By Nigel Farmer
It is over seven years since MiFID was introduced into the European markets, bringing with it the obligation for investment firms to ensure ‘best execution’ for their clients. Now, with MiFID II fast approaching, and as firms re-evaluate their policies and procedures, this is probably a good time to assess the current landscape in terms of what is working and what isn’t.
Unfortunately, the picture is not particularly encouraging.
According to a comprehensive review of best execution undertaken by the Financial Conduct Authority (FCA) last year , there remains a great deal of confusion and ignorance on this topic amongst market participants, with many aspects of best execution being routinely ignored. In the words of David Lawton, FCA Director of Markets, “…our review shows many firms unacceptably fail to put their clients’ interests first, undermining market integrity and inhibiting competition”.
Perhaps not surprisingly, the FCA - along with regulators in other jurisdictions - is now fining firms for failing to act in their clients’ best interests. In one case last year for example, foreign exchange company FXCM was fined £4m for allegedly withholding profits that should have been passed onto its clients. And in the US, Citigroup, Merrill Lynch and Morgan Stanley are all examples of investment banks that have been fined by FINRA for best execution contraventions.
It is clear that investment firms can easily fall foul of the regulators if they fail to get a grip on best execution. But perhaps more importantly, they can also suffer serious damage to their reputations and a potential loss of business. Firms need to be able to act in a way that not only satisfies the regulators, but also ensures that their clients are consistently getting the best execution possible.
Is that so hard?
Well, one of the main problems with the best execution obligation under MiFID is the fact that it is so poorly defined. It’s not just about securing the best price on a trade; various other factors also need to be taken into consideration, such as overall costs, speed, likelihood of execution and settlement, order size and a whole range of other characteristics.
Clarity around all of these factors can be difficult to ascertain, particularly in some of the less liquid, quote-driven fixed income markets, or in the more opaque OTC markets where pricing is risk-based. Even in the highly liquid, standardized equity markets, there are no clear rules stating, for example, how many execution venues a firm should route its clients’ orders to in order to ensure best execution is being achieved. (In fact, MiFID does not prohibit routing orders to a single venue if firms can demonstrate that best execution can be achieved that way).
In short, the whole thing is a bit of a minefield. But it doesn’t have to be that way.
Technology can help significantly in this regard. More specifically, complex event processing (CEP) technology, which not only enables firms to analyse large quantities of data from multiple sources in real time, but also gives them the ability to define flexible rules about what action to take based upon that data.
In practice, this works by firms implementing their best execution rules and policies within the CEP engine, which has the ability to analyse multiple sources of data on the fly to determine exactly how a particular order should be handled, taking all factors into consideration, without impacting on latency and the ability to execute.
The same technology and investment can be also be utilised to monitor the quality of execution achieved post trade, ensuring that front office and compliance departments are joined up and using the same data, rules and algorithms. A combination of the more traditional alert based system with profiling can be used to warn of breaches of policy, whilst also assessing the execution quality over time, across clients, desks and traders for example. This can provide powerful insight which can be used in the continual improvement in processes and execution.
So does best execution have to be so hard? No it doesn’t, as long as you have the right technology in place.
Nigel Farmer is Solutions Director, Capital Markets at Software AG