Best Execution Under and Beyond MiFID II – a User’s Guide post Brexit
The new best execution requirements under MiFID II, which comes into effect on 3 January 2018, will require banks, asset managers, and other MiFID investment firms to put into place substantial procedural and technical changes across a wide range of asset classes. Businesses are particularly focused on how the MiFID II rules will impact fixed income, FX and alternative investment product lines, especially in light of the recent criminal convictions in the LIBOR scandal, the $10 billion in fines levied worldwide in connection with the FX scandal, as well as a stream of recent high-profile best execution litigation and enforcement actions on both sides of the Atlantic.
Notwithstanding Brexit, compliance departments and front office execution teams have retained their budget and timeline for implementing MiFID changes, especially as the FCA has issued a statement reminding UK firms that they “must continue with implementation plans for legislation that is still to come into effect.” Since the EU treaties provide for a two-year period within which the UK has to renegotiate its relationship with the EU, MiFID II will have been implemented by that time. Moreover, to continue doing business in the EU after a Brexit, the UK financial services regime will need “equivalency” which can only be achieved by implementing MiFID II-like regulation in the UK. Both front office trading and compliance officers therefore remain steadily focused on best execution implementation.
This article seeks to break down the texts of the relevant regulations, with a particular focus on the practical implications for the fixed income and FX markets. This article will also provide insight into how the MiFID II best execution requirements are of relevance even to those products and companies outside the technical scope of the legislation, and in many ways set the new standard for how best execution should be monitored and assessed. Lastly, this article seeks to emphasise the importance of new technologies and rigorous data analysis in this new era of best execution compliance.
Finally, we want to hear from you. Please contact us with any questions or comments about this article or to learn more about how BestX can be part of your better execution solution.
Best Execution Goes Beyond MiFID II
Before we begin to focus on MiFID II, it is worthwhile to note that best execution is an obligation across jurisdictions, regulations, and products. So for example, a hedge fund with management arms in the US and UK faces similar best execution principles both under the Investment Advisers Act and MiFID II, although the fine points are different and require careful legal and technical attention.
Products that sit outside the scope of MiFID II should also not be left out of firms’ best execution remediation. A regulator such as the FCA has in its power to find firms in violation of its Principles for Businesses for failing to deliver best execution where clients are relying on them to do so. And in fact, in the FX scandal, which involved non-regulated spot FX, the FCA found banks breached Principle 3 (risk management systems and controls) by failing to take reasonable care to organise and control their affairs responsibly and effectively, including failing to “strive for best execution for the customer” when managing client orders.[3] As a result the FCA levied over $2 billion in fines on 6 banks – a fifth of the $10 billion in fines levied worldwide – underscoring that regulators have massive powers even beyond MiFID II to require best execution.
The FCA used Principle 3 again in December 2015 to bring a £6 million fine against an asset management company that failed to verify the integrity of fixed income best execution quotes, thereby allowing a fund manager to execute eight trades which were at variance with market price.[4] The FCA has also noted that best execution falls squarely under Principle 6 (treating customers fairly), and used that Principle as a basis to levy a £4 million best execution fine involving rolling spot, which is a MiFID product.[5]
Finally, firms that are not subject to MiFID II but a different EU regime such as AIFMD or UCITS should continue to pay close attention to the MiFID II developments. The FCA has explicitly noted its intent to implement MiFID II in such a manner as will create a consistent regulatory regime across products and types of regulated firms in order to maintain a “consistent level of protection for clients and mitigate against regulatory arbitrage and any resultant distortions in competition between substitutable products.”[6] Moreover, since the coming into force of the UK’s new Senior Managers Regime on 7 March 2016, senior managers can be held accountable for any misconduct that falls within their areas of responsibilities. Likewise, the new Certification Regime and Conduct Rules aim to hold individuals working at all levels in banking to appropriate standards of conduct.
It is therefore fair to say that the new MiFID II best execution obligations set a standard of wide relevance and should hopefully be seen as an opportunity to achieve and deliver efficiency and transparency both to client and the firm.
