Publications
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
Using Execution Benchmarks - Why ?
"However beautiful the strategy, you should occasionally look at the results"
Sir Winston Churchill
Using Execution Benchmarks - why bother ?
Benchmarking execution within FX has become standard practice. Benchmarks provide the reference points against which to measure performance, which needs to be viewed in both absolute and relative terms. When reviewing execution quality as part of a best execution policy, it is clearly necessary to be able to compare different counterparties, methods of execution (e.g. RFQ, Streaming, Voice,...), liquidity venues and execution products (e.g. algos) and such a relative comparison requires the use of standardised benchmarks.
So using benchmarks is a no-brainer, however, the selection of appropriate benchmarks, and ensuring they are computed using a standard methodology using consistent market data, is far from a no-brainer. Indeed, it can become a minefield of opaque complexity that can be extremely difficult to navigate. In this article we explore some of the larger landmines to look out for, and offer some suggestions for an approach for benchmark selection.
Benchmark Types
Let’s first explore the taxonomy of execution benchmarks. There are many different types of benchmarks out there, but they broadly fall into 2 categories as illustrated in the figure below: Point In Time or Average. Within the first of these categories, it is possible to further subdivide into 3 sub-categories: Risk Transfer, Arrival Price and Fixings. One could argue that fixings such as the WMR Fix are technically not a point in time benchmark as this rate is now computed as the median observed over a 5 minute window but however, for the sake of simplicity, we’ll include WMR in this sub-category together with other ‘snapshots’ taken during the day such as the ECB Fix.
Even within relatively simple benchmark types, such as TWAP, there are layers of complexity. For example, what duration should be chosen ? Two types of TWAP are often referred to, Interval and Fixed Period. Interval TWAP corresponds the rate that is computed over exactly the same period that the order was active in the market, whereas Fixed Period are obviously values based on fixed durations such as 1 hour or 24 hours.
Ok, so, Arrival Price is just Arrival Price isn’t it ? Not necessarily. There are many different points in the trade lifecycle where an Arrival Price can be snapped. For example, for measuring implementation shortfall, you really should be measuring Arrival Price at multiple decision points including, for example, when the portfolio manager first decides to trade; when the order arrives at the execution desk; when the order is placed into the market; when the order is filled. In terms of basic performance measurement, it is the Arrival Price snapped at the last of these time stamps that is typically used. But care should be taken to make sure the definition is understood.
Data Sources & Methodologies
Ok, so the time you measure your Arrival Price is agreed, surely that must be it ? No further cause for confusion ? Well, not necessarily. Exactly what rate is taken at that precise time stamp ? Is it mid, or bid, or offer ? In our view, market convention should be that it is always the mid. However, this is not always the case as there are example post-trade reports out there that use an Arrival Price based on bid or offer. There’s nothing that says this is technically incorrect, it is just important that the convention is totally transparent. A bigger issue is that it makes it impossible to compare performance versus Arrival Price across providers if one uses bid/offer and other uses mid.
Surely, once the time stamp and rate is agreed, that is it ? No, unfortunately not. There’s still the issue of the data source used to compute the Arrival Price mid (or bid or offer). Each liquidity provider computes their own estimate of mid based on multiple price sources, often using algorithms that take into account fill ratios and the quality of available liquidity. For liquid currencies, during liquid times of the day, you would expect everyone’s mids to be pretty similar. However, in more volatile and less liquid conditions, or for less liquid pairs, differences will arise.
Unlike the Equity market, FX doesn’t have a ‘tape’, i.e. a central price source from which an ‘official’ market rate is published. There are discussions commencing in the industry about developing such a tape for FX, although it is probably fair to assume that this will take considerable time to implement, even if it did have the support of all the major market participants. There are a number of other initiatives seeking to establish a standard market mid for FX, which do at least provide a solution to allow comparative analysis.
