Good morning. I am very pleased to be here today to address you on MiFID's best execution requirements – a sometimes controversial but central aspect of MiFID. Some aspects of the MiFID requirements pose a major challenge for all of us in Europe and best execution is no exception.
During the course of this year, we have been engaged in constructive dialogue with all sections of our industry on MiFID's best execution requirements and our thinking has evolved. Our implementation proposals are set out in the Reforming Conduct of Business CP [06/19], published last month and we continue to listen to views from all stakeholders. Today, I aim to give our current thinking on the key issues.
As many of you will be aware, the FSA's regulatory approach is moving away from the rigidity of detailed prescriptive rules to a more flexible (and we think more effective) principles-based approach, where the onus is on market participants to make the right judgement. So, implementation of MiFID's best execution requirements is taking place in the context of a changing regulatory environment where high level principles will be the order of the day. We believe that this brand of regulation puts the UK ahead of other international financial centres and our approach to implementation of the best execution requirements seeks to preserve a principles-based approach wherever possible.
Even so, in initial discussions with industry with respect to implementation of MiFID's best execution requirements in OTC markets, we have been accused of being alternately super-equivalent and under prescriptive. To the first point may I be clear: we have no evidence of market failure in this area that would justify regulatory intervention, and consequently we have no intention of being super-equivalent. We recognise that OTC markets are an important and successful component of the London financial marketplace and we are not trying to restructure them. Rather, we are committed to a compliant, pragmatic and minimalist implementation of the new Directive's requirements. On the second point, our principles-based approach utilising 'intelligent copy out' wherever possible, may mean for some it feels under prescriptive. However where that is the case we would invite industry to consider producing their own 'trade guidance' which where appropriate we will be willing to confirm.
So what does this mean in practice? I shall begin by outlining the circumstances in which we believe MiFID's best execution requirements will apply (the so-called "scope" issue) before turning to the detail of the best execution requirements themselves - and what industry needs to do to implement them.
Scope: Who is subject to best execution requirements?
It is fair to say that MiFID's best execution requirements are reasonably straightforward where a traditional equity broker executes an order under the rules of an exchange. More difficult questions arise in dealer markets. In the UK, best execution rules do not attach to quote-driven transactions. In this respect, MiFID changes the status quo because it is within the contemplation of MiFID that the best execution requirements would apply to, at least some, transactions in dealer markets.
The October Reforming COB CP has taken extensive account of feedback received from both the buy- and sell-side to both our best execution DP and our August client classification paper, which included some further thinking on the scope of the best execution requirement.
The August paper set out our view that MiFID's best execution protections would not apply when a firm performs an investment activity without providing an investment service. We said that whether a firm is providing a service or an activity will depend on the nature of the relationship between the parties. The paper listed the circumstances in which a "client relationship" could exist. We said that, although it was clear that some financial services business could only sensibly be provided by way of a service, such as advice and portfolio management, a firm dealing on own account could perform an investment activity without providing an investment service, depending on the nature of its relationship with its counterparty.
In the October CP, we concluded that there is room for further flexibility on scope. We have taken the view that it does not make sense to require a dealing firm to deliver best execution on a quote-driven transaction if the customer is relying on its own due diligence in deciding to buy or sell a financial product. On the other hand, if a customer, such as a portfolio manager indicates it wants best execution and the dealing firm is willing to provide it, MiFID's best execution requirements will apply. In short, dealing firms are not required to provide best execution but they may elect to do so either generally or when a customer requests it.
We said this approach will be possible in both retail and dealer markets on the basis that the customer decides for itself where, and with whom, it wants to deal – resulting from its own selection of available products and prices. In such cases, the dealing firm responding to the customer’s acceptance of the quote is not "executing orders" as such.
In sum, we have come to the conclusion that MiFID does not require firms operating in quote-driven markets to provide best execution. However, firms can agree to provide best execution on quote-driven transactions if they wish to do so.
Firms that provide quotes to customers without providing best execution must make their customers fully aware of this and any related consequences.