What is Best Execution?
So without further ado, let us turn to defining best execution. MiFID II Article 27(1) defines best execution as the obligation on firms to “take all sufficient steps to obtain . . . the best possible result for their clients taking into account price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to execution”.[7]
The term “all sufficient steps” is a higher legal standard than MiFID I Article (21) under which firms were obliged to take “all reasonable steps” to achieve the best possible results for their clients.[8] Just as reasonable suspicion is a relatively low standard of proof in criminal law, the language of “reasonable steps” historically set the bar relatively low for best execution compliance. Firms should therefore be cognisant that they now face a higher burden in achieving and evidencing best execution.
As will be discussed further below, best execution is focused on best possible overall results on a consistent basis, and not best price for an individual trade. Explicit costs such as fees and commissions and implicit costs such as those tied to signalling risk must also be a part of the best execution analysis, as well as factors such as speed, likelihood of execution, etc. Firms will be expected to demonstrate how they have incorporated each of these factors into their best execution procedures, and to support their conclusions with unbiased quantitative analysis.
Article 64(1) of the Delegated Acts sets out the criteria for determining the relative importance of the different factors set out above, namely price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to execution. These include: the characteristics of the client, the characteristics of the order, the characteristics of the financial instrument and the characteristics of the execution venues to which that order can be directed. So for example, for a professional customer speed and implicit costs such as signalling risks might be ranked alongside price as top criteria, whereas for a retail client price may be the only top criteria. Firms should equip themselves with the technological and system tools to apply the execution factors in light of these criteria.
Who is Required to Deliver Best Execution?
The obligation to provide best execution falls on investment firms when executing orders for a client or where a client is legitimately relying on the Firm (e.g. where the Firm is exercising discretion on behalf of the client). Investment firms carrying out portfolio management and receiving and transmitting orders need to procure best execution, even if they are not executing themselves.
Specific Instructions
An investment firm satisfies its best execution obligations to the extent that it executes an order or a specific aspect of an order following specific instructions from the client. A firm must provide a clear and prominent written warning that any specific instructions from a client may prevent the firm from taking the steps that it has designed to obtain best execution.
What About Fees and Expenses?
The best possible result is a multi-factored determination. Firms must look at all implicit costs, as will be discussed in the next section, as well as all external costs, taking into account “total consideration.” This includes all expenses related to the execution of the order such as execution venue fees, clearing and settlement fees, and any other fees paid to third parties involved in the execution of the order.[9]
The firm should also take into account the effect of its own fees and commissions on the total consideration to the client. Investment firms are free to set their fees or commissions at the level they choose, provided that no venue is unfairly discriminated against. As Article 64(3) of the Delegated Acts underscores, “[i]nvestment firms shall not structure or charge their commissions in such a way as to discriminate unfairly between execution venues.” A firm may not charge a different commission (or spread) for execution on different venues unless the difference reflects a difference in the cost to the firm.
ESMA’s predecessor, the CESR, explained: “In practice a firm is unlikely to be acting reasonably if it gives a low relative importance to the net cost of a purchase or the net proceeds of a sale. . . . For example, if a firm has included a regulated market and a systematic internaliser in its execution policy (or is itself a systematic internaliser), . . . the firm will need to take into account not only the prices displayed by those two venues, but also any difference in fees or commission it charges the client for executing on one venue rather than the other (as well as any other costs or other relevant factors).” [10]
Implicit Versus External Costs
Best execution does not stop at best price. Speed, likelihood of execution, market impact and other implicit transaction costs should be analysed as part of the total consideration analysis. Many firms have in turn begun to assess whether their current best execution surveillance software is fit for purpose and can incorporate implicit costs into the best execution analysis.
As Pete Eggleston discussed in his recent article, Best Execution – What Actually Is It?, best execution needs to be viewed as a process, analysing average performance over longer time horizons as well as individual transactions. As that article explains:
Getting a ‘great’ price on one trade may not be ideal if by doing so you push the market significantly higher, making future purchases much more expensive. Spraying orders across the market, potentially creating significant ‘signalling risk’ (i.e. providing indications to market participants of your trading behaviour and intentions) can be very damaging to your overall execution performance on a given day.