And isn’t TWAP a simple, standard calculation meaning that all liquidity providers must be using the same numbers in their post-trade reports ? Nope, unfortunately not. Clearly the source of the data is one way that TWAPs will differ, as explored above, but another key factor is the precise methodology. For example, you could construct a TWAP from quoted mid rates sampled at different frequencies. Even if you sample over the same frequency, e.g. every second, do you sample at the beginning of the second, in the middle or at the end ? Also, you could use bid/offer quote data or even actual traded prices (paid/given) data instead of mid data. There are many reasons why TWAPs can differ, thus again, making it difficult to perform a like for like comparison of performance.
Benchmark Selection
A commonly asked question is what benchmark should be used ? There is no one right answer as it depends on a number of factors, including the purpose of the transaction, the objectives of the underlying portfolio and the mandate of the execution desk. It is our view, therefore, that benchmark selection is a client-specific process, that should be explained and justified in the best execution policy. It is very likely that within the same institution, a number of different benchmarks would be appropriate for the varying range of portfolio mandates. Indeed, for an individual portfolio, there is an argument that more than one benchmark would be valid to allow for measurement of different performance metrics.
Broadly speaking, in terms of trading purpose, FX transactions can be divided into 3 categories:
Alpha – trades that are initiated with the objective of profit maximisation, over a range of different time horizons
Funding – trades that are required in order to fund the purchase of securities or pay dividends etc
Hedging – trades that are required to hedge foreign currency exposure of assets and liabilities back into the base currency of the portfolio or institution
Each category lends itself to different benchmark selection and it may be possible to group appropriate benchmark types for each, as exemplified in the diagram below.
So, for example, it would not make a lot of sense for an alpha trade, where the investment horizon is a matter of minutes, to be solely benchmarked to a 24 hour TWAP measure. In this case, Arrival Price and/or a Fair Value Risk Transfer may be more appropriate. Conversely, for a large funding trade conducted over an entire day, where the objective is to achieve as close to the day’s average as possible, Arrival Price would not be appropriate, whereas an Interval TWAP or VWAP may be better suited. The ‘no one size fits all’ cliché is very valid in the realms of benchmark selection for FX.
Conclusion
The world of execution benchmarks would appear to be a little more involved than one would think. It is clearly an area of the best execution process that requires careful thought at a strategic level in terms of selection, but also on a more tactical level when measuring and comparing performance on an ongoing basis to ensure that fair comparisons and conclusions are drawn. Selection needs to be client and portfolio specific, so it is important that any post-trade analytics allow for this flexibility. The chosen benchmarks can also be supplemented with other metrics, including measures of market impact and spread earning etc, to help complete and provide a holistic view of execution performance.
Navigating the potential pitfalls of the benchmark maze is critical in order to ensure appropriate usage of benchmarks, which are a necessary component of any best execution process. You can only manage what you can measure. Another very appropriate cliché as benchmarks are key to the measurement process. Careful selection and judicial usage of benchmarks provides the foundation for you to analysis the results of your trading strategies with confidence.
Best Execution – What actually is it?
Best Execution. A widely used phrase within the financial industry, but one that has many different interpretations. Clearly, the regulatory focus on execution has brought about a multitude of new interpretations, requirements and definitions. We’ll explore the regulatory implications in a separate article but for now let’s just focus on exploring the definition of best execution from first principles.
Kicking off contentiously…
Best Execution is not necessarily synonymous with best price
What? How can that possibly make sense? Surely my best possible execution is where I have purchased something for the lowest possible price, or sold something for the highest price? Well, not necessarily. What if you were buying a new bespoke suit. You do your due diligence and visit 5 highly respected tailors, that you’ve asked for prices from before, and tell them that you are looking for a new suit, explaining that you are asking for a number of quotes. One tailor manages to provide a price that is marginally cheaper than the others and you decide to purchase from him. However, these tailors know your buying habits from previous experience and anticipate that when you buy one suit you very often come back for another shortly thereafter. True to form, you decide to buy another and once again ask for quotes from the same tailors. The prices have all gone up, and the premium you now have to pay far exceeds the ‘saving’ you made on your first purchase.
Best Execution needs to be viewed as a process
A longer-term perspective is also important, i.e. view average performance over longer time horizons as well as individual transactions. 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. We will return to signalling risk in a later article, but suffice to say, some execution methods and products can create much more risk than others, thereby imposing implicit costs. Quantifying these implicit costs and associated risks is a key current research theme.
