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European regulated market providers, investors and the firms that service them are becoming increasingly aware of the ‘Best Execution’ provisions anticipated under Article 21 of the EU’s Markets in Financial Instruments Directive (MiFID). But what exactly constitutes ‘Best Execution’, and how many exchanges will recognise the critical role they might play in facilitating this debate?
At the start of this decade, Europe’s political leaders committed the EU to become by 2010 “the most dynamic and competitive knowledge-based economy in the world capable of sustainable economic growth with more and better jobs and greater social cohesion, and respect for the environment”. The underlying assumption was that flexible market-based financing and the pooling of liquidity would lead to more efficient markets, sustaining growth, competitiveness and employment. Both the Lisbon and Stockholm European Councils placed integration of European financial markets at the heart of the European economic reform agenda; and an essential guiding principle for operating within a harmonised single financial services market for Europe should be that any regulated entity would be able to ‘passport’ itself into any other EU Member State, thus enabling them to sell products and services throughout the European Economic Area (EEA).
Realising a single, liquid market, whether actual or virtual, is a serious stretch goal, because it assumes a degree of not only market but also political will in each member state. So behind the grand design of removing the artificial barriers to easy cross-border trading lay the European Parliament and its Council of Ministers, who delegated much of the work involved in delivering this plan to the European Commission. Analysis through simulations conducted by the European Commission had suggested that the benefits of establishing integrated, deep and liquid equity and corporate bond markets alone were likely to be significant, involving a permanent reduction in the cost of equity capital of 0.5%, generating once-off increases in both employment (0.5%) and GDP (1.1%). The European Commission tasked the Committee of European Securities Regulators (CESR) with producing the necessary regulations and directives, which would be implemented by the regulators in each of the EU Member States.
Regulation in Europe has moved into hyper-drive this year. Over 40 separate directives featuring high-level principles will challenge financial intermediaries between now and 2008, and there are several high-impact directives which will be particularly onerous. The implementing measures behind each directive will be adopted by the Commission through so-called 'comitology' procedures (consultations with market participants and Member States, taking into account advice from CESR). In the midst of this are two mega-directives which are likely to impact the behaviours and the very structures of the underlying markets themselves – these being the Risk Based Capital Directive (formerly Basel II) and the Markets in Financial Instruments Directive, the focus for this article.
MiFID replaces the Investment Services Directive (ISD), which was fully adopted by 1993 and became the cornerstone of the EU legislative framework for investment firms and ‘regulated markets’. The ISD defined ‘home’ and ‘host’ state regulators, establishing the conditions under which authorised investment firms and banks could provide specified services in other EU Member States on the basis of home country authorisation. This framework of mutual recognition by national authorities enabled authorised firms to passport into other EU countries without re-authorisation, thereby creating in effect a single ‘passport’ for trading institutions across EU Member States. The scope of ISD covered dealing, arranging or managing financial instruments, but ISD also permitted a concentration rule, effectively forcing all share trading through a local regulated exchange, and post-trade clearing and settlement through favoured national market depositories (CSDs).
This latter aspect is interesting and highly relevant, because cross-border trading generally operates in a relatively transparent and cost-efficient manner compared with cross-border clearing and settlement downstream in the trade cycle. Many consider that the clearing and settlement of transactions forms the backbone of the EU-25’s financial system. While national arrangements are generally (although not always) efficient, they combine inefficiently at the EU level. Accordingly, a cross-border transaction is unnecessarily complex and can cost many times more than the corresponding services for a domestic transaction.
It is also apparent that any consolidation of exchanges is happening faster than the corresponding consolidation of the 22+ clearing and settlement infrastructures, where the mindset is ‘one country, one CSD’. It is little surprise perhaps that cross-border clearing and settlement within the EU is an order of magnitude more costly the domestic US market. This fact will become even more evident as intermediaries look to justify Best Execution measures to their investors (see later).
