WHAT’S IN A NAME?

Best Execution still means different things to different firms. Heather McKenzie reports.

More than five years after the introduction of MiFID one of the central principles of the directive – best execution – remains ill-defined and open to interpretation. However, buyside firms are beginning to take more responsibility for ensuring whether or not they are getting the best deal from their brokers.

MiFID was put together in 2004 and implemented in 2007 – before the financial crisis hit its peak in September 2008. The original intent was to break down the barriers between trading in different countries in Europe and to make trading fairer and more transparent, particularly for retail investors. These intentions, however, were hijacked by the financial crisis, which brought the issue of systemic risk to the fore and significantly pushed back all other considerations.

In October 2011, the European Commission published proposals for a review of MiFID to take into account the changes wrought on the financial markets by the crisis and also the consequences of the original MiFID, which led to a proliferation of trading and clearing venues. When the proposals were released, Commissioner for Internal Market and Services, Michel Barnier, said: “Financial markets are there to serve the real economy – not the other way around. Markets have been transformed over the years and our legislation needs to keep pace. The crisis serves as a grim reminder of how complex and opaque some financial activities and products have become. This has to change. Today’s proposals will help lead to better, safer and more open financial markets.”

For the trading community Article 21 was of great interest as it highlighted the “obligation to execute orders on terms most favourable to the client”. Six elements of the article outline what is meant by this, without giving too much detail – Europe, unlike the US, tends to opt for ‘principle-based’ regulation, leaving it to industry practitioners to hammer out the details. Investment firms must have an order execution policy that enables them to obtain for their clients “the best possible result” in accordance with the elements listed above. The firms’ clients must agree with the policy before orders are executed.

Brad Wood, a partner at London-based consultancy GreySpark Partners, notes that best execution was never meant to be well-defined or prescriptive. “The concept of best execution is principle-based, designed to oblige firms to define what they mean by best. This was in response to reluctance from market participants for heavy-handed regulations.”

Adam Toms, chief executive Instinet Europe, agrees, adding. “I think people in the industry understand what best execution needs to be; that it is not just about price but includes many other aspects such as the quality of execution end to end. Due to there being so many different reasons for participants to trade with particular counterparties and taking into account the fact that market conditions change, best execution rules should not be too rigid.”

Chapter II

It had been thought that the review proposals would add clarity but they focus more on the additional trading platforms, new safeguards for algorithmic and high frequency trading activities, increased transparency, reinforced supervisory powers and stronger investor protection. The proposals have since been passed to the European Parliament and the Council for negotiation and adoption.

A clearer definition of best execution is unlikely. Instinet’s Toms says the MiFID Review will deliver limited change in the definition, but there are “related topics” such as treatment of dark pools, that will change as a result of the Review and will help improve execution. The individual best execution policies of market participants are unlikely to change, he says.

Rainer Riess, managing director Xetra market development at Deutsche Börse, says the current best execution regime is very suitable for Europe. However, the enforcement of the regime is inconsistent. “Approaches to best execution differ in different countries and sometimes within countries. This is an area that needs harmonisation in the regulatory and legal efforts.”

Guidelines on how the best execution principle is being applied and analysis of how banks and brokers are doing best execution would be helpful, he says. “The biggest concern for buyside firms is their ability to judge whether or not they have achieved best execution.”

Steve Grob, director of group strategy at technology vendor Fidessa, believes the main problem for firms trading in Europe is that the buyside does not have an absolute measure of best execution. “Without a way of measuring broker performance, such as a consolidated tape, buyside firms cannot get an independent view of whether their broker has executed a trade in the best possible way,” he says.

According to Grob, Fidessa’s buyside clients have three challenges. First, there is greater fragmentation of trading venues which means that money saved in execution is being lost downstream. Second, as more venues trade the same instruments and stocks, high frequency trading activity is flourishing and buyside firms are trying to prevent their flows intermingling with HFT flows. Finally, there are concerns about information leakage, making it difficult to execute large blocks of trades.

The tape

A consolidated tape that combines every execution venue and every execution on those venues would enable firms to understand at which point in time and where they achieved best execution, says Tom Riesack, managing principal at securities industry consultancy Capco. However, the sticking point is who would mandate it and who would pay for it. Such a solution would require huge amounts of data. “We need to find a better way to define best execution, but we have to take into account that it is a very individual thing. Each firm needs a better understanding of what best execution means for them.”

Large buyside firms, for example, may want to ensure there is no big movement in price when they execute a large block order, whereas hedge funds, particularly those with HFT strategies, may be more concerned about the price and latency of execution. “No single answer covers everyone when it comes to best execution,” says Riesack.

These differences spawned the growing number of transaction cost analysis (TCA) solutions. “Firms can use TCA tools to address their most pressing issues, rather than what they are being provided with by sellside firms,” he says. “The effect of using TCA is that firms will get different types of best execution policies that are specific to their processes or strategies.”

GreySpark’s Wood notes that a growing number of buyside firms are demanding more detail about their brokers’ best execution policies. “Firms want their brokers to increase the level of detail about how they consider the performance of their algorithm, for example, fits in with their definition of best execution.” The different priorities of buyside firms could eventually lead to brokers competing by providing differentiated definitions of best execution. Synthetic order types that take into account the specifics of a client’s requirements may be tuned into algorithms in order to meet that particular best execution scenario, he adds.

Jon Fatica, head of analytics at New York-based TradingScreen, believes that TCA will develop into an intraday analysis tool and eventually into a real-time monitoring solution. “Most of the challenges with best execution involve data availability. Some of the new MiFID rules will address the shortcomings of data availability.”

He agrees with Wood that buyside firms are pressing brokers to tell them more about their algorithms. “Things are getting better and people are getting closer to how they want to execute a trade. But it is a zigzag path and the markets are not very liquid, they are challenging.”