Current industry discussions on best execution tend to focus on the implementation of the Markets In Financial Instruments Directive II (MIFID II).
The topics being discussed, though, are global and reflect common issues shared by the US and other major equity markets. While the challenges of achieving best execution are the same, the ways and means used to achieve it have been different.
It is useful to compare approaches used in Europe with those of the US to clarify the underlying assumptions and issues in policy debates in both Europe and the US. Two major differences become clear:
Creating new pieces of market structure versus building new reporting mechanisms
A focus on price versus process.
Best execution is generally understood as executing a trade in a manner that obtains the best result for the client. But why do we need these policies? Best Execution is an attempt to address a potential “moral hazard” problem in market structure.
The relationship between clients and their brokers is a principal-agent relationship. Business incentives and motivations in these relationships may have diverging interests and information asymmetry.
A client, for instance, will want their broker to route orders to the optimal venues for their trade, while the broker may want to minimise their efforts and route the trade to a venue which maximises their own revenue.
Alternatively, a broker may have information about market situations not readily available to their clients creating potential adverse selection. In many cases, especially in less liquid markets , the client does not have access to the same quality and quantity of information to monitor a broker’s efforts and incentives.
The growth of electronic trading and the ensuing fragmentation of markets opened up a new set of potential moral hazards related to the speed of quoting and trading.
About 10 years ago when electronic trading and market fragmentation became issues, regulators in both the US and EU developed reforms to address them. The challenge for both was to balance an equitable approach to handling client orders consistent with best execution without impinging on competition between trading venues.
The differences in approach cut against traditional policy stereotypes. The US is usually thought of as a less regulated environment. However, in this case, the US approach has been to intervene and create new market structures while the EU focused on developing transparent reporting mechanisms that placed greater confidence in the market and market participants.
In 2005, Reg NMS (National Market System) was instituted in the US market, outlining rules that describe how orders should interact between different trading venues. There were two key parts. The regulators compelled trading venues to establish direct electronic linkages with each other to ensure the client received the best price even if displayed in a different trading venue. The “Trade-through” rule required all trading venues to send all orders to the venue with the best-displayed price or matched at that price.
In 2004, the EU proposed the first iteration of MIFID. In contrast to Reg NMS, MIFID I did not include any market interaction rules. It gave market participants the latitude to choose the best execution strategy for their orders. It sought to address the moral hazard problem by mandating a detailed series of reporting obligations. Rather than mandating how orders should move through the venues, the directive focused on requiring brokers to review execution strategies with investors to ensure that they understand customer requirements.
While the US focused on defining best execution as executing at the best price, the EU approach emphasised creating a process to obtain the best possible result by taking into account price, cost, speed and likelihood of execution.
The EU framework explicitly avoids an absolute criterion such as price, by incorporating other factors. This served the needs of large institutional clients trading large order sizes, who require immediacy of execution.
MIFID does not prescribe how orders should interact between venues. While both approaches for achieving Best Execution are designed to provide transparency to the client. MIFID aims to provide transparency through comprehensive reporting and requires disclosure on where trades are executed and payment incentives, as well as information on how that price and trade size compares to other venues at that time.
These particular best execution solutions were first formulated over 10 years ago. The issues surrounding trading speed and market fragmentation continued to evolve, however.
Market fragmentation produced greater competition between venues for execution flow. To compete, venues sought to segment their clients into different types of trading strategies.
Venues competed for market share against each other by offering technological advances in finding liquidity, improving electronic connectivity and building data centres to allow customers to place their trading algos close to matching engines – leading to higher execution speeds and high speed data feeds. The result has been a new set of potential best execution issues with potential moral hazards.
Devil in the detail
MIFID II is much further along, but it is clear in the US, that a new round of regulation relating to market structure and Best Execution is coming. MIFID II appears to be following the same general philosophy for Best Execution as MIFID I because it is again requiring detailed reporting to assist with investor decision making.
A review of the European Securities and Markets Authority’s (ESMA) technical specifications suggests that the increasing complexity of the markets is being addressed by increasing the complexity of the reporting requirements. Although accommodating all of the reporting requirements could be burdensome and undoubtedly costly, this may still be preferable to an explicitly interventionist approach.
In the US, the Securities and Exchange Commission’s 2010 Concept Release on Equity Market Structure and the ensuing comments indicated that there is a consensus that the current regulatory regime does not adequately address the new developments of the past 10 years.
The 2016 regulatory discussion will be dominated by the minimum tick size pilot program, where the effects of increasing the minimum spread from one to five cents for small cap stocks will be evaluated, as well as potential new regulations regarding dark pools. Early indications suggest that the US could potentially maintain its own activist philosophical approach towards best execution.