The goal of MiFID is to ensure that investors and intermediaries can transact freely with clients in other EEA Member States on the same terms and conditions as business transacted in their home country. Issuers should be able to tap a deeper and more liquid market, in which spreads and transaction costs and the cost of capital would be reduced as suggested above. Market infrastructure enablers such as exchanges should be able to make their facilities available to market participants and users throughout the EEA.
MiFID itself contains 73 articles (more than twice the length of the existing ISD which it replaces) and will impact exchanges, banks and investment banks, pension and other asset managers, investment service providers and issuers. MiFID expands the definitions of financial instruments to include other frequently-traded instruments, including contracts for difference (CFDs) and other types of derivatives such as credit, commodity, weather and freight derivatives. MiFID also recognises and formalises the regulation of Multilateral Trading Facilities (MTFs) such as electronic communication networks (ECNs) and automated trading systems (ATSs), reflecting the growth of such activities since the original ISD was enacted.
MiFID’s scope is also pervasive, encompassing best execution, client agreements, client assets, client classification, compliance, conflicts of interest, derivatives (both on/off-exchange), execution only services, information disclosure, internal systems, outsourcing, pre- and post-trade transparency and record keeping. MiFID’s scope is so broad that the task facing regulated firms in implementing this Directive will be considerable, requiring them to address a moving target. Firms will need to consider a wide range of changes to their corporate governance arrangements and new business processes in order to comply with the new Conduct of Business requirements.
One of the major consequences of MiFID will be changes to the role and operation of market structures such as exchanges. MiFID circumvents the concentration rule, allowing proper cross-border trading via Multilateral Trading Facilities and also treating certain broker-dealers that currently cross trade internally on a systematic basis as regulated markets (‘systematic internalisers’). The latter will be required to publish firm public quotes during trading hours in shares they deal in that are quoted on a regulated market, and, in effect, will be acting as mini stock exchanges. This is because the transparency rules suggest that pre-trade firm quotes have to be made public on a reasonable commercial basis, and that post-trade reporting of volume, price and time of trade has to be done close to real-time.
Meanwhile, exchanges in the EU-25 have started delivering on their promises of better cost-effectiveness, liquidity management, direct market access and market transparency, by becoming more electronic and order-book driven. Nevertheless, the MiFID provisions will pose some interesting data publication, dissemination, consolidation and monitoring challenges for regulated exchanges. the broker-dealers and especially the end investors looking to justify best execution processes. How might the relevant data be published, in a manner that is accessible, supports greater efficiency, and enables intermediaries to demonstrate ‘Best Execution’ to their investor clients? Should quotes be made EU-wide or be published on a national basis, and how might data quality be ensured e.g. who should check the data for cleanness and anomalies? Should there be market ‘monitors’; how might such entities be regulated/accredited; and what co-ordination arrangements would there be between monitors across the EU-25 member states?
Developments in the portfolio and management spaces (not to mention access to ‘upstairs’ liquidity via tools such as Liquidnet) have of late enabled buy-side portfolio managers and traders to exert an increasing amount of control and sophistication over executing a trade. Changes to order handling rules and the development of ECNs and ATSs have provided competition to established trading centres such as exchanges, as well as anonymity. Despite the current prevalence of the concentration rule in many continental European centres (where liquidity flows to regulated market entities under the principle of ISD), future service-oriented architectures coupled with directives such as MiFID will ensure that complex trading strategies can be implemented across decentralised markets in an immediate fashion. The central issue, if this becomes the case, will be whether there is a price to be paid which manifests as portfolio risk-weighted rate of return (alpha).
The reason for this is that portfolio managers would prefer immediate execution at current prices, but the market charges a premium for providing immediate liquidity. The question is whether to go for quality price performance, or immediacy and certainty of execution? The historic accepted wisdom was that the ability to secure best execution depended on the broker’s willingness to commit capital during times of market distress to grant the buy-side immediacy in execution. The sell-side would assume the risk that they could locate a natural counterparty to the trade from their extensive knowledge of trading styles and relationships on the street. So although the majority of portfolio managers at asset manager firms would ordinarily prefer immediate execution at current prices, the market reality would be to charge a premium to locate and provide immediate liquidity.