Especially when relying on algorithmic trading it is all too easy to become focused on price/commission (e.g., $/million charge). But price is only one input into achieving best execution. A best execution policy needs to be supported by historical data, it must be repeatable going forward and it must be justified by constant testing and exception analysis. Fortunately, new technologies are available that can undertake these sophisticated tasks by quantifying implicit costs and associated risks.
The FCA, in its recent Thematic Review of best execution, has emphasized this point, noting that
Firms should measure implicit costs as part of their arrangements to monitor execution performance and review the execution quality of entities or execution venues . . .. A trade may appear more expensive in terms of explicit costs but may be less expensive when implicit costs are considered. For example, a firm that works a large order over time, preserving the client’s confidentiality and minimising market impact, may achieve the lowest total costs (and the best net price). Unlike explicit costs, the impact of implicit costs can only be precisely assessed after a trade is completed and even then, implicit costs are difficult to quantify. As a result, ahead of a trade, a judgement needs to be made by firms about the likely implicit costs of an execution strategy and firms are required to take all reasonable steps to manage them.[11]
Businesses that are sophisticated in so many ways need best execution systems to match. A robust best execution process will look at both explicit and implicit costs at both the pre and post trade stage. For example, in the fixed income and FX sphere, new technologies offer pre-trade tools combining sophisticated and auditable pre-trade analytics in a live pricing environment, as well as post trade best execution management and exception reporting.
Best Execution Criteria for OTC Products
Article 64(4) of the Delegated Acts is explicit that when executing orders or taking the decision to deal in OTC products, including bespoke products, investment firms must check “fairness” of the price proposed to the client “by gathering market data used in the estimation of the price of such product and, where possible, by comparing with similar or comparable products” (emphasis added).
This emphasis on ‘fairness’ and ‘market data’ is a departure from MiFID I, and underscores the need to formalize and place rigor around best execution processes for OTC products. In the December 2015 FCA best execution case cited above, the FCA took issue with reliance on “copied and pasted Bloomberg chat extracts [that] can easily be modified” and emphasized that regular best execution monitoring must be extended to OTC derivatives.[12]
Therefore, for fixed income and FX OTC products, it is prudent that firms have access to pre-trade TCA analysis tools that allow them to analyse the fair price for the underlying product or currency.
Establishing and Monitoring Best Execution Arrangements
Not only do firms have to deliver best execution, they also, under MiFID II Article 27(4) and (7) have to “establish and implement effective arrangements” for complying with and monitoring best execution. This requirement is arguably the most difficult best execution deliverable and has presented the most difficulty for firms in the past.
In the FCA Thematic Review on best execution, discussed above, the FCA found that:
Most firms lacked effective monitoring capability to identify best execution failures or poor client outcomes. Monitoring often did not cover all relevant asset classes, reflect all of the execution factors which firms are required to assess or include adequate samples of transactions. In addition, it was often unclear how monitoring was captured in management information and used to inform action to correct any deficiencies observed by firms.[13]
The FCA concluded that “not enough is being done by firms to ensure best execution is being consistently delivered to clients”,[14] and made clear that it will be paying close attention to monitoring capability in further best execution reviews. The FCA also emphasized that it expects “senior management with responsibility for trading activities to take greater responsibility for ensuring that policies and arrangements remain fit for purpose.“[15]
Firms, and especially their senior management, should therefore think carefully about relying on old, outdated methodologies, in particular in fixed income and FX asset classes. MiFID II Recital 92 explains that “[a]dvances in technology for monitoring best execution should be considered when applying the best execution framework”.
