reuters/kacper pempel special report: best … out of firms’ best execution remediation. a...

Special Report: Best Execution for Asset Managers Under and Beyond MiFID II – A User’s GuideBy Shoshana Wainer

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2 SPECIAL REPORT: BEST EXECUTION FOR ASSET MANAGERS UNDER AND BEYOND MIFID II – A USER’S GUIDE

Contents

Introduction 3

Best Execution Goes Beyond MiFID II 4

What is Best Execution? 5

What about Fees and Expenses? 5

Implicit Versus Explicit Costs 6

Best Execution Criteria for OTC Products 6

Establishing and Monitoring Best Execution Arrangements 7

Order Execution Policy, Disclosure, and Consent 8

Annual Publication of Top Five Venues for Each Class of Instrument 9

Conclusion and Next Steps for Compliance Officers 10

SPECIAL REPORT: BEST EXECUTION FOR ASSET MANAGERS UNDER AND BEYOND MIFID II – A USER’S GUIDE 3

REUTERS/Toby Melville

Special report by Shoshana Lopatin Wainer. Shoshana serves as General Counsel at BestX. She is a qualified lawyer in both the US and England with sixteen years of experience in financial services regulation and compliance, practicing at Covington & Burling in New York and Herbert Smith Freehills in London. Prior to joining BestX, Shoshana worked at Morgan Stanley in EMEA FX Compliance.

IntroductionEspecially in light of the LIBOR and FX scandals, as well as a stream of recent high-profile best execution litigation and enforcement actions on both sides of the Atlantic, asset managers are highly focused on how the new best execution requirements under Markets in Financial Instruments Directive (MiFID) II, which comes into effect on 3 January 2018, will require substantial procedural and technical changes across a wide range of asset classes, including fixed income, FX and alternative investment product lines.

Notwithstanding Brexit, compliance departments have retained their budget and timeline for implementing MiFID II changes, especially as the Financial Conduct Authority (FCA) released a consultation paper on MiFID II on 29 July 2016 wherein it reminded firms that the “MiFID II is in the category of legislation that is still to come into effect. It is due to apply from 3 January 2018, so both firms and we need to continue with implementation plans.”1 Since the EU treaties provide for a two year period within which the

UK has to renegotiate its relationship with the EU, both MiFID II and Market Abuse Regulation will have been implemented by that time. Moreover, to continue doing business in the EU after a Brexit, the UK financial services regime will need “equivalency” which can only be achieved by implementing MiFID II-like regulation in the UK. Compliance officers at asset management firms therefore remain steadily focused on best execution implementation.

This report breaks down the texts of the relevant regulations, with a particular focus on the practical implications for the fixed income and FX markets. It also provides insight into how the MiFID II best execution requirements are of relevance even to those products and companies outside the technical scope of the legislation, and in many ways set the new standard for how best execution should be monitored and assessed. Lastly, the importance of new technologies and rigorous data analysis in this new era of best execution compliance is emphasized.


Best Execution Goes Beyond MiFID II

It should be noted first of all that best execution is an obligation across jurisdictions, regulations, and products. For example, an asset manager with management arms in the US and UK and/or the EU faces similar best execution principles under both the Investment Advisers Act and MiFID II, although the fine points are different and require careful legal and technical attention.

Products that sit outside the scope of MiFID II should also not be left out of firms’ best execution remediation. A regulator such as the FCA has the power to fine firms in violation of its Principles for Businesses for failing to deliver best execution where clients are relying on them to do so. And in fact in the FX scandal, which involved non-regulated spot FX, the FCA found banks had breached Principle 3 (risk management systems and controls) by failing to take reasonable care to organise and control their affairs responsibly and effectively, including failing to “strive for best execution for the customer” when managing client orders.2 As a result the FCA levied over $2 billion in fines on 6 banks – a fifth of the $10 billion in fines levied worldwide – underscoring that regulators have massive powers even beyond MiFID II to require best execution.