There are no free lunches in trading. Immediacy is granted at the cost of leaking information from the buy- to the sell-side, with adverse affects on price. Buy-side firms choosing to make trades on ATSs such as Instinet, or through buy-side only facilitation routes such as Liquidnet, do so because they need anonymity, and for good reasons. If the street sees a buy-side firm trading in a name, the other sellers and buyers are interested in the size and investment style. This information would lead the street to infer as to why the buy-side firm is trading, which is how the street anticipates price action – reflected in market impact. The analogy is wishing to sell your house, telling the market that the reason you wish to do so is because you are emigrating imminently, and watching the impact on the bids you receive!
The question is whether obtaining the best possible price is more important than achieving immediacy – defined as speed, coupled with certainty of execution. The assumption is that there is always a market-making side willing to commit capital in order to grant immediacy – one that could well be challenged by the transparency provisions of MiFID (article 27). When sell-side liquidity was abundant, the use of capital to guarantee the buy-side immediacy was relatively free and easy. However, most houses over the last couple of years have started to look at the cost of committing capital. The consequence is that sell-side firms have become much more selective in terms of choosing who to commit capital to, and this is accompanying a greater reluctance on the part of the sell-side to commit capital to markets at large. Trends towards associated demands of financing, shifts towards program trading, block trading, financial engineering involving derivatives and so on, compete for capital commitment as higher-margin businesses, and thus take over vanilla executions. The demands in terms of how to price capital, in other words, are becoming more intensive.
Definitions of ‘Best Execution’ already grace many a marketing pitch, RFP or vendor offering, having come to the fore in the UK under the provisions of the FSA’s Consultation Paper 154. ‘Best Execution’ is also a cornerstone of MiFID (article 21 – see below). However, despite the 15+ year search, ‘Best Execution’ has proved highly elusive, notwithstanding the many assurances otherwise. For example, from the point of view of the trading desk, Best Execution can be defined in two subtly different ways representing either a value or a cost play:
‘placing trades via a broker-dealer or automated trading system in order to realise the maximum value of the firm’s investment decisions’; and
‘placing trades with the intent of minimising transactional implementation costs.’
There are several open issues however. How might end investors influence which route the market professionals and intermediaries take on their behalf? And should the scope merely cover market prices as such, or should it be more expansive and cover overall end-to-end transaction costs relating to clearing, settlement and custody costs?
In the US, the SEC’s approach to best execution was set out in Gene Gohlke’s November 2000 paper ‘What constitutes Best Execution’ which stated: “Best Execution from the SEC’s point of view is the execution of ‘transactions for clients in such a manner that the client’s total cost or proceeds?[are] the most favourable under the circumstances”. By 2002, the SEC had already revised its view to define Best Execution as: “A duty to seek the most favorable execution terms reasonably available given the specific circumstances of each trade”, which is helpful but open to challenge under the trading conditions within a fragmented market. If there is no central reference indicating where the most favorable terms are likely to be (e.g. because they are internalised without any transparency of information granted to investors), then sourcing “most favorable execution terms” may not be feasible.
For the MiFID provisions to be effective, they must address the challenge that ‘Best Execution’ can be viewed differently depending on whether you are looking from the buy-side, the sell-side or the market provision side of the debate. Every view is determined by the transparency of processes and the availability of underlying information to support each process. The problems with achieving Best Execution, therefore, cannot be separated from the existing economics of trading systems, and the appetite of traders to change the way they approach the trading function. ‘Best Execution’ is not merely synonymous with measuring and minimising trading costs (Trading Cost Analysis – TCA), but about having an implementation process that is consistent with the underlying management style, and about measuring the process and gathering feedback to make changes.
For example, an asset manager could well question what ‘Best Execution’ looks like in a fragmented liquidity environment comprising regulated exchanges, multilateral trading facilities, internalised matching and multiple order management systems (OMSs)? Would a sell-side firm offering the price discovery function have the interests of the buy-side client at heart, or might proprietary trading considerations get in the way, particularly as sell-side firms typically commit capital to provide immediacy of execution? And lastly, if there is to be a notion of ‘Best Execution’, might the thinking evolve to enable buy-side firms to begin to think about ‘Best Settlement’ and ‘Best Asset Servicing’?
The paragraphs within Article 21 of MiFID show a high degree of prescription with regards to the principle of ‘Best Execution’ in the holistic sense. Article 21.1 states that “Member States shall require that investment firms take all reasonable steps to obtain, when executing orders, 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 the execution of the order. ?” There are new obligations to tell clients at which venue or venues a firm will execute the trade and obtain the best result for its customer. The Best Execution obligation applies “to the firm that has the contractual or agency obligations to the client”, regardless of whether the order is executed directly or indirectly.
CESR does not see any conflict between a manager's obligation to deliver performance and the efficient execution of client orders. Articles 21.2 & 21.3 of MiFID thus state that “?Member States shall require investment firms to establish and implement an order execution policy to allow them to obtain, for their client orders, the best possible result in accordance with paragraph 1”, and, “The order execution policy shall include?information on the different venues where the investment firm executes its client orders and the factors affecting the choice of execution venue”. However, it is interesting to note under MiFID that ‘execution venue’ may include regulated markets, MTFs, or investment firms acting as systematic internalisers, In the case of the latter, when an investment firm deals on its own account to execute a client order or crosses client orders, then the firm itself can be the execution venue.
Article 21.4 in MiFID makes specific reference to the context of Best Execution by stating: “Member States shall require investment firms to monitor the effectiveness of their order execution arrangements and execution policy in order to identify and, where appropriate, correct any deficiencies. In particular, they shall assess, on a regular basis, whether the execution venues included in the order execution policy provide for the best possible result for the client or whether they need to make changes to their execution arrangements?”. This is another area where MiFID demonstrates considerable prescription, because the factors that investment firms will need to consider when selecting, monitoring and reviewing execution venues will include price, liquidity, fees, commissions and explicit costs, average size of orders, types of market participants, client preference, trading capabilities, potential for price improvement, appetite for immediacy, execution service, access costs and settlement capabilities.
Finally, Article 21.5 of MiFID states that “Member States shall require investment firms to be able to demonstrate to their clients, at their request, that they have executed their orders in accordance with the firm's execution policy”. This will assume that the policy is able to differentiate between the relative importance of factors such as price, speed, size, costs, and probabilities of execution and settlement. The issue of cost comes to the fore here. For example, the Level 2 text should not mandate investment firms to access venues where it would not be commercially viable to do so. Also, and perhaps more obviously, firms would also need to take implicit costs such as the impact of a size order on the underlying price behaviour (market impact) into account in determining how to get the best possible result.
On March 3, 2005, CESR published their ‘Draft Technical Advice on Possible Implementing Measures of MiFID’. CESR proposed that investment firms (Section 64) “?should consider all relevant factors when assessing whether a particular [execution] venue achieves the best possible result?where implicit costs are relevant to the investment firm's assessment, they should be considered?For example, if implicit costs, such as market impact, in relation to an order or a series of orders are relevant to the service provided by the firm, then clearly the firm should take these implicit costs into account in determining how to get the best possible result. But the significance to be given to this factor, as against all the others, must be for the investment firm to judge?”
The FSA’s CP 154 published in October 2002 also recognises Best Execution requirements as a key component of securities markets regulation, providing assurance to investors that market intermediaries will act in their best interests when dealing for them in the markets. Firms need to exercise judgement about the best methods for achieving execution while at the same time minimising the indirect or implicit costs. CP 154 Sections 3.17-3.20 notes that direct or explicit costs such as spreads, commissions, taxes (such as Stamp Duty) and charges associated with settlement and custody are more readily quantifiable than indirect or implicit costs. The latter account for approximately two-thirds of total transaction costs and are principally of two types:
- market impact – the adverse price movement which can occur once the information in a transaction has become known to the market place; and
- opportunity cost (also referred to as implementation shortfall) – the cost implicit in a decision to trade on a phased or patient basis that arises when the market moves before the trade or investment strategy can be fully implemented.