The initial feedback on this approach from the sell-side has been very positive; they see our approach as preserving current OTC market practices. But initial feedback from the buy-side is that the analysis may have significant drawbacks for them.
More specifically, the buy-side is worried that this analysis will allow sell-side firms to treat them as "non-clients" and as a result, they will not benefit from certain client-facing protections in MiFID, including conflicts of interest and client money protections. The buy-side has told us that "non-client" status removes protections that apply under our current rules and therefore, that this analysis is detrimental to their interests. More particularly, "non-client" status would seem to allow practices - such as front running - which are currently prohibited or, at a minimum, require disclosure to clients.
We will be considering these issues and any other responses we receive during the consultation period before we reach any conclusions. At the same time, in pursuing its Level 3 agenda, which includes best execution, CESR has written asking the Commission to comment on three issues, one of which is the circumstances in which dealing on quotes is not subject to best execution. We await the Commission's response and we will, of course, attach due weight to it. And I invite you in the audience to tell me your views today, especially if you disagree with my summary of the buy or sell-side views.
Demonstrating Compliance: If you are subject to MiFID's best execution requirements, what does that mean for your business in practical terms?
Before I delve into the detail of the best execution requirements, I would like to deal with a point that has attracted a great deal of industry and media attention. Benchmarking is a well-recognised technique for demonstrating best execution in liquid and transparent markets. Indeed, you could say that stock exchanges provide a kind of benchmark themselves. So in our May Discussion Paper we thought it would be appropriate to signal our support for benchmarking techniques by offering a formal safe harbour. Industry however, became very concerned that we would transform this safe harbour into a super-equivalent requirement and impose it on transactions in illiquid markets. These concerns were unwarranted, I can assure you. But we see no point in proposing guidance that the industry views as unhelpful, so there is no benchnarking proposal in the October CP. Of course, we will be open to discussion should the industry decide that benchmarking would be a useful item to address in their own codes.
Returning to the broader question, if a firm does agree to provide best execution, practically speaking, what must it do? The MiFID standard is that a firm that executes orders on behalf of clients must take "all reasonable steps" to obtain the "best possible result". It does not, it should be said, require firms to obtain the best possible result for every order.
The MiFID standard is intended to drive orders to those venues that deliver the best possible result for clients. It is interesting to see that the marketplace is already changing to compete against this standard. We have noted with interest the recent announcement by a group of major banks that they intend to establish a bank-driven European trading platform. We anticipate that MiFID will continue to stimulate competition and that this will drive down the cost of dealing across Europe.
By driving trading to venues offering the best results, MiFID is also intended to strengthen price formation. Although MiFID allows flexibility in defining what is "best", it also declares that for retail clients, other factors are relatively less important than price and cost. Therefore, when firms execute orders on behalf of retail clients, the best possible result must be determined in terms of "total consideration" , that is, the price of the financial instrument and the costs related to execution.
With respect to professional clients, MiFID allows more flexibility. But some respondents to our discussion paper argued that MiFID allows them to rank the factors however they like, provided that their clients consent. Others argued that price has no place in the best execution analysis for many instruments. We are sceptical of these arguments. MiFID sets an objective standard; firms may not contract out of it. To reinforce this point, we have proposed guidance to clarify that ordinarily, price merits a high relative importance in obtaining the best possible result. However, the guidance also acknowledges that for some clients, orders, instruments or markets, a firm may appropriately determine that other execution factors are more important than price in obtaining the best possible execution for the client.
Meeting the MiFID standard is a fairly straightforward task for traditional brokers. But it is more complex for firms that agree to provide best execution when they execute orders by dealing on own account. A dealer which has agreed to provide best execution on an OTC transaction must consider relevant information about the wider market in formulating its price. To put it simply, a firm cannot agree to provide best execution and then do something less.
In this context, I should also mention the issue of internal models. Some respondents to our DP argued that internal pricing models would be a valid means of satisfying their best execution obligations. We are clear that while firms are free to formulate their quotes on whatever basis they choose, where a firm has agreed to provide best execution to a client, it can rely on its internal model only if its model allows it to take all reasonable steps to ascertain the best possible result in the wider market. In more practical terms, if a firm dealing in a quote-driven market agrees to provide best execution, then intrinsically it cannot be the firm's own risk appetite that defines best execution. The narrowest spreads can be found where multiple risk appetites interact.