New monitoring arrangements must look not just at price but also the speed and likelihood of execution (such as fill rate), the availability and incidence of price improvement, and implicit as well as explicit costs. As Recital 107 of the Delegated Acts notes:
Availability, comparability and consolidation of data related to execution quality provided by the various execution venues is crucial in enabling investment firms and investors to identify those execution venues that deliver the highest quality of execution for their clients. In order to obtain best execution result for a client, investment firms should compare and analyse relevant data including that made public in accordance with Article 27(3) of Directive 2014/65/EU and respective implementing measures.
In the fixed income and FX sphere, new technologies and new sources of data have made pre- and post-trade transaction cost analysis and exception reporting more readily available and regulators will reasonably expect firms to rely on such software, especially software that can be verified as truly independent. Regulators will also reasonably expect to see evidence that senior management has engaged in regular review of best execution-related management information.
As noted below, firms must detail for their clients in writing how they monitor and verify best execution, and they should be prepared to disclose to clients the extent to which they rely on independent analysis and/or best execution software.
Order Execution Policy, Disclosure, and Consent
MiFID II Article 27(4) and Article 66 of the Delegated Acts reiterate the obligation of MiFID I Article 21(2) for firms executing client orders to establish and implement an order execution policy. But revamping old policies will not do. Responding to concerns about the generic and standardised nature of many firms’ order execution policies, MiFID II requires order execution policies to be clear, easily comprehensible and sufficiently detailed so that clients can easily understand how firms will execute their orders.
Under MiFID II Article 27(5), the written order execution policy must include, in respect of each class of financial instruments and type of service provided:
information on the different venues where the investment firm executes its client orders and the factors affecting the choice of execution venue, and
a list of those venues that enable the investment firm to obtain on a consistent basis the best possible result for the execution of client orders.
Not only will companies have to revamp their written order execution policies, they will also have to revise their client disclosures with regard to such policies. As Article 27(5) goes on to explain: “That information shall explain clearly, in sufficient detail and in a way that can be easily understood by clients, how orders will be executed by the investment firm for the client.” Firms will also have to obtain prior consent of their clients to the order execution policy, the logistics of which should be done with country specific legal advice.
Article 66(3)-(9) of the Delegated Acts provide more details around this obligation, explaining that investment firms shall provide clients in a durable medium, or by means of a website, with certain details on their execution policy in good time prior to the provision of the service. We highlight some of these details below, including:
an account of the relative importance the investment firm assigns to the various best execution factors.
a list of the execution venues on which the firm places significant reliance for each class of financial instruments and for retail versus professional client orders.
a list of factors used to select an execution venue, including qualitative factors such as clearing schemes and circuit breakers.
how the execution factors of price costs, speed, likelihood of execution and any other relevant factors are considered as part of all sufficient steps to obtain the best possible result for the client;
where applicable, information that the firm executes orders outside a trading venue, and the consequences, for example counterparty risk.
a summary of the selection process for execution venues, execution strategies employed, the procedures and process used to analyse the quality of execution obtained and how the firms monitor and verify that the best possible results were obtained for clients.
information on different fees applied depending on the execution venue.
information on any inducements received from the execution venues.
Firms that perform portfolio management and reception and transmission of orders also need a similar policy under MiFID II Article 24(4) and the Delegated Acts Article 65. Again, the written policy must identify, in respect of each class of instruments, the entities with which the orders are placed or to which the investment firm transmits orders for execution.
Annual, Regular and Material Change Review
At a practical level, firms are expected to review their execution policies and order execution arrangements at three intervals: annually, whenever there is a material change that could impact parameters of best execution, and on a regular basis. Such reviews should be undertaken with a fair degree of formality and independence, such that they are sufficient to help a firm identify and, where appropriate, correct any deficiencies. Such reviews should take advantage of newly available execution data made public by execution venues, as required by MiFID II Article 27(3), as well as information published by firms on their top five execution venues, as discussed below. In turn, investment firms must notify clients of any material changes to their order execution arrangements or execution policy.
Annual Publication of Top Five Venues for Each Class of Instrument
Historically clients have had little information about where their trades were actually likely to be executed. A key concern when drafting MiFID II was therefore transparency, and specifically that investors be able to form an opinion as to the flow of client orders from the firm to execution venue. Is flow going to a sister organisation? Is flow going to an execution venue that has a recent enforcement action related to the relevant financial instrument?