The FCA used Principle 3 again in December 2015 to bring a £6 million fine against an asset management company that failed to verify the integrity of fixed income best execution quotes, thereby allowing a fund manager to execute eight trades which were at variance with market price.3 The FCA has also noted that best execution falls squarely under Principle 6 (treating customers fairly), and used that Principle as a basis to levy a £4 million best execution fine involving rolling spot, which is a MiFID product.4

It is also worth noting that the exemptions for spot FX and spot PM are very narrow. MiFID II Article 24(4) requires firms to disclose to clients or potential clients “in good time” all costs and charges related to the provision of an investment service, including charges related to ancillary services (e.g. spot FX or spot PM transactions which are connected to the investment service). This disclosure must be made to clients at least annually during the life of the investment. Firms must also be able to provide an itemised breakdown should a client request it. Clients will effectively be able to request itemised charges relating not just to “financial instruments” but also any “connected” spot FX trades so clients will be able to distinguish between the “flat” execution price and the mark up.

FX is also the continued topic of litigation in the US. Class action litigation stemming from the FX scandal brought against over a dozen banks has led to settlements in amounts of over $2 billion for the plaintiff class5 and continues to work its way through the US Federal court system.6

Moreover, in the US, recent FX cases involving custodian banks have resulted in over $1.2 billion in fines and penalties. One bank paid $700 million in settlement costs, as well as $30 million in SEC penalties, and multi-year supervised remediation after admitting that contrary to representations to clients that it provided “best rates” and “best execution,” the bank actually gave clients the worst reported interbank rates of the trading day.7 In July 2016 the SEC levied further fines against a second custodian bank, which agreed to pay $382.4 million in a global settlement for misleading mutual funds and other custody clients by applying hidden markups to foreign currency exchange trades.8 In addition, the same institution agreed to pay $147.6 million to settle private class action lawsuits filed by bank customers alleging similar misconduct, for a total of $530 million.9

Finally, firms that are not subject to MiFID II but a different EU regime such as the Alternative Investment Fund Managers Directive or Undertakings for Collective Investment in Transferable Securities should continue to pay close attention to the MiFID II developments. The FCA has explicitly noted its intent to implement MiFID II in such a manner as will create a consistent regulatory regime across products and types of regulated firms in order to maintain a “consistent level of protection for clients and mitigate against regulatory arbitrage and any resultant distortions in competition between substitutable products.”10 Moreover, since the coming into force of the UK’s new Senior Managers Regime on 7 March 2016, senior managers can be held accountable for any misconduct that falls within their areas of responsibilities. Likewise, the new Certification Regime and Conduct Rules aim to hold individuals working at all levels in banking to appropriate standards of conduct. Finally, the new Bank for International Settlements Global Code of Conduct for the Foreign Exchange Market, which was published on 26 May 2016, with the target date for finalisation of the Code in May 2017, will set new standards and principles for behaviour in the FX market.

It is therefore fair to say that the new MiFID II best execution obligations set a standard of wide relevance and should hopefully be seen as an opportunity to achieve and deliver efficiency and transparency both to client and firm.


What is Best Execution?

What about Fees and Expenses?

MiFID II Article 27(1) defines best execution as the obligation on firms to “take all sufficient steps to obtain . . . the best possible result for their clients taking into account price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to execution” (emphasis added).11

The best possible result is a multi-factored determination. Firms must look at all implicit costs, as well as all external costs, taking into account “total consideration.” This includes all expenses related to the execution of the order such as execution venue fees, clearing and settlement fees, and any other fees paid to third parties involved in the execution of the order.13

The term “all sufficient steps” is a higher legal standard than MiFID I Article (21) under which firms were obliged to take “all reasonable steps” to achieve the best possible results for their clients (emphasis added).12 Just as reasonable suspicion is a relatively low standard of proof in criminal law, the language of “reasonable steps” historically set the bar relatively low for best execution compliance. Firms should therefore be cognisant that they now face a higher burden in achieving and evidencing best execution.