CP154 Section 3.28 equally views context as key:
“The current best execution requirements recognise that price cannot be viewed in isolation, but must be viewed in the context of what is available at the time for similar orders ‘of the kind and size concerned’?Respondents saw the key elements as follows:
- Size: size is clearly a key factor in deciding when and how to trade, especially for institutional business, and price and size are closely inter-related;
- Timing: given a large size order (c.f. normal market size), it may be appropriate to execute on a phased or patient basis, to avoid or minimise adverse market impact. Alternatively, a customer may require, or a firm may decide on, immediate execution (or execution at a particular time – for example when the market opens or closes etc.), regardless of market impact.
- Price limits: orders may be subject to a price limit – an absolute amount, a benchmark such as the day’s high/low or open/close or VWAP measured over a specified time period.”
- Counterparty limits: a firm may have a risk management policy in place which, from time to time, impacts on its ability to deal with a particular counterparty once it has reached or is close to its internal credit limit for that counterparty;
- Settlement: some investors, prefer to settle on a basis that limits the choice of execution venue – so settlement requirements are a key order dimension in some cases”.
CESR’s Draft Technical Advice on Implementing MiFID (2nd CP, Sections 58 & 60) requires that a firm’s trading arrangements equally takes account of factors such as client preference, order volume, broker fees, transaction fees, regulatory costs, potential for price improvement, immediacy, costs of clearing and settlement, service quality, and technology costs for implementation, integration and connection (access costs). Additionally, firms are advised to consider factors such as execution quality, ability to avoid market impact, operational efficiency, credit worthiness, reputation and service quality (ibid, Section 59) when selecting an execution intermediary. It is clear that under MiFID, the need to devise, populate and update metrics will grow exponentially. The challenge will be how to maintain order out of a sea of data chaos, and how to employ transaction cost analysis as an effective benchmark.
Buy-side traders have mobilised to suggest changes to the market structure (evidence the shaping behind FIX since 1993) and regulatory reforms such as Myners that have transformed the market from a sell-side dominated structure to one that better serves the needs of both sophisticated institutional buyers and individual investors. The changing requirements of asset managers (particularly the rise of hedge fund and algorithmic trading), the growth in retail order-flow, and the dispersal of liquidity resulting from new price formation mechanisms such as MTFs and the rise of internalisation, have all been factors. Further, increasing pressure focused on best execution from AIMR and the SEC and its global equivalents in Europe have forced consultants and brokers to respond to the increased demand for quality trading cost analysis (TCA) measurements.
So a Best Execution strategy could depend upon exactly when a trader decides to step forward to trigger a trade, not to mention the costs of the other trades on a chart. But how should this be computed when an order is fragmented into smaller tranches and executed algorithmically over a sequence of trades, resulting in liquidity and market impact dispersal? With the growth of MTFs creating markets within themselves, how could the investor ever have prior knowledge of where the liquidity is and what is the best price? To benchmark every area will require a relatively high degree of sophistication and data maintenance, not to mention solid business process and data management in a MiFID-compliant environment. And without consistent TCA benchmarks for market quality as a function of price delivery, much less price discovery, how could Best Execution ever be a viable candidate for regulatory oversight alone?
Traditionally, transaction cost analysis (TCA) modelling featured two kinds of analysis – pre- and post-trade. Pre-trade analysis was historically the domain of professional service firms such as Accenture or consultants such as Plexus. These firms focused on delivering reports to management and/or trade oversight committees at pension fund, local authority or corporate firms, often from an ‘audit’ perspective. Their primary measurements often involved a single trading benchmark, usually allowing for investment styles (e.g. active vs passive, growth vs value, momentum, statistical arbitrage etc) as well as liquidity considerations such as trade size or market cap. Traditionally, there was a relative dearth of TCA tools for the mid- to back offices apart from BECS (Best Execution Comparison Services) and statistics provided by SWIFT, Omgeo or the Tower Group. Not only were costs of settlement fails or confirmations tracked in dollar amounts (as opposed to basis points), but key risks such as counterparty credit or operational risks hardly figured. For a TCA process to be useful, results must be analysable by portfolio managers, risk managers, traders, trustees, and regulators.
