MiFID2 best execution: Top 10 Questions on Top 5 Disclosure

Firms should now be actively engaging in the preparation of their Top 5 Disclosures. Ahead of the first publication deadline on 30 April 2018, we share in this article our thoughts on certain frequently asked questions about Top 5 Disclosure and we discuss how Simmons & Simmons can assist firms with Top 5 Disclosure.

Publication of the Top 5 Disclosure is one of the first significant deliverables for a firm following MiFID2 coming into force in January, and we expect that there will be industry wide-interest in the content of firms’ public disclosures, including from competitors, trading counterparties, regulators, investors and the media.

We cover the following topics:

1. Which firms are subject to Top 5 Disclosure? 
2. What triggers Top 5 Disclosure?
3. When must firms publish their first RTS 28 Report?
4. What must the RTS 28 Report contain?
5. What other issues are relevant in preparing the quantitative element of the RTS 28 Report?
6. How should the RTS 28 Report be published? 
7. How should firms produce their first RTS 28 Report which covers a period before MiFD2 came into force?
8. How is this relevant for AIFMs?
9. Can AIFMs publish more information than is required?
10. How can Simmons & Simmons help?

1. Which firms are subject to Top 5 Disclosure?

The following firms are subject to Top 5 Disclosure:

• Investment firms subject to MiFID2;
• Management companies (Mancos) of UCITS funds. In the UK (as a result of FCA gold-plating), the obligation applies to the whole of the Manco’s business (not just to its MiFID top-up activities); and
• In respect of certain activities only, EU alternative investment fund managers (AIFMs) (see Q8 below).

“Pure” AIFMs which do not hold MiFID top-up permissions are not subject to Top 5 Disclosure.

Non-EU firms (such as a US or Hong Kong investment manager which trades on EU markets or with EU counterparties) are not subject to Top 5 Disclosure.

2. What triggers Top 5 Disclosure?

Top 5 Disclosure is triggered by two parallel rules in respect of two parallel MiFID activities.

• Direct order execution: under the MiFID2 Level 1 Directive, a firm which directly executes client orders must summarise and make public on an annual basis, for each class of financial instruments, the top five execution venues in terms of trading volumes, where it executed client orders in the preceding year, together with information on the quality of execution obtained.

(Article 27(6) of MiFID2. The UK FCA implemented this rule at COBS 11.2A.38R)

• Passing orders to another firm for execution (indirect execution): under the MiFID2 Level 2 Delegated Regulation (2017/565) (the “DR”), portfolio managers placing orders with other entities for execution, and firms providing the service of reception and transmission of orders, are subject to an equivalent rule. In particular, when a firm selects other firms to provide order execution services, it shall summarise and make public, on an annual basis, for each class of financial instruments, the top five investment firms in terms of trading volumes where it transmitted or placed client orders for execution in the preceding year and information on the quality of execution obtained.

(Article 65(6) of the DR, which is directly applicable in EU member states).

The distinction between direct order execution and indirect order execution is relevant both to (i) the content of the Top 5 Disclosures (see below at the heading “What must the RTS 28 Report contain?”) and (ii) in the case of AIFMs, how the obligation applies (see Q8 below).

In both cases, there is additional technical detail on the content of the Top 5 Disclosures in RTS 28, in one of the regulatory technical standards made under MiFID2 (Commission Delegated Regulation (EU) 2017/576). The Top 5 Disclosure is often referred to as the “RTS 28 Report”.

3. When must firms publish their first RTS 28 Report?

ESMA has confirmed that firms must publish their first RTS 28 Report by no later than 30 April 2018, in respect of client orders executed during calendar year 2017 (see Q7 below).

4. What must the RTS 28 Report contain?

The report is split into quantitative and qualitative elements. Both elements will require firms to gather data for each sub-class of MiFID financial instruments (there are 22 sub-classes in total, as listed at Annex I of RTS 28) on their trading volumes with different counterparties and on different venues; a “venue” for these purposes is defined widely and includes not just exchanges, multilateral trading facilities and organised trading facilities but also systematic internalisers, market makers and other liquidity providers with whom the firm has traded directly (eg as OTC counterparties).