Best execution is focused on best possible overall results on a consistent basis, and not best price for an individual trade. Explicit costs such as fees and commissions and implicit costs such as those tied to signalling risk must also be a part of the best execution analysis, as well as factors such as speed, likelihood of execution, etc. Firms will be expected to demonstrate how they have incorporated each of these factors into their best execution procedures, and to support their conclusions with unbiased quantitative analysis.

The firm should also take into account the effect of its own fees and commissions on the total consideration to the client. Investment firms are free to set their fees or commissions at the level they choose, provided that no venue is unfairly discriminated against. As Article 64(3) of the second of the Delegated Acts14 released by the European Commission on 25 April 2016, underscores, “[i]nvestment firms shall not structure or charge their commissions in such a way as to discriminate unfairly between execution venues.” An asset manager may not charge a different commission (or spread) for execution on different venues unless the difference reflects a difference in the cost to the firm.

The European Securities and Markets Authority’s predecessor, the Committee of European Securities Regulators, explained: “In practice a firm is unlikely to be acting reasonably if it gives a low relative importance to the net cost of a purchase or the net proceeds of a sale…For example, if a firm has included a regulated market and a systematic internaliser in its execution policy (or is itself a systematic internaliser), …the firm will need to take into account not only the prices displayed by those two venues, but also any difference in fees or commission it charges the client for executing on one venue rather than the other (as well as any other costs or other relevant factors).”15


Implicit Versus Explicit Costs

Best Execution Criteria for OTC Products

Best execution does not stop at best price. Speed, likelihood of execution, market impact and other implicit transaction costs should be analysed as part of the total consideration analysis. Many firms have in turn begun to assess whether their current best execution surveillance software is fit for purpose and can incorporate implicit costs into the best execution analysis.

Article 64(4) of the Delegated Acts is explicit that when executing orders or taking the decision to deal in OTC products, including bespoke products, investment firms must check “fairness” of the price proposed to the client “by gathering market data used in the estimation of the price of such product and, where possible, by comparing with similar or comparable products” (emphasis added).

As Pete Eggleston discussed in his recent article, Best Execution – What Actually Is It?16, best execution needs to be viewed as a process, analysing average performance over longer time horizons as well as individual transactions. As that article explains:

Getting a ‘great’ price on one trade may not be ideal if by doing so you push the market significantly higher, making future purchases much more expensive. Spraying orders across the market, potentially creating significant ‘signalling risk’ (i.e. providing indications to market participants of your trading behaviour and intentions) can be very damaging to your overall execution performance on a given day.

Especially when relying on algorithmic trading it is all too easy to become focused on price/commission (e.g. $/million charge). But price is only one input into achieving best execution. A best execution policy needs to be supported by historical data, it must be repeatable going forward and it must be justified by constant testing and exception analysis. Fortunately, new technologies are available that can undertake these sophisticated tasks by quantifying implicit costs and associated risks.

The FCA, in its recent Thematic Review of best execution, has emphasized this point, noting that:

“ Firms should measure implicit costs as part of their arrangements to monitor execution performance and review the execution quality of entities or execution venues … A trade may appear more expensive in terms of explicit costs but may be less expensive when implicit costs are considered. For example, a firm that works a large order over time, preserving the client’s confidentiality and minimising market impact, may achieve the lowest total costs (and the best net price). Unlike explicit costs, the impact of implicit costs can only be precisely assessed after a trade is completed and even then, implicit costs are difficult to quantify. As a result, ahead of a trade, a judgement needs to be made by firms about the likely implicit costs of an execution strategy and firms are required to take all reasonable steps to manage them (emphasis added).”17

Asset managers that pride themselves on their sophistication and outperformance need best execution systems to match. A robust best execution process will look at both explicit and implicit costs at both the pre- and post- trade stage. For example, in the fixed income and FX sphere, new technologies offer pre-trade tools combining sophisticated and auditable pre-trade analytics in a live pricing environment, as well as post-trade best execution management and exception reporting.

