The European Securities and Markets Authority (ESMA) defines best execution under MiFID II regulation as a principle that all financial services firms trading on behalf of clients “must take all sufficient steps to obtain the best possible result, taking into account price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order."
ESMA’s wording has left many market participants scratching their heads. Some have said it’s impossible to achieve perfect best execution with everything taken into consideration. Others have assumed best execution is simply about getting the best price for your client.
Director of Markit trading analytics at IHS Markit, Michael Richter, described the wording as “pretty open-ended.”
But can best execution actually be achieved?
“As long as a firm evaluates all of the above in its approach to trading, using all the tools available to it on a pre- and post-trade basis as well as taking the client instruction into account, it is possible to achieve best execution, in the regulatory sense,” Richter explained.
He added that achieving ‘best’ execution in a literal sense is something of a red herring, but ‘better’ execution is a “real and valid term.”
“While this seems like semantics, it isn’t, since ‘best’ implies that each trade can be executed optimally, while ‘better’ implies substantive improvements to the trading process as a whole,” Richter explained.
In October this year, ESMA released a Q&A in an attempt to answer some of the lingering questions on best execution.
According to the latest guidelines, the best execution requirement under MiFID II does not need to be obtained for clients on every single occasion, but firms will need to verify efforts on an on-going basis.
ESMA said those executing on behalf of clients must verify “their execution arrangements work well throughout different stages of the order execution process.”
It added that all companies should take “appropriate remedial actions if any deficiencies are detected,” to prove they have taken “sufficient steps.”
In a recent interview with The TRADE, KCG’s chief executive officer in Europe, Phillip Allison, explained the firm is “pleased about the focus on best execution under MiFID II.”
“It’s a helpful catalyst for us to move our business forward in Europe and as a market maker, the systematic internaliser framework is a natural one for us to operate in,” Allison said.
To follow up on the issue of best execution, The TRADE spoke with KCG’s recently appointed head of execution sales, Michael Seigne.
“There are a whole series of angles and nuances to best execution, but in essence it is possible and it can be achieved,” he explained.
Most market participants appear to agree that best execution is something that can be achieved.
But how can you achieve this in a practical way?
Process from policy
The overarching theme presented from buy- and sell-side participants is that outlining and applying an appropriate process that works for your company and the instruments you trade is key.
Senior regulatory adviser at Fidessa, Christian Voigt, asserted that best execution “will never be a simple box ticking process, but it is a continuous policy.”
The whole process of best execution starts with the best execution policy and this is all about being able to demonstrate a process and that must fall in line with the policy.
Mark Northwood, former global head of equity trading at Fidelity International and founder of Bips Global, added that hypothetically, firms would need knowledge and control of what every other market participant is doing, “which would be an amazing, illegal hack!”
However he added, “a process with the ‘sufficient steps’ thoughtfully developed around your particular type of trading activity certainly is [achievable].”
KCG’s Michael Seigne echoed this: “It’s clear from regulatory authorities that you need to set up a process and it’s not just about getting a single price. Are you applying your best execution process and are you adhering to giving your client the best outcome you can get?”
The key is to establish a systematic, disciplined approach to trading that leverages statistical analysis of execution quality of various trading methods, Richter at IHS Markit explained.
“All of these processes should also be outlined in an up to date best execution policy that all investment firms will need to provide to their regulator,” he added.
This requires data… a lot of data.
Almost every market participant The TRADE spoke with about the issue of best execution discussed the importance of data when trying to apply a best execution process. In fact, data has been named on many occasions as the biggest problem for the buy- and sell-side ahead of MiFID II.
Mark Northwood explained specifically that: “Managing the trade off between obtaining more information about the current market, and the signalling that comes from doing so, be it responding to IOIs and axes, sending RFQ’s or starting to trade,” is a major challenge.
IHS Markit’s Richter agreed, stating that obtaining “good quality data that enables firms to evaluate orders on a pre- and post-trade basis as well as at the point of trading,” confronts those seeking best execution.
