Khepri's A to Z: Best Execution - Buy and Sell-Side Compliance
Introduction
Best execution is the obligation for firms to take all sufficient steps to obtain, when executing orders, the best possible results for its clients considering the execution factors:
Price;
Costs;
Speed;
Likelihood of execution and settlement;
Size; and
Nature or any other consideration relevant to the execution of an order.
Application
In board terms, the best execution obligations apply in the UK to persons who are receiving and transmitting orders for execution, executing orders for clients (either as principal or agent), or transmitting orders in connection with an investment decision. This means that the Best Execution obligations are applicable to the following types of businesses:
Discretionary investments managers;
Fund managers;
Agency brokers;
Brokers dealing as a riskless principle; and
Market makers.
The extent and nature of the application of the obligations will depend on the role of the firm in the chain of execution and the extent to which they (a) can influence outcomes for clients and (b) the nature of the relationship between the firm and the customer.
This broad point can be illustrated if we consider the specific example of a broker that is dealing as principle on a request for quote basis (RFQ). The FCA (Financial Conduct Authority) says in COBS (Conduct of Business) 11.2A.6 that “if a firm provides a quote to a client and that quote would meet the firm’s obligations to take all sufficient steps to obtain the best possible result for its clients under COBS 11.2A.2R if the firm executed that quote at the time it was provided, then the firm will meet those same obligations if it executes its quote after the client accepts it, provided that, taking into account the changing market conditions and the time elapsed between the offer and acceptance of the quote, the quote is not manifestly out of date”.
Where are the rules?
The FCA’s best execution obligations can be found here:
COBS 11.2 - Best execution for AIFMs and residual CIS (Collective Investment Schemes) operators
COBS 11.2A - Best execution – MiFID provisions
COBS 11.2B - Best execution for UCITS management companies
COBS 2.3B – Inducements and Research
COBS 2.3C - Research and execution services
What should be in your best execution policy?
A firm's Best Execution policy should be tailored to the specific nature and complexity of the firm's business. However, at a minimum, a Best Execution policy should include the following elements:
A clear statement of the firm's commitment to achieving Best Execution for its clients;
A description of the factors that the firm considers when assessing the quality of execution, including price, speed, likelihood of execution, costs, size, and nature of the order;
A summary of the different execution venues (e.g., exchanges, brokers, dealers, etc.) that the firm uses to execute client orders;
A description of the procedures and criteria that the firm uses to select execution venues and counterparties, including any conflicts of interest that may arise;
A statement of how the firm considers client characteristics, such as classification as a retail or professional client, when executing orders;
A summary of any specific instructions that the firm has received from clients in relation to the execution of their orders;
A description of how the firm monitors and reviews the quality of execution it achieves for clients and how it ensures that execution arrangements continue to deliver Best Execution;
A summary of how the firm discloses Best Execution information to clients;
A description of how the firm manages any material conflicts of interest that may arise in relation to the execution of client orders;
A statement of how the firm ensures that its staff is trained and competent to implement the Best Execution policy; and
A summary of the firm's record-keeping procedures in relation to Best Execution.
The policy should be regularly reviewed and updated to reflect changes in the firm's business, market conditions, and regulatory requirements.
Conflicts of interest
Investment firms may face potential conflicts of interest that could impact their ability to achieve Best Execution. Some of these conflicts of interest include:
Proprietary trading: Investment firms may engage in proprietary trading, which involves trading for their own account. In some cases, the firm may prioritize its own interests over those of its clients, potentially resulting in inferior execution quality for the client.
Research provision and “soft dollar” arrangements: Investment firms may have arrangements with brokers that provide non-monetary benefits in exchange for order flow. Such arrangements are prohibited in the UK because these arrangements may incentivise the firm to direct orders to brokers that offer the most benefits, rather than those that provide the best execution quality. In the UK, firms must comply with COBS 2.3B and COBS 2.3C which specify how research payment accounts can be used to pay brokers with respect to the research received by the buy-side firm.
Directed order flow: Investment firms may be affiliated with or have ownership interests in broker-dealers. This affiliation may create incentives for the firm to direct order flow to the affiliated broker-dealer, potentially resulting in inferior execution quality for the client.