This emphasis on ‘fairness’ and ‘market data’ is a departure from MiFID I, and underscores the need to formalize and place rigor around best execution processes for OTC products. In the December 2015 FCA best execution case cited above, the FCA took issue with reliance on “copied and pasted Bloomberg chat extracts [that] can easily be modified” and emphasized that regular best execution monitoring must be extended to OTC derivatives.18

Therefore, for fixed income and FX OTC products, it is prudent that firms have access to pre-and post-trade TCA analysis tools that allow them to analyse the fair price for the underlying product or currency.


Establishing and Monitoring Best Execution Arrangements

Not only do firms have to deliver best execution, they also, under MiFID II Article 27(4) and (7) have to “establish and implement effective arrangements” for complying with and monitoring best execution. This requirement is arguably the most difficult best execution deliverable and has presented the most difficulty for firms in the past.

In the FCA Thematic Review on best execution, discussed above, the FCA found that:

Most firms lacked effective monitoring capability to identify best execution failures or poor client outcomes. Monitoring often did not cover all relevant asset classes, reflect all of the execution factors which firms are required to assess or include adequate samples of transactions. In addition, it was often unclear how monitoring was captured in management information and used to inform action to correct any deficiencies observed by firms.19

The FCA concluded that “not enough is being done by firms to ensure best execution is being consistently delivered to clients” (emphasis added),20 and made clear that it will be paying close attention to monitoring capability in further best execution reviews. The FCA also emphasized that it expects “senior management with responsibility for trading activities to take greater responsibility for ensuring that policies and arrangements remain fit for purpose.“21

Firms, and especially their senior management, should therefore think carefully about relying on old, outdated methodologies, in particular in fixed income and FX asset classes. MiFID II Recital 92 explains that “[a]dvances in technology for monitoring best execution should be considered when applying the best execution framework” (emphasis added).

New monitoring arrangements must look not just at price but also the speed and likelihood of execution (such as fill rate), the availability and incidence of price improvement, and implicit as well as explicit costs. As Recital 107 of the Delegated Acts notes:

Availability, comparability and consolidation of data related to execution quality provided by the various execution venues is crucial in enabling investment firms and investors to identify those execution venues that deliver the highest quality of execution for their clients. In order to obtain best execution result for a client, investment firms should compare and analyse relevant data including that made public in accordance with Article 27(3) of Directive 2014/65/EU and respective implementing measures (emphasis added).

In the fixed income and FX sphere, new technologies and new sources of data have made pre- and post-trade transaction cost analysis and exception reporting more readily available and regulators will reasonably expect firms to rely on such software, especially software that can be verified as truly independent. Regulators will also reasonably expect to see evidence that senior management has engaged in regular review of best execution-related management information.

Order Execution Policy, Disclosure, and Consent

MiFID II Article 27(4) and Article 66 of the Delegated Acts reiterate the obligation of MiFID I Article 21(2) for asset managers to establish and implement an order execution policy. But revamping old policies will not do, especially as relates to FX where so many order execution policies are so far off the mark. For instance, some leading asset managers do not mention FX spot and derivatives at all in their order execution policies, and others simply state that they will execute with a related institution, without any explanation as to how that achieves best execution. Responding to concerns about the generic and standardised nature of many firms’ order execution policies, MiFID II requires order execution policies to be clear, easily comprehensible and sufficiently detailed so that clients can easily understand how firms will execute their orders.

Under MiFID II Article 27(5), the written order execution policy must include, in respect of each class of financial instruments and type of service provided:

1. information on the different venues where the investment firm executes its client orders and the factors affecting the choice of execution venue, and

2. a list of those venues that enable the investment firm to obtain on a consistent basis the best possible result for the execution of client orders.

Article 66(3)-(9) of the Delegated Acts provide more details around this obligation, explaining that investment firms shall provide clients in a durable medium, or by means of a website, with certain details on their execution policy in good time prior to the provision of the service.

These include:

1. a summary of the selection process for execution venues, execution strategies employed, the procedures and process used to analyse the quality of execution obtained and how the firms monitor and verify that the best possible results were obtained for clients (emphasis added).

2. information on any inducements received from the execution venues.