Portfolio managers and RTOs
I would now like to clarify the position of portfolio managers and receivers and transmitters of orders vis-à-vis best execution. As some of you will be aware there was considerable Level 2 negotiation in this area. It is now clear that buy-side firms are subject to the best execution requirements.
Where the buy-side does not execute client orders, they must comply with the requirements under Article 45 of Level 2. Where they execute orders themselves, Article 21 applies. Both Articles rely on the same high level principle of taking all reasonable steps to achieve the best possible result. The main differences are that Article 21 requires firms to gain client consent to their execution policy and to demonstrate to clients that they have executed their client orders in accordance with that policy.
Although buy-side firms have disputed the idea, the Commission has recently clarified that it intends portfolio managers to comply with Article 21 when they deal directly on regulated markets, MTFs or with dealers that do not themselves execute. In practice, we do not expect portfolio managers to find these two requirements particularly burdensome as we understand that most already use two-way client agreements and where they consult more than one venue, already record the relevant prices in their records.
I would like to emphasise, however, that we continue to hold the view stated in our May DP that best execution requirements should be applied flexibly and proportionately, reflecting the nature of the functions performed and minimising duplication. This is particularly important where more than one firm is involved in a transaction or where chains of firms perform particular services in relation to a transaction. This approach has received broad support from industry.
Review and monitoring
Finally I would like to turn to the obligation of firms to review and monitor their execution policies and arrangements.
We predict that these requirements will be important drivers of market efficiency. MiFID requires investment firms to regularly assess whether the execution venues included in their execution policy continue to provide for the best possible result on a consistent basis. They must look to other possible execution venues and ensure that those they select for "possible trading" are likely to provide the best possible result - rewarding the most efficient execution venues with order flow. In this way, the universe of possible venues is reviewed and the venue list is reconsidered and, as a result, on an ongoing basis orders are routed to those venues offering the best results.
For quote-driven transactions by dealers, the dealer will itself be the execution venue for the transaction. A firm will therefore need to select (or reject) particular dealers for its execution policy based on the MiFID standard.
The Level 2 measures clarify that, at a minimum, firms should undertake these reviews annually. In addition, if there is a material change that affects a firm's ability to provide the best possible result to clients, an immediate review may be necessary.
In relation to monitoring, we have suggested that firms look at two types of performance – firstly, firms' internal compliance with their own execution policies and arrangements and secondly – whether these arrangements are actually obtaining the best possible result for firms' clients.
Industry in the UK has responded, on the whole, favourably to our proposals on monitoring and review. The majority of respondents stated that the proposals were flexible and proportionate.
Data will play a crucial role in how firms monitor and review and execution quality will be a key concept. Execution venues may begin to publish execution quality statistics in a bid to attract order flow. Such data will be useful to firms when conducting their annual review of execution venues. Some execution venues in the UK are already alive to this challenge.
Conclusion
In conclusion, I hope I have been able to provide clarity on our proposed approach to best execution, recognising that we are still in listening mode and that our proposals are still not final. In particular, there are further ongoing discussions with CESR. As they stand however I believe that they do achieve our goal of implementing the Directive in a compliant but simple and cost-effective manner. I believe now our detailed proposals are available, the industry's initial concerns over both costs and the degree of disruption to current industry practices will have been allayed.
However, I would like to finish by observing whilst our proposals do not in our view per se force significant change on the industry, I do believe the focus the debate has put on 'Best Execution' may well in itself lead to changes in working practices. The debate has forced us all to clarify both what we mean by best execution and who is actually obtaining it. This greater clarity and focus may well lead to changes as buy side institutions seek to ensure that greater clarity is achieved in practice. But such a change would be led by industry rather than regulators which is the essence of principles based regulation.
I hope my remarks have been helpful. As I have said a number of times we are still in a consultation period and thus would particularly welcome feedback on my comments today.
Thank you for your time.