Market structure: Certain market structures, such as dark pools and internalisation, may create conflicts of interest by allowing investment firms to internalize orders or execute orders away from the public markets. In some cases, these practices may not result in the best execution quality for the client.
To address these potential conflicts of interest, investment firms must have policies and procedures in place to manage them effectively. For example, they may establish controls to ensure that order routing decisions are based on objective factors that prioritise client interests, and they may disclose any conflicts of interest to clients in a clear and transparent manner. Additionally, investment firms may be subject to regulatory oversight to ensure that they are complying with their Best Execution obligations and managing conflicts of interest effectively.
Monitoring best execution
Investment firms should have robust monitoring procedures in place to ensure that they are achieving Best Execution for their clients. The specific metrics used to monitor Best Execution will depend on the nature of the firm's business and the types of orders it executes. However, some common metrics that investment firms may use to monitor Best Execution include:
Price: Investment firms may compare the execution price achieved for client orders to the prevailing market prices at the time of execution.
Speed of execution: Investment firms may monitor the time it takes to execute client orders, including the time from receipt of the order to execution and the time between execution and confirmation.
Likelihood of execution: Investment firms may track the percentage of client orders that are executed successfully, as well as the percentage of orders that are cancelled or rejected.
Costs: Investment firms may track the costs associated with executing client orders, including brokerage fees, exchange fees, and other transaction costs.
Quality of execution: Investment firms may use benchmarks to measure the quality of execution achieved, such as the volume-weighted average price (VWAP) or the implementation shortfall.
Client feedback: Investment firms may solicit feedback from clients on the quality of execution achieved for their orders, as well as any issues or concerns they may have.
Investment firms should also regularly review and assess the effectiveness of their Best Execution policies and procedures. This may involve conducting regular audits of execution quality, analysing order routing decisions, and reviewing feedback from clients. Additionally, investment firms should maintain records of their execution activities, including order routing decisions and the metrics used to monitor Best Execution, to demonstrate compliance with regulatory requirements and to identify areas for improvement.
Should VWAP be used to monitor best execution?
Volume-Weighted Average Price (VWAP) is a commonly used benchmark for measuring the quality of execution achieved by investment firms. VWAP is calculated by taking the average price of a security over a given period, weighted by the volume of trades executed at each price. VWAP is often used as a benchmark to measure the quality of execution achieved for large orders or for orders executed over an extended period.
While VWAP can be a useful metric for monitoring execution quality, it is important to note that it may not be appropriate for all orders or all market conditions. VWAP is most effective when used as a benchmark for executing large orders over an extended period, as it can help to ensure that the execution price achieved is close to the average price over the entire period. However, VWAP may not be appropriate for orders that are executed quickly or in rapidly changing market conditions.
Moreover, VWAP should be used in combination with other metrics that are tailored to the specific nature and complexity of the firm's business and the types of orders it executes. Investment firms should use a range of metrics to assess the quality of execution achieved for their clients, including price, speed, likelihood of execution, costs, and any other relevant factors.
Investment firms should select the metrics that are most appropriate for their business and the types of orders they execute, and they should regularly review and assess the effectiveness of their Best Execution policies and procedures to ensure that they are meeting regulatory requirements and providing the best possible outcome for their clients.
Good practice
The following are examples of good practice for dealing desks:
General approach: In the absence of specific instructions from a client, it is beneficial to document the general approach to execution in your execution policy in addition to the approach being taken on a trade-by-trade basis.
Rationale for thresholds: Make sure it is clear why certain thresholds have been set to monitor best execution.
System output: Document the queries that are used to export system information to allow best execution reviews to take place.
Time stamps: Ensure that you have documented each stage of the order from decision to deal through to confirmation of execution and settlement.
Poor practice
The following are examples of poor practice for dealing desks:
Phone orders: If additional instructions are given to the traders over the phone and these are not documented
User rights: Not documenting who has access to input a decision to deal and execute a trade – ensure that this is approved.
Contemporaneous review: Not documenting contemporaneously the review or rationale for placing with broker if outside of pre-agreed general strategy
Compliance review: Not documenting the evidence to support agreement with a trading decision.
Additional reading
Investment firms may find it instructive to review the following final notices which explain the FCA’s thinking on how they are supervising the best execution rules:
