Best Execution: The New Partnership
Best execution is now firmly in the regulators’ sights. Traditionally considered the provision of enhanced execution performance as a fiduciary duty to end-investors, the main challenge to date has been the interpretation of this provision, which can alter dependent on the participant, the investment strategy, or the time of trade.
While recent events and changing market structure potentially make best execution harder to achieve, new regulatory obligations to quantify and qualify best execution performance will intensify these challenges. The increased regulatory focus now tops the reasons for investment firms to choose to review best execution policies.
Under Article 27 of MiFID II, investment firms are now required to take all “sufficient steps ” to achieve best execution, including the publication of the quality of execution achieved, as well as internal monitoring processes to verify the effectiveness of the execution. The publication of the Regulatory Technical Standards by ESMA states that the regulation applies to “investment firms in relation to client orders executed on trading venues, systematic internalisers, market makers or other liquidity providers”, including third country entities that perform a similar function. The debate is what constitutes the definition of “investment firm” and “client”. In reviewing the MiFID level one text, the best execution framework has been enhanced to include a framework for retail investors, which could mean asset managers are interpreted as the investment firm rather than the client by the regulator, and this interpretation may be expanded further in the MiFID II Delegated Acts due later this year.
New monitoring obligations will require investment firms to publish a “summary of the analysis and conclusions it draws from its detailed monitoring of the quality of execution obtained on the execution venues ”. Whether in their role as a client or as an investment firm executing client orders, demonstrating best execution from both a fiduciary and regulatory perspective will necessitate a change in approach by many. From the buy-side internally reassessing what best execution means within their organisation, to externally communicating these requirements to the sell-side, as well as incorporating technology to demonstrate effective monitoring – all of which will require an investment in stronger partnerships throughout the execution life-cycle.
Market structure developments have already accentuated long-standing challenges in delivering best execution. The concentration of asset managers and decrease in contra trading by buy-to-hold investors makes entering or exiting an investment strategy problematic when the order size represents several days’ volume. The decline in the use of capital commitment combined with the need for greater transparency over order execution has led many on the buy-side to shift to self-directing order flow. Yet with ownership comes responsibility and greater accountability.
Without the traditional protection of brokers, the buy-side are already turning to independent analysis of their execution performance. The increased propensity by the buy-side to trade off-exchange using broker dark pools has accentuated this demand. Recent fines and exposure of potentially toxic activity in some US dark pools impacted levels of trust between participants and the venues they use. All market participants are now under pressure to demonstrate that they do not fall prey to nefarious activity, nor inadvertently encourage this type of activity. As clients’ needs evolve, the ability by trading partners to understand and interpret these needs – from low touch algorithms to high touch blocks – will be critical. Only the unconflicted broker who enhances their buy side clients’ ability to achieve best execution for the end investor through greater transparency over both process and performance will emerge successful in the post MiFID II world.
Sell-side to buy-side, it will be access to accurate, reliable and timely data that will be critical to demonstrate this provision of best execution. As such, the majority of respondents’ highlighted data as their current main challenge. Venue performance can fluctuate over time according to external market conditions as well as the individual parameters of the order being executed. Asset managers now need to understand not only where orders are executed but also the impact of executing on a particular venue at a particular time.
Greater accuracy and availability of information will enhance post-trade analysis and subsequent pre-trade selection. Managing different trading strategies based on long-, mid- and short-term alpha horizons as and when they occur maximises the opportunity to achieve best execution. While implicit costs are difficult to predict on an order-by-order basis, persistent patterns can emerge in aggregated data over time. As post trade data is fed into pre-trade venue selection, the increased use of real-time analysis will enable order execution to be tweaked even mid-execution to enhance optimal performance.
The provision of best execution has historically been linked to the provision of research. As unbundling takes hold, many firms are struggling to adapt current processes in assessing and selecting counterparties on the basis of execution alone. As such there is an increased focus towards a quantitative data metrics approach by heads of dealing to demonstrate they meet delivery of best execution. The technology arms race is increasing and market complexities will potentially offer those brokers with scale and technology an ability to differentiate.
This will become increasingly important as market volatility increases; not least as regulators will place as much importance on monitoring executions as delivering best execution. Enriched data will allow asset managers to monitor broker performance as well as their own selection process. This will also require standardisation in the provision of data to enable sufficient like-for-like comparisons. The introduction of the use of Market Identifier Codes under RTS 28 will be an important step forward in this process.
However, the reality remains that the majority of buy-side participants are still far from receiving all the data required. Even when data is provided, not all buy-side firms have the capability to consume the data, let alone conduct sufficient analysis. While there may not be the demand yet from the end-investor to provide this level of scrutiny, the overall regulatory objective is clear. Asset managers owe a duty of best execution to their end-clients and this must not only be evidenced but also rigorously monitored.
To discuss the challenges now facing the buy-side in the provision and monitoring of best execution, TABB Group conducted research with 81 global heads of trading, more than 70% of which were institutional investors based across the globe.
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