Taking a novel approach, MiFID II Article 27(6) and Regulatory Technical Standard (“RTS”) 28 contains a new requirement, not present in MiFID I, that firms who execute client orders must publish annually for each class of financial instruments the top five execution venues in terms of trading volumes where they executed client orders in the preceding year and information on the quality of execution obtained.
In order to provide very precise and comparable information, RTS 28, Article 2 sets out further detail regarding this publication obligation, explaining that firms must include the following information in specified format:
class of financial instruments
venue name and identifier
volume of client orders executed on that execution venue expressed as a percentage of total executed volume
number of client orders executed on that execution venue expressed as a percentage of total executed orders
percentage of the executed orders referred to in point (d) that were passive and aggressive orders
percentage of orders referred to in point (d) that where directed orders
notification of whether it has executed an average of less than one trade per business day in the previous year in that class of financial instruments [16]
RTS Article 2(3) further requires investment firms to publish for each class of financial instruments, a summary of the analysis and conclusions it draws from its detailed monitoring of the quality of execution obtained on the execution venues where it executed all client orders in the previous year. This information must include:
an explanation of the relative importance the firm gave to the execution factors of price, costs, speed, likelihood of execution or any other consideration including qualitative factors when making assessments of the quality of execution;
a description of any close links, conflicts of interests, and common ownerships with respect to any execution venues used to execute orders;
a description of any specific arrangements with any execution venues regarding payments made or received, discounts, rebates or non-monetary benefits received;
an explanation of the factors that led to a change in the list of execution venues listed in the firm’s execution policy, if such a change occurred;
an explanation of how order execution differs according to client categorisation, where the firm treats such category of client differently and where it may affect the order execution arrangements;
an explanation of how the investment firm has used any data or tools relating to the quality of execution including any data published under 27(10)(a) of Directive 2014/65/EU;
an explanation of how the investment firm has used, if applicable, output of a consolidated tape provider established under Article 65 of Directive 2014/65/EU which will allow for the development of enhanced measures of execution quality or any other algorithms used to optimise and assess execution performances.
As these RTS make clear, the new MiFID II regime expects firms to use new technology and data, including algorithmic analysis, to optimize and assess execution performance.
RTS 28 Article 3 establishes that this information must be made available on firm websites in machine-readable electronic format, in accordance with a set template, and available for downloading by the public.
Execution on a Single Venue Must be Supported by Relevant Data
Until now, many investment firms selected a single and often related entity for execution. Such a practice is at odds with the standard of publicising the top five execution venues per financial instrument. The Delegated Acts make clear that going forward such a practice may only continue if supported by strong data and rigorous analysis. Investment firms will have to:
[be] able to show that this allows them to obtain the best possible result for their clients on a consistent basis and where they can reasonably expect that the selected entity will enable them to obtain results for clients that are at least as good as the results that they reasonably could expect from using alternative entities for execution. This reasonable expectation should be supported by relevant data published in accordance with Article 27 of Directive 2014/65/EC or by internal analysis conducted by these investment firms. [17]
It is important to note that the emphasised language was not present in MiFID I.[18] Firms that have traditionally relied on a single execution venue should therefore promptly review whether that decision is sufficiently supported, ideally by analysis that uses independent data. Moreover, as with MiFID I, a firm may not direct all its orders to another firm within its corporate group “on the basis that it charges its clients a higher fee for access to other venues that is unwarranted by higher access costs.”[19]
Data Publication Obligations on Execution Venues
Last but not least, at the heart of the new best execution rules are the new data publication obligations on execution venues set out in MiFID II Article 27(6) and RTS 27. Trading venues, systematic internalisers, market makers and other liquidity providers will be required, on a quarterly basis, on the first day of February, May, August and November, to make available to the public free of charge, data relating to the quality of transactions on that venue. Reports will include details about price information for each trading day, costs, speed, and likelihood of execution for individual financial instruments. This is a sea change from MiFID I, and certainly constitutes a significant new regulatory burden on execution venues, but it also is the single most important rule change in terms of improving market transparency.
