UK buy-side trading desks have been warned they need to undertake a thorough review of their best execution procedures in light of a Financial Conduct Authority (FCA) review published last week.
Though the scope of the review was focused primarily on banks, brokers and wealth managers, one market expert said it was merely “fortunate” that the review did not also take in asset managers as it would likely have found similar issues.
The FCA’s review, ‘TR13/14 – Best execution and payment for order flow’, provided a damning assessment of the industry’s application of best execution rules. Its key findings were that few firms were fully aware of their best execution obligations, were relying on use of prohibited carve-outs and frequently has insufficient controls and lines of responsibility to ensure best execution was being provided on behalf of clients.
It concluded by saying that firms within the scope of the review should ensure they evaluate the findings and seek to prevent similar failings in their business. It also advised the buy-side to take a close look at their own procedures.
“I think asset managers are very fortunate that the review was focused on brokers instead of them as they will have the chance to examine the findings and make the necessary changes to their business before the FCA starts looking into institutional investors’ handling of best execution,” said Richard Phillipson, principal at buy-side consultancy Investit.
UK buy-side body the Investment Management Association (IMA) agreed that asset managers will need to ensure their own processes are up to scratch.
Ross Barrett, adviser on capital markets at the IMA, explained: “Our members will need to make sure they are getting the best execution from their brokers that they expect and have processes and controls in place to ensure they can demonstrate to the FCA that they are achieving best execution.”
Adrian Hood, adviser on regulation at the IMA, added: “The FCA has given us the clearest explanation yet of what they expect from best execution. This document is a very useful tool for asset managers to review their broker relationships and look at the service they received.
The IMA said a key concern for institutional investors is to ensure they are correctly classified and not subject to general carve-outs, as being wrongly classified by brokers could lead to them not being fully protected on best execution.
Buy-side firms will have some responsibility to ensure they have some oversight over their brokers’ provision of best execution in order to safeguard their own clients.
"There's an element of caveat emptor for the buy-side as things stand. It seems there is an expectation from the sell side that the clients should be policing best execution. There is an implicit message that asset managers need to have much more scrutiny over the sell-side to ensure they have the processes in place to monitor execution performance. Ultimately the FCA is expecting the sell side to up its game and be more transparent in managing of conflicts of interest and its processes for demonstrating best execution. ”said Michael Sparkes, director of analytical products at agency broker ITG.
One particular issue raised by the FCA was that understanding of where best execution applies was often patchy, particularly around non-equity asset classes, where most brokers thought that best execution obligations did not apply.
Monitoring of best execution through the use of transaction cost analysis (TCA) is relatively well established, though for a number of reasons other asset classes are only beginning to be targeted by TCA services.
“A lot of best execution mandates have read across from equities, which has tended to focus on routing issues to different venues,” explains Jonty Field, head of EMEA for Quantitative Brokers, which specialises in providing best execution in fixed income and futures.
“In the futures market, you tend to trade on single exchange, but this doesn’t mean you can’t get best execution, but you need to approach it differently and think about other factors, such as slippage, that will affect your execution performance.”
ITG has been pushing out its own TCA offering into the FX market and is also tackling its implementation in fixed income, but Sparkes said there remain many challenges to be able to analyse these markets in the same way as equities are today.
"Being able to measure best execution outside of equities is still very much a work in progress and is much more challenging in illiquid or OTC markets. TCA is branching out across asset classes but it will take time."
Sparkes adds that there is a lot at stake for the industry to get things right, "As the FCA highlights, just a single basis point cut off trading costs equals £264 million per annum of retained value in funds and if you assume the average length of pension savings is 30 years then that adds up to £37.5 billion, a huge sum of money.