Firms need to judge implicit costs pre-trade and take all reasonable steps to manage them
The FCA, in its recent Thematic Review of best execution, has explicitly warned on 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” (TR 14/13 at p.11). The FCA further emphasized that this guidance was relevant to all “firms which execute, receive and transmit or place orders for execution, including portfolio managers.” (TR 14/13 at p.6)
Trading should allow efficient absorption of risk within the market
Further to the FCA’s point, its important to highlight that trading in a way that does not allow for the efficient absorption of risk within the market can also result in sub-optimal execution performance. For example, say you have 1bn AUDUSD to trade over the course of a morning. You decide to divide the parent order up into individual clips of 100m and start executing via risk transfer over the phone. Pleased with the price for the first clip, you immediately call again and ask for prices for another clip. The counterparty with whom you traded the first clip no longer has the ‘best’ price, so you trade with a different counterparty. The first counterparty is still trying to work out of the risk, and now another is doing the same. This creates difficulties for both counterparties, incurring losses and subsequently widening their prices to you for later clips. Waiting for the first clip to be fully ‘digested’ would have been preferable, allowing the liquidity to refresh and enabling your counterparties to minimise losses from hedging activities. Again, quantification would be helpful here, for example, on average at that time of day, how long does it take to trade 100m AUDUSD without significantly pushing the market? This would provide an indication of recommended time intervals for each clip in order to achieve best execution for the entire order.
So, what are the key features for a robust best execution process ?
Best Execution process should be Repeatable, Measurable, Flexible and Justifiable.
Why repeatable? Execution decision making needs to be based on some structure. For a similar trade, in similar market conditions, with the same objective and benchmark, there should be preferred execution methods that, based on past performance, achieve the best possible result. It is difficult to defend a random decision.
Why measurable? To be able to explain, manage and improve the process. Best execution is an evolving process, that needs to adapt to changing market conditions e.g. structural changes/new products/evolving liquidity conditions and performance. What was appropriate or delivered the best results last year, may not be the same this year. It is difficult to make such informed decisions without independent, objective measurement that compares performance on a level playing field. Such comparative analysis needs to be performed cross-sectionally, i.e. across counterparties, venues, products etc, and also temporally, i.e. how performance evolves over time.
Why flexible ? Execution is a complex process. Any given trade can have different objectives or benchmarks depending on the purpose for the transaction. For example, was the FX trade transactional, for hedging purposes or to generate alpha ? Depending on the purpose and mandate of the portfolio and execution desk, this may dictate different execution benchmarks and trading objectives. In addition, market conditions are obviously very variable, and there are indications that depth of liquidity has become more volatile over recent years. One execution method may typically work well when volatility is low, and the available liquidity is deep, but may deliver sub-optimal performance in less liquid conditions. It is important to have the flexibility within the process to allow the selection of the right tool for the job, and it is therefore key to have the full range of execution options available. What method provides best execution on one day for a given trade may be very different on another.
Why justifiable ? The focus on FX over recent years has made this aspect critical. Asset owners, audit and compliance, regulators are all paying significantly more attention to FX execution than ever before. To be able to justify a given execution, in terms of chosen method (e.g. voice risk transfer vs hitting a streaming price on a multi-dealer platform vs using an algo etc), product (e.g. which algo), venue/platform and counterparty has become an essential component of the best execution process. Clearly, justification is only possible if the other features have been incorporated. It is difficult to justify a random decision making process with no supporting data.
Firms need to ensure they are seeking out the assistance they need to achieve the best possible results for their clients.
With a looming deadline of 3 January 2018, the Markets in Financial Instruments Directive (MiFID II) requires investment 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” (Art. 27). However, neither MiFID II, nor any other related regulatory legislation, specifically defines how to achieve best execution. The result is an incredibly introspective process, wherein firms need to have a hard look at the products and markets in which they operate, and make certain they are seeking out the assistance they need to achieve the best possible results for their clients. We will explore the regulatory requirements for best execution in a subsequent article but suffice to say it is clearly an area where better information results in better execution, and where repeatability, measurability, flexibility and justifiability remain key.