Fines and Sanctions
Articles 69 and 70 of MiFID II give regulators broad supervisory and sanctioning powers to implement fines and measures that are “effective, proportionate and dissuasive.” In the case of legal entities, regulators may impose maximum administrative fines of at least €5,000,000 or up to 10% of total annual turnover. Furthermore, if the benefit derived from an infringement can be determined, regulators can impose an administrative fine of at least twice the amount of the benefit derived from the infringement even if it exceeds the maximum amounts specified above.
Conclusion
The new best execution requirements under MiFID II, which apply from one day to the next to an extremely wide range of asset classes, require that investment firms carefully evaluate existing best execution processes and be prepared for new transparency and data publication obligations.
With the recent uptick in best execution enforcement, new high-level fines under MiFID II, as well as the potential for increased personal liability under the new Senior Manager’s Regime, it is easy to understand why technological solutions are being seen as an imperative. Moreover, the language of the regulations itself anticipates that businesses will step up their sophistication and rely on new technologies that in turn will incorporate the newly available data. Fortunately, especially in the field of fixed income and FX, new software is available that can ease this administrative burden and facilitate profitability by offering independent pre- and post-trade TCA tools and benchmark analysis, combined with sophisticated audit trail functionality, exception reporting, and management tools.
Although MiFID II provides a daunting best execution challenge, it also provides a great opportunity. Both MiFID financial institutions and non-MiFID businesses should see these regulations as setting a new standard in best execution compliance and transparency, and one that should be welcomed as a chance to differentiate companies that provide excellence in execution and client service.
References
[1] http://ec.europa.eu/finance/securities/docs/isd/mifid/160425-delegated-regulation_en.pdf
[2] The first part of the MiFID II Delegated Acts was published on 7 April 2016 at http://ec.europa.eu/finance/securities/docs/isd/mifid/160407-delegated-directive_en.pdf
[3] FCA fines five banks £1.1 billion for FX failings and announces industry-wide remediation programme (Nov. 2014) at http://www.fca.org.uk/news/fca-fines-five-banks-for-fx-failings and https://www.fca.org.uk/news/fca-fines-barclays-for-forex-failings
[4] https://www.fca.org.uk/news/fca-fines-threadneedle-asset-management-limited-£6m
[6] FCA, Developing our approach to implementing MiFID II conduct of business and organisational requirements, DP 15/3 (March 2015) at https://www.fca.org.uk/news/dp15-03-mifid-ii-approach
[7] http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32014L0065
[8] http://eur-lex.europa.eu/legal-content/EN/TXT/?qid=1398325978410&uri=CELEX:02004L0039-20110104
[9] MiFID II Article 27(1).
[10] CESR, Best Execution under MiFID Q11.3 and 12.4 (May 2007) at https://www.esma.europa.eu/sites/default/files/library/2015/11/07_320.pdf
[11] FCA, Thematic Review: Best execution and payment for order flow TR 14/13 (July 2014), p.11 at https://www.fca.org.uk/static/documents/thematic-reviews/tr14-13.pdf
[12] See note 4, supra.
[13] FCA Thematic Review at p.5, cited at note 11, supra.
[14] Id. at p.8.
[15] Id at p.36.
[16] ESMA, Final Report –regulatory technical and implementing standards Annex I- ESMA 2015/1464 (28 Sept 2015), RTS 28: Draft regulatory technical standards under 27(10)(b) of MiFID II, Recital 4 and Article (2)(2) at https://www.esma.europa.eu/sites/default/files/library/2015/11/2015-esma-1464_annex_i_-_draft_rts_and_its_on_mifid_ii_and_mifir.pdf
[17] Delegated Acts Rec. 100 and 108
[18] See CESR, Best Execution under MiFID at Q9 cited at note 10, supra.
[19] CESR, Best Execution under MiFID, Q13.1 cited at note 10, supra