On the positive side, if asset managers are able to demonstrate best use of trading rules encompassing investment vehicles and execution options to the regulators, this could result in a significant shift in market behaviour post-MiFID and a massive boost to algorithmic trading. Algorithmic trading refers to portfolio managers or dealers on the buy-side conveying requests for bid, orders and allocations (splits) to their brokers and/or trading counterparts via the FIX protocol. Instead of the orders for single stocks or portfolio trades needing to be executed manually (often by highly-compensated dealers on the desk), a trading engine is used to slice and price the order intelligently using a selected set of rules or algorithms pre-defined between the trading counterparties. The asset manager can assume greater control of the execution without requiring dedicated trading resources and can also participate in the broker-dealers internal flows – a trend which is likely to expand once algorithmic trading takes off.
Algorithmic trading differs from sequential rules-based trading developed during the late 1990s on account of the greater flexibilities granted by newer technologies. The volume sizes or the time intervals for portfolio trading can be randomised in a dynamic, not sequential, manner, with in-built logic and feedback processes. Algorithmic trading takes rules-based trading and puts it on steroids by allowing individual stocks (or a portfolio of stocks) to be worked by the desk with complete insight into the bigger picture, both within the firms and across the universe of activity in that security. Algorithmic trading ensures dynamic monitoring of performance until execution is complete (ie the end helps decide the means, not the other way around as with rules-based trading). Finally, when combined with automated order handling and compliance systems via FIX, algorithmic trading of the cash instruments can be linked to the leading derivative markets to provide a better liquidity profile surrounding the execution of individual stocks (or a portfolio of stocks).
It is the ability to create versatile trading algorithms that is driving the rapid growth in electronic trading in our industry. A recent Tabb Group report indicated that as many as 60% of US Investment Managers are already using or experimenting with algorithmic trading. As the US market led the way with electronic trading and leveraging OMSs, this suggests that the European markets can’t be that far behind, and directives such as MiFID will act as a catalyst. Algorithmic trading is a logical extension of rules-based trading – it’s just that over the last five years, the rules deployed by execution agents have become increasingly sophisticated. More investors have become attuned with benchmarking against the volume weighted average price (VWAP), which attempts to beat or match or beat the average trading prices in the market over a pre-specified period, ranging from intra-day to a full day. In general, VWAP has become a popular benchmark on account of the belief that it is an efficient vehicle for expressing the trade-off between execution risk and execution impact.
If algorithmic trading is one possible wunderkind of MiFID, this presupposes that a critical mass of asset managers invest in the necessary technology, buying solutions from the likes of Apama and FlexTech, to construct and test the algorithms with their counterparts in real-time on their respective OMS systems. If this is not forthcoming, then the development of algorithms could prove to be a one-sided affair, with the sell-side making all the running and even taking advantage of their asset manager clients who do not have the wherewithal to invest in the technology – somewhat akin to a sophisticated proprietary lock-in, this time around the trading methodology, not the technology. The price-performance argument against the backdrop of MiFID could be a critical one in persuading more asset managers of the case making the switch towards algorithmic trading.
If all these innovations are occurring at the intermediary level, how do exchanges respond in an environment where technologies such as common FIX standards have the potential to level the playing field? This is where linkage with the clearing houses and national depositories points to the way forward. The scope of MiFID links pre- and post-trade under the guidelines of Best Execution. MiFID will also catalyse the replacement of antiquated links between markets which have enjoyed the monopoly of the concentration rule, strengthening market linkages to provide immediate access to the national best bid and offer in a manner somewhat akin to the NMS in the US. If all exchanges provide automatic execution, there could be a pseudo national market limit order book, forcing all marketplaces to attract orders by competing on fees, better service, and trading enhancements in a more transparent manner. The challenge will be to link these innovations to improvements in capital adequacy to allow the middle and back office to develop innovations in liquidity management to match. This will certainly be an interesting space to watch during the rest of this decade.
