Capital Markets Advisors

Monday, October 19th, 2015
by GEORGE BOLLENBACHER

Tucked away in Article 27 of MiFID 2 is a potentially disruptive requirement – the ‘Obligation to execute orders on terms most favorable to the client.’ Unfortunately, what constitutes best execution, and when the rules apply, aren’t clear. As a result, there are 5 tasks investment firms must tackle before MiFID 2 becomes effective at the end of 2016.

Tucked away in Article 27 of MiFID 2 is a potentially disruptive requirement – the “Obligation to execute orders on terms most favourable to the client.” I don’t know about you, but whenever I see something like “most favourable” in a rule, the voice of my college logics professor starts ringing in my ears: “How do we know that any terms are the most favourable?” But that’s the requirement, so it looks like we have to get into Article 27, and the applicable RTSs, in considerable detail.

Let’s begin where the article begins, with the requirement that investment firms obtain, “when executing orders, 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 the execution of the order.” Does this language help or hinder our attempts to comply? Unfortunately, the answer is yes. First there are a couple of clarifications – this only applies when an investment firm is dealing with a client, and best execution incorporates any consideration relevant to the quality of the execution.

But we immediately find some uncertainties. What happens when one investment firm, say an asset manager, requests a quote from another investment firm, say a dealer? Is the dealer obligated to quote the best price at which he would do the trade? What if the dealer’s quote is the best showing in the market, but not necessarily the best he, or some other dealer, would do? If the asset manager executes on that quote, was there ever an order at all? Did the asset manager get the best possible result for its client? Were the dealers obligated to quote better prices? If the instrument is illiquid, does MiFID require exposing the RFQ to multiple dealers, thus possibly affecting the resulting quotes such that the execution would now be on worse terms?

Perhaps the biggest unanswered question, subsumed in the previous paragraph, is what constitutes an order. In markets where participants are used to trading as principal, and a customer requests a quote, if the customer acts on the quote without countering, does that constitute an order? If, after receiving a quote, the customer counters and the dealer accepts the counter, was the counter an order? If any of these transactions – or any others, for that matter – are not deemed to be orders, is all of Article 27 inapplicable to them?

The answers to all these questions should be in the final proposed RTSs issued by ESMA in late September. Unfortunately, no such luck. The best execution section covers a grand total of five pages (out of 402) and does not actually contain any proposed regulatory technical standards. Instead, it discusses some of the commenters’ responses, but only to sections 10(a) and 10(b) of the article, and only talks about whether ESMA agreed with the comments.

But Sections 10(a) and 10(b) only cover the obligation to report on the quality of executions, not the requirements for the executions themselves. Those are covered in section 9, which says:

“9. The Commission shall be empowered to adopt delegated acts … concerning:

“(a) the criteria for determining the relative importance of the different factors that … may be taken into account for determining the best possible result taking into account the size and type of order and the retail or professional nature of the client;

“(b) factors that may be taken into account by an investment firm when reviewing its execution arrangements and the circumstances under which changes to such arrangements may be appropriate. In particular, the factors for determining which venues enable investment firms to obtain on a consistent basis the best possible result for executing the client orders;

“(c) the nature and extent of the information to be provided to clients on their execution policies, pursuant to paragraph 5.”

Neither the final RTSs nor the May 2014 discussion paper address this critical section, so investment firms are pretty much flying blind when it comes to the executions themselves. And nowhere do the ESMA documents discuss how the execution requirements will be enforced, except via the recordkeeping section. Thus, investment firms are left with the following best execution tasks before MiFID 2 becomes effective at the end of 2016:

1. Initiate conversations with your regulators – Since so much of Article 27 is still up in the air, the first step is to engage your regulators in a series of conversations about implementation and enforcement. In many cases the regulators are grappling with the specifics as much as the firms are, so an open discussion will probably pay big dividends.
2. Identify all the business areas that are involved – The term “investment firm” covers a very wide range of activities, from a pure dealer to a pure customer to financial service provider, including activities that only touch markets tangentially. Thus, a firm must undertake an exhaustive survey of all its activities in or around financial instruments to make sure that it doesn’t miss an area that has a hidden best execution responsibility.
3. Prepare policies and procedures – Some of the P&Ps are cut and dried, such as no compensation of any kind for order flow; but others are very much judgment calls. What counterparties are exempt from the best execution requirements? What constitutes an order? What execution agreements must we have with what counterparties? What monitoring and alert functions must we have to ensure compliance?
4. Review your trading technology – Everyone is acutely aware of the recordkeeping requirement involved in best execution, but compliance will also place significant demands on order management systems, on-boarding systems and trade booking systems. Firms that attack their technology requirements early (and probably often) will be in a better competitive position in early 2017, because they will be able to respond to customer inquiries or take advantage of market opportunities without having to stop and second-guess themselves.
5. Educate traders, salespeople and asset managers – Since MiFID 2 changes many trading practices in many venues, an early and ongoing training program is a necessity. ESMA, among others, has indicated that it will be evolving its regulation and enforcement, so a one-and-done approach to training will leave you vulnerable. Regularly scheduled sessions are the only answer, since they can be abbreviated or canceled if not much is happening at that time.

By now, every market participant is used to the ceaseless march of regulatory change, but the best execution component appears to be among the worst designed and most difficult to get one’s arms around. However, it is coming on us nonetheless. Perhaps we would be allowed to observe that the best place for a best execution requirement was in the drafting of the rule itself.