Firms that perform portfolio management and reception and transmission of orders also need a similar policy under MiFID II Article 24(4) and the Delegated Acts Article 65. Again, the written policy must identify, in respect of each class of instruments, the entities with which the orders are placed or to which the investment firm transmits orders for execution.

Comply and compete in a cross-asset, real-time world.

Putting your plans in place.Your strategic partner in MiFID II.

Find out more at www.mifidii.com

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Annual Publication of Top Five Venues for Each Class of Instrument

Historically clients have had little information about where their trades were actually likely to be executed. A key concern when drafting MiFID II was therefore transparency, and specifically that investors be able to form an opinion as to the flow of client orders from the firm to execution venue. As noted above, is flow going to a sister organisation? Is flow going to an execution venue that has a recent enforcement action related to the relevant financial instrument?

Taking a novel approach, MiFID II Article 27(6) and Regulatory Technical Standard (RTS) 28 contains a new requirement, not present in MiFID I, that firms who execute client orders must publish annually for each class of financial instruments the top five execution venues in terms of trading volumes where they executed client orders in the preceding year and information on the quality of execution obtained.

In order to provide very precise and comparable information, RTS 28, Article 2 sets out further detail regarding this publication obligation, explaining that firms must include, inter alia, the following information in specified format for each class of financial instrument:

• volume of client orders executed on that execution venue expressed as a percentage of total executed volume;

• number of client orders executed on that execution venue expressed as a percentage of total executed orders.22

RTS Article 2(3) further requires investment firms to publish for each class of financial instruments, a summary of the analysis and conclusions it draws from its detailed monitoring of the quality of execution obtained on the execution venues where it executed all client orders in the previous year. This information must include, inter alia:

1. an explanation of the relative importance the firm gave to the execution factors of price, costs, speed, likelihood of execution or any other consideration including qualitative factors when making assessments of the quality of execution;

2. a description of any close links, conflicts of interests, and common ownerships with respect to any execution venues used to execute orders;

3. a description of any specific arrangements with any execution venues regarding payments made or received, discounts, rebates or non-monetary benefits received;

4. an explanation of the factors that led to a change in the list of execution venues listed in the firm’s execution policy, if such a change occurred;

5. an explanation of how the investment firm has used any data or tools relating to the quality of execution including any data published under 27(10)(a) of Directive 2014/65/EU;

6. an explanation of how the investment firm has used, if applicable, output of a consolidated tape provider established under Article 65 of Directive 2014/65/EU which will allow for the development of enhanced measures of execution quality or any other algorithms used to optimise and assess execution performances.

As these RTS make clear, the new MiFID II regime expects firms to use new technology and data, including algorithmic analysis, to optimize and assess execution performance.

RTS 28 Article 3 establishes that this information must be made available on firm websites in machine-readable electronic format, in accordance with a set template, and available for downloading by the public.


Conclusion

NEXT STEPS FOR COMPLIANCE OFFICERS:Compliance officers must ask the following questions of their asset management firms:

The new best execution requirements under MiFID II, which apply from one day to the next to an extremely wide range of asset classes, require that asset managers carefully evaluate existing best execution processes and be prepared for new transparency and data publication obligations.

With the recent uptick in best execution enforcement, new high-level fines under Articles 69 and 70 of MiFID II (at least €5,000,000 or up to 10% of total annual turnover), as well as the potential for increased personal liability under the new Senior Managers Regime, it is easy to understand why technological solutions are being seen as an imperative. Moreover, the language of the regulations itself anticipates that businesses will step up their sophistication and rely on new technologies that in turn will incorporate the newly available data. Fortunately, especially in the field of fixed income and FX, new software is available that can ease this administrative burden and facilitate profitability by offering independent pre- and

post-trade TCA tools and benchmark analysis, combined with sophisticated audit trail functionality, exception reporting, and management tools.

Although MiFID II provides a daunting best execution challenge, it also provides a great opportunity. Both MiFID financial institutions and non-MiFID businesses should see these regulations as setting a new standard in best execution compliance and transparency, and one that should be welcomed as a chance to differentiate companies that provide excellence in execution and client service.

