The recent findings in the Financial Conduct Authority (FCA)’s thematic review on “Best Execution and Payment for Order Flow” published in July 2014 has forced firms to change the way that they view and address the concept of best execution and the associated regulatory obligations.
Indeed, best execution is not a “tick the box” exercise but is to be viewed as a critical tool in ensuring protection for investors, sustaining the integrity of the price formation process and promoting competition among trading venues. It is also much broader than just securing a ‘best price’ and firms must consider all best execution factors such as price, costs, speed, likelihood of execution and settlement, and the nature and size of the order.
As part of the review, the FCA targeted 36 firms including investment banks, retail banks, wealth managers, brokers/interdealer brokers and contract for difference (CfD) providers. The two main messages from the FCA were:
- Most firms are not doing enough to deliver best execution through adequate management focus, front-office business practices or supporting controls
- Firms need to improve their understanding of the scope of their best execution obligations, the capability of their monitoring and the degree of management engagement in execution strategy
Confusion amongst firms as to the scope of best execution is a fundamental cause of concern for the regulators, and firms need to get this right in order to minimize the risk that clients will not consistently be given best execution. However, the rules on best execution are not prescriptive and firms need to be able to exercise their own judgement in the best interests of their clients.
We have identified that whilst many firms have considered the best execution requirements for equities, other asset classes such as fixed income, options and futures, have often been omitted from any analysis undertaken. In many cases, firms had not undertaken any assessment to determine how different trading scenarios including, for example, the different categorization of clients, market models or instruments, would impact on their best execution obligation.
Other deficiencies were also identified with regard to firms’ best execution obligations, for example, the lack of monitoring (both from a front office and a compliance perspective), accountability and responsibility, training and general policy, and procedure documentation.
Another key factor of best execution that has often been overlooked by firms is a consideration of whether or not the client is legitimately relying on a firm for best execution. This is determined through the European Commission’s four-fold cumulative test and was referenced in the thematic review. This test focuses on the economic reality of the relationship between the firm and the client and, specifically, whether the client ‘legitimately relies’ on the firm to protect its interests in relation to pricing and other important elements of the transaction. ‘Legitimate reliance’ is driven by relevant factors including the categorization of the client and by other characteristics of the transaction. The four-fold cumulative test specifically assesses:
- Which party initiates the transaction
- Market practice and the existence of a convention to ‘shop around’
- The relative levels of price transparency within a market
- The information provided by the firm and any agreement reached.
Whilst some firms were aware of the four-fold cumulative test, very few were able to evidence that it had been applied. The challenge that firms now face, in particular with regard to their professional clients, is that in the absence of any documented evidence that supports that such a test has been applied to clients to determine “legitimate reliance”, firms are unable to ascertain that their professional clients do not rely on the firm to achieve best execution.
In the past few years we have seen greater demand from investors for more transparency from firms. Likewise, regulators are committed to protecting market integrity and creating more transparency in the financial markets. Best execution falls squarely within these objectives and the onus is on firms and execution venues to effectively provide clients with best execution, to monitor that they are delivering best execution and to publish this information for their clients.
Article 27 of MiFID II states that there will be a requirement on all investment firms to publish data on the top five venues where they have executed client orders, as well as information on the quality of execution obtained. This will increase transparency to clients about firms’ execution arrangements and increase the quality of monitoring and review that firms undertake.
In 2014, global regulators have also been focused on corporate governance and the accountability of senior management, and we have seen several cases of enforcement by the regulators. Senior management accountability is relevant to best execution and was actually one of the FCA’s key findings from their thematic review. Management accountability for best execution should be a key area of focus for firms.
Best execution will continue to be a key theme for future regulations, and firms will have to monitor future regulations such as MiFID II for any best execution updates. Our expectation is that there will be increased attention on best execution in 2015 as the FCA digests and assesses the efforts of the firms involved in their thematic reviews to remediate any best execution deficiencies.
In conclusion, to ensure that firms are meeting the FCA’s expectations, they should:
- Ensure that their best execution policy is reviewed and includes all asset classes and execution factors
- Use the European Commission’s four-fold cumulative test
- Document venue selection and venue quality, process and results
- Ensure at stringent monitoring procedures are in place for monitoring the quality of execution and that these procedures are challenged and kept under review by senior management
- Ensure senior management uses results of the firm’s monitoring and review to demonstrate to clients that they are delivering best execution
- Demonstrate compliance
- Prepare for MiFID II