A key tenet of the EU’s MiFID II directive is best execution. The UK’s Financial Conduct Authority (FCA) has also identified this as a key focus area but the question remains: what exactly does it mean?
ESMA’s final Regulatory Technical Standards (RTSs) provided clarity in many areas, but best execution wasn’t one of them. There is a sense of disappointment that out of the 552 pages in the RTSs, only the last 35 cover best execution, and only at a very high level. The expectation now is that best execution will be further clarified in the delegated acts.
One of the major changes in MiFID II as opposed to MiFID is that market participants are now obliged to take all reasonable steps to secure best execution. The consultation paper states that firms can send orders to a single venue only if it can show that this allows it to satisfy the overarching best execution requirement. This must be supported by relevant data.
What we do know from reading RTS 28 is that firms and investment firms handling client orders will be required to identify their top five execution venues per instrument class, in terms of trading volume, for the preceding year. The challenge here is to classify the instrument correctly. Yet, these measurements do not really say anything about the quality of execution.
In addition, firms will need to provide customers with a clearly written execution policy. The execution policy will describe where and how (on what basis) orders are routed. Clients must be notified of any material changes to the policy. Whilst the execution policy provides insight into the firm’s intention, it does not give any indication of the subsequent execution.
Last but not least, firms will have to publish an assessment of the quality of execution obtained on all venues used by the firm. The assessment should provide a clear picture of the execution strategies and the tools used to measure execution quality. The RTS does not provide great detail or guidance into the definition of quality of execution beyond price, cost, speed, and likelihood of execution.
The thematic review published by the FCA in July 2014 provides a much more colorful and detailed description of the terms best execution and quality of execution, but there is still a need for common measurements and presentation formats to guide buy-side investors to the firms that provide best execution.
One measurement commonly used in the industry is to compare the slippage of each fill towards the best opposite side of EBBO. This measure will ensure that no fill is done on an inferior price, but it does not provide the full picture. What are the missing pieces, you might ask. Let’s illustrate with the order book below and assume you want to buy 3000 @ 188,30.
If you successfully capture all the liquidity, you will get a 0 bps contribution against EBBO. If you fail to capture all the liquidity and post in the book (and eventually get filled), you will get a positive bps contribution. The measure favors passive fills and missed opportunities.
We believe that quality of execution has to be ensured by several measures, and that it is also dependent of the initial intent/instruction that led to order placement. Looking at the quality of execution of smart order routers (as above), we must definitely also look at how efficiently they capture liquidity when the intent was to trade aggressively.
Regardless of what measures are applied, they must be equal and comparable. Also, an annual assessment of execution quality is good, but far from sufficient. Quality must be measured monthly, weekly, daily, and in real time to capture outliers and spot trends. As mentioned in the thematic review, providing a thorough TCA on orders or programs should be expected going forward.
At first glance, best execution might look trivial but when you scrape the surface, the challenges appear. The industry now eagerly anticipates the delegated acts, in hopes that they will provide more clarity.
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