In order to preserve some element of protection from disclosing commercially sensitive information, ESMA has provided that the volume of execution and number of executed orders is to be expressed as a percentage of the firm’s total execution volume and a percentage of the number of executed orders in that sub-class of financial instrument, rather than as absolute values.

4.1 Quantitative disclosure:

The quantitative element requires an in-scope firm to list, for each of the 22 separate sub-classes of financial instruments1:

• In respect of direct execution: its top five execution venues in terms of trading volumes for transactions that the firm has executed during 2017, both: (1) directly on a trading venue (ie as a member of or participant in that venue); or (2) on an OTC basis directly with a counterparty (the “Venue Report”)
• In respect of indirect execution: its top five brokers in terms of trading volumes for all transactions during 2017 resulting from the firm placing orders with, or transmitting orders to, another entity (eg a broker) for that other entity to execute on the firm’s behalf (the ”Broker Report”), and
• In addition: its top five execution venues in terms of trading volumes for all executed orders in securities financing transactions during 2017.

Transaction volumes should be calculated by reference to market price for securities trades and notional for derivatives trades.

There is a prescribed template for the quantitative disclosure, as set out at Annex II of RTS 28. It is mandatory for firms to use this form of template for the quantitative disclosure.

4.2 Qualitative disclosure:

The qualitative element requires firms to gather data and produce a summary of the analysis and conclusions drawn from its detailed monitoring of execution quality obtained on execution venues or, as the case may be, from brokers in the previous year for each class of financial instrument. This will need to include analysis explaining why the firm considers that the quality of executions obtained from the top five brokers and venues listed in the quantitative section of the report, justify the relevant brokers’/venues’ status as part of the top 5. The qualitative element should also disclose the existence, and details, of any links or conflicts of interests between the firm and the relevant venues/brokers in the top 5.

There is no prescribed format for the qualitative disclosure, and so firms may choose their own template. Simmons & Simmons has produced a template for the qualitative disclosure (see Q10 below).

5. What other issues are relevant in preparing the quantitative element of the RTS 28 Report?

A number of frequently asked questions have been raised in relation to the preparation of the quantitative report. We summarise below half a dozen of the most common questions.

5.1 Do we need to distinguish passive orders and aggressive orders?

Yes, the quantitative information to be published will, in certain circumstances, need to differentiate between “passive” and “aggressive” orders. A “passive” order is one which adds liquidity to the relevant order book (eg submitting an order to an exchange which does not match an existing resting order); whereas an “aggressive” order is one which removes existing liquidity from the order book (eg submitting an order to an exchange which is immediately matched with an existing resting order).

5.2 Do portfolio managers which pass an order to an executing broker need to distinguish between passive and aggressive orders?

Not normally, no. In differentiating between orders that are passive or aggressive, ESMA has clarified that these terms are unlikely to be relevant in the context of order transmission/placement by portfolio managers and, as such, the passive/aggressive fields would usually not need to be completed in the Broker Report for such entities.
The only exception would be where the firm attaches a specific instruction to the order telling the broker to execute the order passively or, as the case may be, aggressively.

5.3 Do we still need to distinguish passive/aggressive orders if the execution venue does not have an order book?

In our view, no. Simmons & Simmons is of the view that the passive/aggressive distinction is only relevant where the trading venue in question maintains the type of order book that enables members of the trading venue to trade both passively and aggressively. So, in the context of the Venue Report, the distinction would not be relevant to over-the-counter, request for quote (RfQ) based trading or for trades on trading venues that are RfQ platforms (where there is no such choice).

5.4 How should we report the use of direct electronic access?

ESMA has confirmed that, where a firm uses Direct Electronic Access (DEA) to access a venue, this is treated as a form of order transmission (to the DEA provider) and so any such trading would form part of the Broker Report rather than the Venue Report, with the DEA provider being the relevant broker. This is somewhat counter-intuitive as, for best execution purposes, many investment managers treat the use of DEA as direct execution by the investment manager (as they are not relying on the DEA provider to ensure best execution for the order).