For the buy-side in particular, reporting responsibility and data collection hasn’t always been at the forefront.
At The TRADE’s MiFID II: Best Execution event in Paris this October, Rachel Hutchins, who is part of the trading solutions, compliance and regulation team at Bloomberg, explained to delegates that the buy-side had no such requirements under MiFID I.
“The sell-side learnt a lot things from reporting under MiFID I. They have learnt from their mistakes and have been fined for those mistakes,” she explained.
“The buy-side are doing this for the first time and they have a lot to learn.”
Liquidnet’s head of EMEA, Mark Pumfrey, echoed Hutchins when he explained that in the past the buy-side has “historically handed most of the responsibility to achieve best execution to their brokers. However, this responsibility has now moved to the buy-side.”
This is where technology steps in.
Pumfrey told The TRADE that technology is the key to data collection and it is crucial that participants collect the correct data to be able to assess the results, a view echoed by many others.
He added that through OMS, EMS and external vendors, participants can look back through transactions to assess why certain routes were chosen at the time.
Northwood considered two questions when asked if technology was the key to unlocking best execution and said the telephone alone does not constitute an arrangement of ‘sufficient steps’.
Firstly, does a firm require technology or can it make better use of what it already has? Secondly, what is the best working combination of smart people a firm has with the technology available?
“As many have noted, technology is good at speed, correlating data and consistent decisions. A good trader is curious about causation, interprets and adapts as market information changes.
“Of course cognitive computing, applying machine learning techniques, is also pushing further into the domain of human traders,” Northwood said.
IHS Markit’s Richter stated that technology is a “major tool” to assist firms with building processes for best execution, but also for other elements of the policy like understanding smart order routers, trading venue performances and algorithmic behaviours.
“Technology, whether in-house or that of a third party vendor, has a huge part to play in best execution.
“The whole trading landscape across all asset classes is technologically-driven so the tools being used to analyse and measure them must be advanced from a technology perspective,” he told the TRADE.
Fidessa’s Voigt echoed this, asserting that “technology for collecting and interpreting data is a key component in meeting best execution requirements.”
However, he added that like many regulatory requirements, “technology is only one part of the answer. The tools provided are only as good as the expert knowing how to use them.”
The buy-side is already well acquainted with technology like transaction cost analysis (TCA) tools, KCG’s Michael Signe said.
“If you speak to the buy-side – depending on where they are on the spectrum – they have a very good idea of what they are trying to achieve in terms of metrics and there are very sophisticated transaction cost analysis tools,” he explained.
Although Richter stated that despite the need to collect vast amounts of data and then put all of the data into a framework – which is generically labelled as TCA – this understates its importance.
“This is where you get the insights that will inform changes to the process by revealing what works well and what needs attention,” he said.
Firms like Liquidnet and KCG have best execution policy at the forefront of their respective businesses.
Mark Pumfrey explained that Liquidnet can provide the buy-side with the data to analyse the trades which have been executed on its venue.
“We discuss with our clients what best practice is and share our views on how they can build a decision tree to identify best execution,” he said.
However, Pumfrey added there is more to best execution than this. Firms must create a process and collect data in order to create an audit trail so the client can understand and assess the quality of execution.
Taking another approach, Michael Seigne, head of execution sales at KCG said the firm uses a “combination of several of our core attributes, such as our market micro structure expertise and our technological infrastructure,” to help its clients with best execution as the market becomes more complex.
Fidessa’s Voigt explained that the concept of best execution is not a static one, but instead it “requires constant re-interpretation given recent market developments.”
Best execution will sweep across the financial services industry on 3 January 2018 when the MiFID II deadline is finally realised. Michael Richter at IHS Markit described best execution in such a way that if all firms were to look at the processes and policy in this way, best execution might just be achievable after all!
“Something that tends to get overlooked; the regulator is looking for firms to keep their best execution policy a ‘living, breathing’ document that is updated on a frequent basis.”