such as the bid-offer spread?

"By integrating trading and portfolio management, opportunity, risk and cost can be holistically evaluated," Mr. Long said. "Ultimately, aggregate portfolio performance, rather than TCA alone, will reflect how well those decisions were made."