Does our best execution analysis cover all relevant factors including explicit costs such as commissions, execution venue fees, clearing and settlement fees, and any other fees paid to third parties?

Does our best execution analysis cover implicit costs such as those tied to signalling risk?

Have we implemented best execution software for all relevant asset classes that can provide independent pre- and post-trade TCA tools and benchmark analysis, combined with audit trail functionality, exception reporting, and management tools?

Does our best execution implementation plan cover all relevant asset classes, including FX??

??

?


References1. Markets in Financial Instruments Directive II Implementation (at 1.2): www.fca.org.uk/static/documents/

consultation-papers/cp16-19.pdf

2. FCA fines five banks £1.1 billion for FX failings and announces industry-wide remediation programme (Nov. 2014): www.fca.org.uk/news/fca-fines-five-banks-for-fx-failings and www.fca.org.uk/news/fca-fines-barclays-for-forex-failings

3. FCA fines Threadneedle Asset Management Limited £6m: www.fca.org.uk/news/fca-fines-threadneedle-asset-management-limited-£6m

4. The Financial Conduct Authority fines FXCM UK £4 million for making ‘unfair profits’ and not being open with the FCA: www.fca.org.uk/news/fca-fines-fxcm-uk-4-million-for-making-unfair-profits-and-not-being-open-with-the-fca

5. Hausfeld Announces Preliminary Approval of More Than $2 Billion in Settlements in FX Litigation: www.hausfeld.com/news/us/hausfeld-announces-preliminary-approval-of-more-than-2-billion-in-settlemen

6. cases.justia.com/federal/district-courts/new-york/nysdce/1:2013cv07789/419538/242/0.pdf?ts=1422559353 and http://law.justia.com/cases/federal/district-courts/new-york/nysdce/1:2013cv07789/419538/582/

7. Administrative proceeding: SEC Finalizes Settlement with The Bank of New York Mellon: www.sec.gov/litigation/admin/2016/ic-32151-s.pdf and www.justice.gov/usao-sdny/pr/manhattan-us-attorney-and-new-york-state-attorney-general-announce-714-million-proposed

8. SEC – State Street Misled Custody Clients About Prices for Foreign Currency Exchange Trades: www.sec.gov/news/pressrelease/2016-152.html

9. State Street Bank to Pay $382 Million to Settle Allegations of Fraudulent Foreign Currency Exchange Practices: www.justice.gov/opa/pr/state-street-bank-pay-382-million-settle-allegations-fraudulent-foreign-currency-exchange

10. FCA: Developing our approach to implementing MiFID II conduct of business and organisational requirements, DP 15/3 (March 2015) – www.fca.org.uk/news/dp15-03-mifid-ii-approach

11. http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32014L0065

12. http://eur-lex.europa.eu/legal-content/EN/TXT/?qid=1398325978410&uri=CELEX:02004L0039-20110104

13. MiFID II Article 27(1)

14. ec.europa.eu/finance/securities/docs/isd/mifid/160425-delegated-regulation_en.pdf

15. CESR, Best Execution under MiFID Q11.3 and 12.4 (May 2007): www.esma.europa.eu/sites/default/files/library/2015/11/07_320.pdf

16. Best Execution – What Actually Is It?: www.bestx.co.uk/publications-root/2016/3/15/whatisbestexecution

17. FCA, Thematic Review: Best execution and payment for order flow TR 14/13 (July 2014), p.11: www.fca.org.uk/static/documents/thematic-reviews/tr14-13.pdf

18. See note 9, supra

19. FCA Thematic Review at p.5, cited at note 17, supra

20. Id. at p.8

21. Id at p.36

22. ESMA, Final Report –regulatory technical and implementing standards

Annex I – ESMA 2015/1464 (28 Sept 2015), RTS 28: Draft regulatory technical standards under 27(10)(b) of MiFID II, Recital 4 and Article (2)(2): www.esma.europa.eu/sites/default/files/library/2015/11/2015-esma-1464_annex_i_-_draft_rts_and_its_on_mifid_ii_and_mifir.pdf

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