One of the primary tenets of the revised Markets in Financial Instruments Directive is best execution and a firm’s fiduciary responsibility to its investors. By now, market participants have become well versed in many key aspects of the upcoming European regulation, like the dark pool trading caps and the unbundling of research and trading commissions. More recently though, best execution and the required processes in which firms will undergo to achieve it have taken center stage. Best execution remains at the heart of the investment process under MiFID II, and as a result, European regulators have been helping firms prepare by offering informational sessions and Q&A documents, like the ESMA’s recently published Q&A on investor protection and the FCA’s dedicated MiFID II website.
Like many aspects of MiFID II, best execution is – sometimes painstakingly – meticulous because it addresses many of the unintended consequences and failures stemming from a combination of questionable practices and outdated regulation. At the same time, the definition of best execution is broad and knowingly subjective simply because many different factors influence its outcome. Participants agree that varying degrees of interpretation are imperative when it comes to achieving best execution, yet despite a reservoir of available information, many are of the belief that demonstrating faultless best execution under the new regulation is simply unattainable. Even though best execution protects and holds accountable all types of investors, enforcing it could produce an outcome that promotes innovation, but could just as easily prevent it.
The broad view: reasonable versus sufficient
MiFID II requires that firms must “take all sufficient 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.” Unsurprisingly, the term sufficient has raised many questions and concerns due to its subjective nature coupled with the varying degrees and methods a firm might employ across the investment lifecycle.
Interestingly, the difference between reasonable steps (current regulation) and sufficient steps (new regulation) was the first question listed in ESMA’s recently published Q&A document on investor protections. It states, “How should firms and competent authorities understand the difference between “reasonable steps” and ‘sufficient steps”? The answer (found on page 9) is well defined, and at the same time, allows the flexibility for investment firms, brokers, and trading venues to apply their own best practices. Still, where does best execution begin? Where does it end? As it pertains to MiFID II, what is an appropriate definition for sufficient, where and to whom does it apply, and in what areas might it be subject to interpretation?
Best execution is detailed and complex
The problem in any attempt to define and enforce best execution is that one firm’s best practices may not be the same as those of another. Additionally, firms are unique in that each one employs its own business model and has its own group of constituents, and routing and execution practices.
At times, a firm’s execution abilities may be limited because of uncontrollable factors. For instance, not all European venues grant fair access. If a buy-side firm sends an order – unbundled of course – to Broker A, and Broker A is unable to access Broker D’s dark venue, and the execution performance is sub-optimal, will that unnecessarily raise regulatory flags around the practices of Broker A? Chances are, no, but it could increase Broker A’s regulatory burden – and costs – which, for many firms could be significant. Holding firms and their processes accountable is critical, but it is entirely reasonable that a firm may choose its practices simply to prevent unnecessary inquiry around specific practices and procedures. Broker A could decide to access all possible venues, or just a select few. A firm who accesses all venues may risk sub-optimal performance due to the higher risk of information leakage, while the firm that trades with a few select venues increases their potential opportunity cost by not trading. Minimizing risk is of paramount priority, so it is entirely possible for a firm to choose the “regulatory safe route” via less advanced execution and routing strategies, thereby inhibiting innovation and precluding the intended spirit behind the regulation.
Unbundling and best execution
In a prior note, we discussed the potential impacts of unbundling on execution quality. On the surface, the divorce of research from execution will provide firms with the ability to choose their best trading partners. Additional rules will help address the need for transparency around trade reporting and disclosures in order routing.
General European trading rules are principles based, which means that, unlike trading in the U.S., brokers are not obligated to route to a particular venue, meaning the responsibility and decision behind where an order is ultimately routed lies with the executing broker. At the same time, the current and future structure of European venues allows for certain benefits and competitive effects. In Europe, all things being equal, if a venue provides sub-optimal execution, it risks failure through a lack of order flow and decline in market share. Alternatively, venues that continue to innovate and offer quality execution and services succeed.
Unbundling creates an environment for the buy-side that is similar to the one currently enjoyed by brokers with respect to their choice of trading venue. With the power of choice resident with the buy-side, the execution landscape inherently becomes much more competitive. The competition for order flow and trade related services will intensify and brokers will place more emphasis on gaining an advantage. To succeed, particularly in the electronic and dark pool space, brokers will need to improve their execution offering through better quality of service and unique product solutions, and convince their clients that their services and execution quality are superior. In other words, satisfying best execution becomes easier through innovation and sophisticated order routing methods. Eventually, this competitive effect will extend beyond venues and brokers and infiltrate other areas of capital markets, like independent research providers, financial technology, and compliance – a “win” for best execution.
Nowadays, firms operate and trade in multiple asset classes and regions, and most firms have found that, in one way or another, MiFID II will affect their business model. The trading rules and regulatory responsibilities of one region alone are complex, and U.S. based global trading firms are considering ways to apply the most stringent rules across all trading regions that affect the firm. Doing so could prevent unnecessary breaches in regulation and reduce their overall operating costs.
We realize that trading in any region is challenging and that the rules around European best execution will probably yield unintended consequences once implemented. However, those same rules have the power to produce thoughtful and creative market solutions that redefine and modernize best execution, similar to the reasons that created Luminex.
As always, if you have any questions, please let us know.