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Measuring your approach - MiFID II Best Execution

  • United Kingdom
  • Financial services and markets regulation - MiFID
  • Financial institutions

07-02-2017

Welcome to Paper 4 in the Eversheds MiFID II Implementation series.

To read the whole paper in a downloadable pdf click here

Introduction

MiFID II changes the obligations for Investment Firms when executing orders, receiving and transmitting orders or when conducting portfolio management services.

In their third Consultation Paper1, the FCA proposed amendments to the existing rules in COBS 11.2 by transposing the new MiFID II standards into the Dealing and Managing chapter as COBS 11.2A. These transpose the relevant MiFID II text and set out the relevant text from the Delegated Regulation.

Firms will need to read the rules in COBS 11.2 together with:

  • The ESMA Q&A on MiFID II and MiFIR investor protection topics - the latest version was published 16 December 20162; and
  • Regulatory Technical Standards (RTS) 27 and 28.

This note summarises the existing rules and the key amendments contained in MiFID II, the Delegated Regulation and RTS 27 and 28.

It is also important to note that firms should consider the following publications when amending their systems and controls to implement MiFID II’s best execution obligations (and front office controls more generally);

  • TR 14/13: Best execution and payment for order flow, July 2014;3
  • CESR’s guidance on Best Execution under MiFID;4
  • The Final Notice for Threadneedle;5 and
  • The Final Notice for Aviva Investors.6

Scope

The FCA is proposing to apply the MiFID II best execution obligations differently depending on the type of firm. Their proposed approach is summarised in the table below:

Firm type Additional obligation
Collective Portfolio Management Investment Firm (including AIFMs and UCITS ManCos) Where these firms perform the activities permitted by FUND 1.4.3 they will be an Investment Firm in relation to those activities and therefore the full suite of MiFID II rules will apply. We set out below the specific requirements if performing collective portfolio management as AIFM or UCITS ManCo.

Collective Portfolio Manager (AIFM)

No change to the existing obligations except for the FCA proposal to extend the RTS 28 disclosure obligations. The FCA will consider whether to apply the full suite of MiFID II rules to these firms in the future.
Collective Portfolio Manager (UCITS ManCo) The FCA is proposing to apply all the MiFID II best execution requirements to UCITS ManCos.
MiFID II Exempt Firms The FCA is proposing to apply the MIFID II best execution obligations to financial advisors that are exempt under Article 3 of MiFID. However, this excludes the RTS 28 reporting obligations.
Small authorised UK AIFMs and operators of residual Collective Investment Schemes (unauthorised schemes where no investors are a retail client)
None









A reminder of the current rules

The basic obligation

A firm must take all reasonable steps, when executing orders, to obtain the best possible result for its clients taking into account the following execution factors:

  • price;
  • costs;
  • speed;
  • likelihood of execution and settlement;
  • size;
  • nature; or
  • any other consideration relevant to the execution of an order.

When executing a client order, a firm must take into account the following criteria for determining the relative importance of the execution factors (see above):

  • the characteristics of the client including the categorisation of the client as retail or professional;
  • the characteristics of the client order;
  • the characteristics of financial instruments that are the subject of that order;
  • the characteristics of the execution venues to which that order can be directed; and
  • for a management company, the objectives, investment policy and risks specific to the UCITS scheme or EEA UCITS scheme, as indicated in its prospectus or instrument constituting the fund.

Policy

A firm must establish and implement effective arrangements for complying with the obligation to take all reasonable steps to obtain the best possible result for its clients. In particular, the firm must establish and implement an order execution policy to allow it to obtain, for its client orders, the best possible result in accordance with that obligation.

The firm must be able to demonstrate that it has executed orders in accordance with its execution policy.

Disclosure obligations

A firm must provide appropriate information to its clients on its order execution policy. When providing services to a retail client there are specific obligations in relation to what should be contained within the execution policy, these include:

  • an account of the relative importance the firm assigns, in accordance with the execution criteria, to the execution factors, or the process by which the firm determines the relative importance of those factors;
  • a list of the execution venues on which the firm places significant reliance in meeting its obligation to take all reasonable steps to obtain on a consistent basis the best possible result for the execution of client orders; and
  • a clear and prominent warning that any specific instructions from a client may prevent the firm from taking the steps that it has designed and implemented in its execution policy to obtain the best possible result for the execution of those orders in respect of the elements covered by those instructions.

Monitoring obligations

A firm must monitor the effectiveness of its order execution arrangements and execution policy in order to identify and, where appropriate, correct any deficiencies. In particular, it must assess, on a regular basis, whether the execution venues included in the order execution policy provide for the best possible result for the client or whether it needs to make changes to its execution arrangements.

Best execution in specific cases

COBS 11.2 makes reference to how to apply best execution rules when:

  • dealing on own account;
  • providing a firm quote to clients;
  • executing for retail clients; and
  • using only one execution venue.

A summary of the key changes

The overarching best execution standard

Currently firms must comply with the overarching standard of taking “reasonable steps…to obtain the best possible results for its clients”. The new obligation under MiFID II is for firms to take “all sufficient steps”, which both ESMA and the FCA have indicate is a higher bar to comply with. However, what does this mean in practice?

ESMA’s Q&A 7 on this topic explains that this enhanced standard will require firms to:

  • ensure policies are designed with the intended outcomes in mind;
  • strengthen front-office accountability;
  • strengthen systems and controls according to which firms will ensure that their detection capabilities are able to identify any potential deficiencies; and
  • monitor not only the execution quality obtained but also the quality and appropriateness of their execution arrangements and policies on an ex-ante and ex-post basis to identify circumstances under which changes may be appropriate.

It is important to note that ESMA have said that this overarching requirement should not be interpreted to mean that a firm must obtain the best possible results for its clients on every single occasion. Rather, firms will need to verify on an on-going basis that their execution arrangements work well throughout the different stages of the order execution process.

When firms are considering strengthening their controls around detection of deficiencies and the duty to monitor the quality and appropriateness of their execution arrangements they should note the FCA’s views on Volume Weighted Average Price (VWAP) contained in TR14/13, an extract is shown below.

“VWAP is not always an appropriate benchmark to use, depending on the characteristics of the order. Where a firm is ‘working’ a large order over the course of a day VWAP can be an appropriate benchmark and, indeed, some clients specifically request that it be used to measure execution performance. However, it has several inherent limitations and there are other measures available. For example, a firm which is trading heavily in an illiquid instrument can impact the VWAP, resulting in it not be being a valid performance measure because the firm would effectively be setting its own benchmark. Likewise, because VWAP is determined on the basis of trading activity throughout the day, it is possible for a firm to estimate the final VWAP. As a result it can choose to delay a trading decision which is made late in the day, that would be executed outside of the VWAP, until the following day when it has a higher probability of achieving VWAP. In this case the execution price might remain the same but its performance against the benchmark would be improved, with no benefit to the client. Similarly, because it is a measure of performance over a day, it is difficult to achieve either very good or very poor performance against VWAP. As a result, whether clients achieve the VWAP may not be able to determine whether they were given best execution.

Where firms elect to use benchmarks for monitoring, these need to support their ability to give best execution on a consistent basis. Having chosen a benchmark, firms also need to set appropriate tolerances. If wide tolerances are set then even an appropriate benchmark will not be useful in determining whether best execution is being obtained. Nevertheless, we frequently found a lack of understanding and supporting documentation, derived from a current risk assessment, demonstrating why particular benchmarks and sensitivities were thought to be adequate, or whether alternative approaches would yield better results for clients by detecting potential improvements.”

Check the fairness of the price for OTC or bespoke products

Article 64 of the MiFID II Delegated Regulation 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”.

ESMA has said that OTC products in this context means products not admitted to trading, or not traded on, a trading venue (i.e. a regulated market, an MTF or OTF).

ESMA expects that firms will need to make use of data analytics so that they can scrutinise the methodologies and inputs underpinning any valuation process and pricing models with respect to OTC products. In practice this could mean:

  • assessing market reference data (interest rates, FX rates, yield curves, etc) to obtain a theoretical value of a derivative instrument rather than just comparing spreads between counterparties
  • considering market information on credit risk, discount rates and yield curves prior to trading debt securities rather than just obtaining multiple broker quotes; and / or
  • using any new published price feeds (as a result of the MiFID II trade reporting obligations) as appropriate.
  • a list of the execution venues for each class of financial instrument broken down for professional/retail clients, on which the firm places significant reliance;
  • a list of qualitative and quantitative factors used to select an execution venue;
  • how the execution factors of price costs, speed, likelihood of execution and any other relevant factors are considered as part of all sufficient steps to obtain the best possible result for the client;
  • where applicable, information that the firm executes orders outside a trading venue, the consequences;
  • a clear and prominent warning that any specific instructions from a client may prevent the firm from implementing its best execution policy; and
  • 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 firm monitors and verifies that best possible results are obtained for clients.

Disclosure – best execution policy

Under MiFID I, there are no prescriptive rules for what needs to be included within the execution policy provided to professional clients. However, there are currently prescriptive rules (see above) for retail clients. The Delegated Regulation, as transposed by the FCA8 has prescriptive rules for both retail and professional clients and includes providing the following information in their execution policy:

an account of the relative importance of the execution factors, with reference to the relevant criteria (see above) and the process by which the firm determines the relative importance of those factors;

In addition, the policy should be customised depending on the class of financial instrument and the type of service provided. This means that the firm will need to have a mapping process within the policy to the various different mandates that they provide for which the relevant factors will be different. A simplistic example would be that the execution factors relevant for a European equity mandate would be different to a mandate focusing on emerging market or high yield debt.

