Returns are the driving force behind the day-to-day activity of buy-side firms, and complying with best execution requirements is as an integral part of optimizing performance. What are the basic best ex requirements, and how can best execution improve your business beyond avoiding hefty fines?
Returns and performance. The heart of every asset managers’ business. The driving force behind the day-to-day activity of buy-side firms. Yet, how many of these firms view complying with best execution as an integral part of optimizing their yield and performance numbers? If I had to hazard a guess, I would say few. In fact, many would be asking themselves what Best Execution has to do with improved performance? Or perhaps simply that it’s another irksome regulation that consumes resources rather than enhances performance.
But it’s not. Best execution can help improve operational efficiency and directly impacts performance. Before we examine how to use best execution to improve your business, let’s look at some of the basic requirements.
What do the regulators have to say about best execution?
ESMA: Introduced in 2007, MiFID I, Article 21, requires investment firms (IFs) to take all reasonable steps to obtain, when executing orders, the best possible results for their clients. With the introduction of MiFID II, the bar has moved up from “reasonable steps” to “all sufficient steps.”
The FCA then added TR 13/14: “Delivering best execution is fundamental to market integrity and to the delivery of good outcomes for clients who rely on agents to act in their best interests.”
What are the consequences of not performing best execution?
As with all regulation, non-compliance brings with it the risk of being penalized. In 2017, the FCA examined whether the issues from their previous Thematic Review had been addressed and declared that: “Our next steps … if we find that firms are still not fulfilling their best execution obligations, we will consider appropriate action, including more detailed investigations into specific firms, individuals or practices.”
There have since been several cases of asset managers being fined for not complying with best execution, including an FCA fine on Threadneedle Asset Management for trading fixed income out of the market price.
Which assets fall under best execution?
Best execution applies across asset classes and is not limited to the MiFID II instruments that require transaction reporting. A good example is FX derivatives trades that do not fall under the scope of MiFID II transaction reporting but require best execution monitoring.
OTC products also fall under best execution obligations, and the regulator requires firms “to check the fairness of the price proposed to the client when executing orders or taking decisions to deal in OTC products, including bespoke products, by gathering market data used in the estimation of the price of such products and, where possible, by comparing with similar or comparable products.”
The bottom line: Using Best Execution to improve performance, execution and operational efficiency
Best execution is not only a regulatory issue but also – and more important – a fund performance issue that can directly impact your financial results. We have seen financial services firms reap the benefits beyond merely complying with the regulation and avoiding hefty fines. Below are three examples of how firms use best execution to improve business performance:
- Enhanced performance: The regulator requires firms to use external market data sources to benchmark their performance, as can be seen here. However, some managers are erroneously using price feeds provided by their brokers for benchmarking. Asset managers that don’t benchmark their brokers against market prices, as well as against each other, are likely to underperform. They also lack the pricing insight that would allow them to put pressure on their brokers to improve their execution policies – and decide to switch brokers if need be.
- Improved operational efficiency: Rather than manually checking prices, doing so systematically is best practice. A solution that offers asset managers a means to benchmark their execution vs. market prices will spare them the need to buy an external data feed or pay for a market data terminal.
- Better execution strategies: Evaluating your execution strategy not only improves internal metrics but also achieves the best possible outcome for clients. This could mean having to make incremental changes to your execution strategy, such as using different execution venues, liquidity pools and execution times throughout the day in order to achieve the desired outcome.
Who would have thought that regulatory compliance could result in improved returns?