ESMA has suggested in its related Q&A that, where firms include DEA trading within their quantitative disclosures in the Broker Report, they should, in the qualitative disclosure, provide details of the main trading venues to which such DEA trades were transmitted.

5.5 How do we disclose if we trade with multiple entities in the same corporate group?

Where firms have traded, or placed orders for execution, with multiple legal entities who are within the same group, each legal entity within the group must be treated separately for the purposes of the calculations that are used to generate the Venue Report or, as the case may be, Broker Report.

5.6 Do we have to disclose if we pass orders to our affiliate to execute?

Similarly, where a firm places an order with its own affiliate for execution by that affiliate, the relevant affiliate needs to be treated as a broker for the purposes of the calculations that are used to generate the Broker Report. It is therefore possible that, for some instrument sub-classes, a firm’s affiliate may appear in its top 5 list.

This may occur, for example, if a UK investment manager makes a discretionary decision and passes the order to its US affiliate’s trading desk to execute the order. In such a situation, this would need to be factored into the calculations for the Broker Report as an order passed to the US affiliate. The UK manager would not, for the purposes of the Broker Report (or Venue Report), “look through” the US affiliate’s processing of the order to the ultimate broker (or execution venue).

6. How should the RTS 28 Report be published?

Firms are required to publish their RTS 28 Report on their websites in a freely accessible format. The quantitative element of the RTS 28 Report must be in machine-readable format (eg a CSV file), available for downloading by the public.

Firms are required to maintain the information on their websites for a period of at least two years following publication.

7. How should firms produce their first RTS 28 Report which covers a period before MiFD2 came into force?

ESMA has acknowledged that firms may not be able to fully report on data which is unavailable or not applicable in relation to the preceding year (for example, because it may be tied to a new provision introduced by MiFID2). ESMA has clarified that its expectation is that some aspects of the first RTS 28 Reports published by firms may lack the level of granularity that would be available for subsequent reports and that, in such circumstances, the RTS 28 Report should be completed on a best efforts basis.

8. How is this relevant for AIFMs?

The FCA stated in its July 2017 Policy Statement (PS17/14) that it would not “goldplate” the obligation to provide RTS 28 Reports to AIFMs in respect of their non MiFID business. AIFMs will, therefore, continue to be subject to the best execution rules contained in AIFMD in respect of their non MiFID business.

However, by virtue of the provisions of the DR (which has direct effect as a matter of EU law), the requirement to prepare a RTS 28 Report will apply to any MiFID business undertaken by an EU AIFM pursuant to any “top up” permission which permits the AIFM to carry on the MiFID activities of portfolio management or the reception and transmission of orders for non-AIF clients in respect of MiFID financial instruments.

This requirement applies only to order placement and order transmission activities, but not to direct executions by the AIFM. Therefore, any order placed with, or transmitted to, a broker for execution that results from decisions by the AIFM to deal in financial instruments on behalf of a client in the context of the AIFM’s MiFID business will be caught by the requirement and will need to feed into the AIFM’s Broker Report. However, EU AIFMs will not need to produce a Venue Report because direct executions are not caught by the requirement.

9. Can AIFMs publish more information than is required?

The rules do not prohibit AIFMs from electing to also publish execution information in respect of their non MiFID business i.e. AIF management activities in addition to the RTS 28 Report on their MiFID business and/or from publishing a Venue Report, and we are aware that some AIFMs are, for reasons of operational convenience, choosing to disclose more widely than is required. Where possible, AIFMs considering disclosing non MiFID business in a Broker Report should not co-mingle their MiFID and non MiFID business if that would potentially lead to a change in the data disclosed in the Broker Report (for example, because trading for their AIFs is not entirely pari passu with trading for the clients to whom they provide MiFID top-up services).

10. How can Simmons & Simmons help?

The qualitative disclosure is required, as a minimum, to include certain prescribed information. Simmons & Simmons has designed a MiFID 2 compliant template to allow firms to capture the necessary information in the qualitative element of the RTS 28 report. We would be pleased to discuss further with our clients how to access this template.