Disclosure – best execution quality

The public reporting obligation in relation to best execution differs depending on whether the firm is a:

A. trading venue, systematic internaliser, market maker or other liquidity provider;

B. an investment firm that executes orders; or

C. an investment firm receiving and transmitting orders or passing orders onto others for execution as part of discretionary investment management services.

The first category of firm above (A) is required to comply with RTS 27. It is important that investment firms understand how the information required to be disclosed under RTS 27 may assist them in evaluating the quality of execution from this category of firm9. This note doesn’t attempt to summarise the disclosure obligations under RTS 27.

The second category of firm above (B) is required to comply with RTS 28 which is an annual public publication requirement. ESMA has stated it considers that firms should release the first annual report under RTS 28 by the April 2018. However, they recognise that the first year’s report may lack some of the detail that would be available for subsequent reports, given that firms may not yet have a whole year of data published under RTS 27. ESMA thinks that information on the top five venues and a summary of the outcomes achieved, such as it is, will still provide useful information to investors.

There is no specific requirement format for publications under RTS 27 or 28. However, it should be in a machine-readable electronic format. In addition ESMA has said that firms could publish these on their website but that they shouldn’t be behind firewalls.

For each class of financial instruments10 investment firms are required to disclose the top five execution venues in terms of trading volumes of executed orders (excluding securities financing transactions). This information should include:

  • class of financial instruments;
  • venue name and identifier;
  • 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;
  • percentage of the executed orders referred to in point (d) that were passive11 and aggressive orders;12
  • percentage of orders referred to in point (d) that were directed orders;13
  • confirmation of whether it has executed an average of less than one trade per business day in the previous year in that class of financial instruments.

For securities financing transactions the publication of the top five venues should contain:

  • 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;
  • confirmation of whether the investment firm has executed an average of less than one trade per business day in the previous year in that class of financial instruments.

In addition to the qualitative criteria shown above the firm should also provide a summary of the analysis and conclusions they draw from their detailed monitoring of the quality of execution obtained on the execution venues where they executed all client orders in the previous year. This shall include:

  • 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 assessing the quality of execution;
  • a description of any close links, conflicts of interests, and common ownerships with respect to any execution venues used to execute orders;
  • a description of any specific arrangements with any execution venues regarding payments made or received, discounts, rebates or non-monetary benefits received;
  • 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 occurs;
  • an explanation of how order execution differs according to client categorisation, where the firm treats categories of clients differently and where it may affect the order execution arrangements;
  • an explanation of whether other criteria were given precedence over immediate price and cost when executing retail client orders and how these other criteria were instrumental in delivering the best possible result in terms of the total consideration to the client;
  • an explanation of how the investment firm has used the information acquired under RTS 27;
  • where applicable, an explanation of how the investment firm has used output of a consolidated tape provider established under Article 65 of MiFID II.

The third category of firm above (C) is required to provide information that is “consistent” with RTS 28. Therefore, whilst RTS 28 doesn’t directly apply to these firms Article 65(6) of the Delegated Regulation creates a link by stating “The information shall be consistent with the information published in accordance with the technical standards developed under Article 27(10)(b) of Directive 2014/65/EU”.

Previous articles in Eversheds MiFID II Implementation Series

Paper 1 - Measuring your approach. Implementing the MiFID II Research Payment Rules

Paper 2 - Measuring your approach. Implementing Transaction Reporting for MiFID II

Paper 3 - Measuring your approach. Implementing the MiFID II Product Governance and Distributor Governance Rules

 


 

1 https://www.fca.org.uk/sites/default/files/cp16-29.pdf

2 https://www.esma.europa.eu/sites/default/files/library/2016-1444_mifid_ii_qa_investor_protection.pdf

3 https://www.fca.org.uk/publication/thematic-reviews/tr14-13.pdf

4 https://www.esma.europa.eu/sites/default/files/library/2015/11/07_320.pdf

5 https://www.fca.org.uk/publication/final-notices/threadneedle-asset-management.pdf

6 https://www.fca.org.uk/publication/final-notices/aviva-investors.pdf

7 https://www.esma.europa.eu/sites/default/files/library/2016-1444_mifid_ii_qa_investor_protection.pdf

8 COBS 11.2A.36EU

9 This note doesn’t describe each and every reporting obligations contained within RTS 27 and instead we refer readers to the following link - http://ec.europa.eu/transparency/regdoc/rep/3/2016/EN/3-2016-3333-EN-F1-1.PDF

10 Included within Annex I to RTS 28

11 A passive order is an order entered into the order book that provided liquidity.

12 An aggressive order is an order entered into the order book that took liquidity

13 A directed order is an order where a specific execution venue was specified by the client prior to the execution of the order.

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