The introduction of MiFID II and MiFIR on 3 January 2018 will impact every aspect of how financial institutions do business. The scale of the task cannot be underestimated. For buy-side firms, getting the right vendor relationships in place will be vital to ensuring that they operate under the regulations in as efficient and compliant a way as possible.
To help frame this vendor selection exercise, in March 2017 the Alternative Investment Management Association (AIMA) compiled a report, detailing the most effective third party vendor solutions. These span: transaction reporting; post-trade reporting; best execution/transaction cost analysis; telephone recording and surveillance; research budgeting, and commodities position monitoring.
Most buy-side firms will need to make some level of adjustment to their internal IT systems to ensure the above areas of MiFID II can be handled.
"MiFID II is significant, more so than a lot of firms realise; particularly smaller asset managers," asserts Leonard Ng, Partner at Sidley Austin LLP. "As it touches every part of operations, trading and governance, the buy-side can't treat it just as a compliance disclosure issue.
"It will impact the way asset managers do business and large financial institutions understand that this requires changing their business model. If you are a hedge fund and you haven't done anything to prepare for MiFID II, you're going to find yourself in a difficult situation because you'll have to make a lot of changes to your internal processes, not just from a compliance perspective but from a business, strategic and commercial perspective."
Arguably one of the biggest challenges facing fund managers is T+1 transaction reporting. Managers will have the option of either handling this function internally and build the necessary systems to capture the data, cleanse it and report to the regulator, or, which is more likely to happen, appoint a third party vendor known as an Approved Reporting Mechanism (ARM). A third option is to use a vendor such as IHS Markit.
"We are not an ARM, we sit above that," explains Kirston Winters, Managing Director at IHS Markit. "We provide the business logic and a data management system with all the mapping in place to disseminate data to the various ARMs, National Competent Authorities and APAs. We work with our clients to plumb in the data from all of their existing sources and then we run it through our validation models, so that when the client submits the transaction report T+1 they already know there are no issues."
Getting the data right up front, at the pre-validation phase, identifying any gaps, etc, will require a change in mindset. Once the transaction report is populated, and the file is completed, IHS Markit's clients send the validated report to the ARM to file on their behalf, or file it themselves.
The problem with MiFID II is that it is a real data challenge. MiFID firms were required to transaction report on equities, previously, but most buy-side firms could simply delegate this to their broker(s). That is not likely to happen under MiFID II, which will require information not only on equities, but OTC derivatives, exchange-traded derivatives, FX, bonds and commodities.
"Uniquely, the regulator will not just want information about the transaction, but also on the entity and the individual making the decision. Reporting T+1 on 65 fields in a transaction report shouldn't be too big a challenge. The reason it is, is simply because of data management," says Winters, confirming that IHS Markit has a product called EDM (Enterprise Data Management) that manages big data for more than 200 clients and which has been repackaged as a full-service data management/transaction reporting solution.
This gives buy-side managers the ability to leverage a system that can handle myriad reporting requirements in addition to transaction reporting e.g. trade reporting to an Approved Publication Arrangement, Annex IV reporting, EMIR reporting.
There's no point building bespoke solutions for each regulatory demand as this replicates the cost base.
"Given its breadth, our clients are looking to put a comprehensive solution in place to replace some of their legacy systems. A future proof solution that not only handles MiFID II but also takes out some of these legacy system approaches that were used previously," adds Winters.
Alejandro Perez is Global Head of Post-Trade Solutions at Bloomberg, which offers a complete suite of solutions under MiFID II from pre-trade workflows (pre-trade analytics, order management), execution workflows (routing and execution) to post-trade workflows (transaction reporting, best execution). He explains that under MiFID II, the handling of personally identifiable information means that the buy-side will likely minimise the amount of reporting it outsources to its trading counterparties.
"We believe most institutions will choose to do the transaction report themselves, either through a third party ARM or by submitting it on their own, if they have the capabilities," he says.
Bloomberg is currently building a personal information database to house all the PII data from its clients, which can then be appended to a transaction report and submitted to the regulators.
"It is important for clients to understand how much data they will need to submit to their appointed third party. They should ensure that the third party can evaluate it in good time and provide the appropriate dashboard capabilities to ensure that clients are aware of what's rejected, what's accepted, and what needs to be managed from an exception perspective," comments Perez.
As well as providing transaction reporting capabilities, Bloomberg can give its clients transparency reporting capabilities, record keeping, trade surveillance, best execution capabilities as well as research evaluation tools.
"Over the last six to nine months we've worked on consolidating those products so that if a client is ticketing in Bloomberg, using one of our order management systems or our MTF, there should be a seamless integration of data within the Bloomberg infrastructure, which can then be passed to record keeping, to best execution, to our Approved Reporting Mechanism for transaction reporting, and so on," explains Mark Croxon, Head of Regulatory and Market Strategy EMEA at Bloomberg.
Role of the ARM
Firms will not be able to merely pull raw data from a core system and push it out to the regulator. The transaction report will require far more in terms of data contextualisation, such as matching ISIN codes against OTC trades, making sure they have Legal Entity Identifier (LEI) data properly tagged and accounted for; issues that are likely to prove quite challenging for smaller fund managers.
"Contextualising data and populating certain pieces of information that in the past there was no need to source, will not be straightforward," explains Geraldine Gibson, CEO of AQMetrics, which operates an Irish-authorised ARM. "It's not the number of fields in the transaction report but the sourcing of the data, for a small sub-set of those fields, that will cause the main challenge. If an LEI is missing for an OTC position, for example, how will that get managed?"
Ultimately, MiFID II is all about data handling. "We look at whether you can get the data that you require for MiFID II from your source systems – internal IR systems, CRM systems, etc – which can then be pulled together and staged, contextualised and prepared for transaction reporting. This process enables us to identify which data is missing in clients' source systems that will need to be handled by AQMetrics.
"If the manager doesn't have an in-house repository for LEI data, which a lot of small managers lack, as their appointed ARM we will pull all that data together from the necessary external sources. It's a very controlled exercise. It has to be because if we miss any of the data for transaction reporting, it becomes problematic," outlines Gibson.
One entirely new market that is springing up as a result of MiFID II is research. Buy-side firms will now be required to unbundle investment research and separate what they receive from their trade commissioning. The objective to this is to enhance investor protection and to ensure that the investment manager consistently acts in his clients' best interests. This means operating a dedicated research budget where the efficacy and value of that research must be continuously assessed.
There are various implications to this. Some fear that the volume of research will subside and put smaller independent research providers out of business. Others argue that it could in fact give independent providers access to a wider audience of clients as research platforms emerge to disintermediate the process, effectively sitting between the manager and the sell-side research desk.
One such platform is London-based RSRCHXchange. As co-founder Jeremy Davies explains, the platform was initially built with the buy-side community firmly in mind but a couple of recent developments have lead to them to more actively support the sell-side; the aim is to have 300 research providers on the platform by year-end.
"Firstly, we've taken on Alan McDonald who was formerly head of research at Nomura and UBS, to help answer problems faced by the sell-side and provide an effective solution.
"Secondly, there has been an epiphany among sell-side firms that technology can really solve something. As they go through the process of understanding who their research clients are, what research they consume and how they value their content (aside from being linked to trading commissions), by using a research platform like ours they can more effectively manage those relationships. Ultimately, they can distribute their research to clients who might not necessarily be core clients," explains Davies.
One unique aspect of research platforms like RSRCHXchange is the ability for the buy-side to track their research consumption. "We can show you what you've read and only we can show you how that research has been consumed and rated. It is simple, effective and done in real-time with no need for reconciliation. It's like rating an Uber driver.
"Other people can provide you with files to reconcile against, but they cannot necessarily provide evidence of consumption. The platform lets you rate the research as you read it, rather than have to wait till the end of the week," adds co-founder Vicky Sanders.
There is no doubt that unbundling research from trade commissions puts a significant burden on the buy-side. For the sell-side, there's really only one requirement, which is to price and separately supply their research.
But that has many potential consequences if one thinks about why a research department exists.
"They will need to adapt," states Sanders. "Some institutions who perhaps feel they have been underpaid for producing research are excited by the opportunity to sell it separately. Others are looking to understand how to drive their research department, going forward, and determine what will be their main revenue drivers. What do they do best and what do clients really value?"
One of the ongoing debates is how the payments for research should be funded and what the price level should be, particularly for non-equity research. Croxon thinks that while most firms will likely be compliant in terms of paying for research, by January 2018, it might take time to determine what the pricing schedules and arrangements will be.
Whatever the accepted model becomes, Bloomberg has focused on two areas for the buy-side, from a product development perspective.
"The first is to take our entitlements database, which has traditionally been used by the sell-side for the provision of research, and retool it so that the buy-side can also use it to entitle what research they wish to receive at fund and firm level, and implement controls to prevent inducement.
"The second area relates to demonstrating both the value and the price of the research you receive. We have evaluation tools that allow managers to create customisable scales of up to seven or eight levels of evaluation on research. They can manage entitlements such that they only receive research for those they want to receive it from, and then evaluate the quality of that research in all of its various forms," explains Croxon.
Best execution and TCA
Aside from transaction reporting and research unbundling, a third important area relates to best execution/transaction cost analysis.
Under MiFID II investment firms will be required to:
"We've been running a TCA, best execution solution for a number of years, where the primary objective of the tool was to provide actionable insight to help equity clients adapt their trading styles. With the expansion into non-equities, we've adapted the solution into a multi-asset class environment to meet the best execution requirement," confirms Michael Richter, Director of Markit Trading Analytics at IHS Markit.
This will enable institutions to run TCA and best execution on instruments such as CDS and IRS, which up until now have mainly traded OTC.
How one can determine best execution on an OTC derivative raises an interesting question. These instruments are not freely traded like equities, they are far more institutional and bilateral in nature.
"Using an evaluated price based on a number of different inputs, at this stage, is the best way forwards in these asset classes where execution data is not plentiful. The regulators understand there are pitfalls to this. What they will want to see is that firms can demonstrate a process for best execution and our offering on a T+1 basis allows firms to do just that.
"This process also has to be in line with an organisation's best execution policy, which needs to be constantly updated. The regulator wants it to be a living, breathing document," explains Richter.
Leveraging existing infrastructure
In conclusion, Ralph Achkar, Strategic Alliances Director, Colt Capital Markets, believes it is important to select a vendor who is open to a partnership approach where they work with other best-of-breed vendors to offer the end client a functioning solution.
"We realised that no matter how much we do, no one vendor is capable of implementing everything. That's why we started reaching out to different vendors to ask them to join our Colt PrizmNet ecosystem.
"For an ARM, rather than having to build out their own infrastructure, they can use Colt's infrastructure, which has connectivity to over 10,000 capital markets locations. It becomes much easier and quicker for customers to reach ARM services, rather than having to build their own connectivity."
This ability to provide access to best-of-breed vendor solutions enabled with market data, from trade surveillance to transaction reporting, is a novel way to supporting vendors under MiFID II.
"It avoids having to incur the cost of running multiple components in an infrastructure with lots of systems and equipment. With such an ecosystem approach, you use one set of physical connections to reach a whole range of services," concludes Achkar.
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