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Getting Better at Best Execution

Tue, 29 Nov 2016 14:50:16 GMT           

By Allan Goldstein

 

The principles of best execution should be fundamental to buy-side traders. After all, making sure that every trading decision achieves the best possible result for the investor seems like common sense. But while the spirit of best-ex might be ingrained in the industry, there has been a wide diversity of approaches to achieving and evidencing best execution in the past.  Additionally, the sell side has historically focused on delivering best-ex to clients, but as the buy-side assumes more and more control over the trading process, they too must consider a process and approach.

 

Popular approaches tend to hinge on scoring, ranking or measuring brokers, venues and strategies across a range of quantifiable benchmarks, often using a third party provider of transaction cost analysis to deliver independent metrics. Meanwhile qualitative measures will extract varying levels of detail on broker practices and capabilities. Gathering, analysing and using this information to make trading desk level decisions is a complex task, and it is perhaps not surprising that there is little consistency in the approach firms take.

 

But there are reasons to expect greater convergence in the future. For one thing, regulators are taking an increasing interest in more succinctly defining their expectations on best execution. Both the UK Financial Conduct Authority and the European Securities and Markets Authority have published papers on best execution over the past two years, while the recast Markets in Financial Instruments Directive (MiFID II) will enforce much greater focus on best execution from 2018 and while the expectations remain less prescriptive and more principals based, the focus is nonetheless magnified.  Apparently, the phrase “all sufficient steps” is meant to raise the bar from “all reasonable steps”.

 

But the industry is not being driven entirely by regulators – it is also taking some steps of its own accord. The Equities Electronic Order Handling Questionnaire is a case in point. This new initiative was launched in 2015 to create a common set of questions for buy-side firms in Europe to ask of their trading counterparties, saving time and reducing inefficiencies on both sides of the market.

 

At the heart of the questionnaire is the concept of qualitative due diligence – the recognition that just as banks have increased the granularity of their know-your-customer routines, so buy-side firms need to make sure they are performing robust analysis on their counterparties’ processes and capabilities. This qualitative exercise will be central to MiFID II including best-ex guidance and technical standards such as RTS-28.  The Electronic Trading Questionnaire (ETQ) is encouraging forthe industry and is already making progress well ahead of its implementation.

 

But having a common methodology in place and asking the right questions of brokers is really only the start of the process. How will the questionnaire be managed?  Will asset managers deliver a pdf file via email?  Will banks and brokers respond by hand written copies scanned and emailed back?  Separate word documents?  Spreadsheets?  References to disclosure webpages? And once the questions are answered, the result is a torrent of information, requiring more complicated and resource-intensive efforts to interpret and standardise than quantitative metrics.  Or maybe the responses will be collected with only a cursory glance.

 

These qualitative nuggets of counterparty information could be critical to broker selection and best-ex measurement. Market participants have now recognised the need for a central platform to manage the sharing and updating of this information on an ongoing basis and are in the process of evaluating possible providers to support the ETQ. 

 

The Plia counterparty management system, operated by Trade Informatics since 2014, is ideally positioned to meet these requirements. The most effective counterparty due diligence hinges not just on a single questionnaire or compliance exercise, but on a wide spectrum of information that often tends to be scattered across multiple departments in different formats and is very difficult to reconcile when needed. Plia can bring that information together and make it accessible across the firm. 

 

As an example of this, a trader might well have front-line experience of a particular counterparty’s performance over time and may know of instances in which that firm’s service did not meet expectations. Meanwhile a compliance officer may have performed more formal checks on the same counterparty as part of an annual or semi-annual due diligence exercise. Baseline capabilities would be established during the formal exercise but in many cases the information is not reconciled and so important details may be missed and the measurement of the counterparty’s performance is false without knowledge of the baseline. 

 

There is tangible value in a central system that can bring together these separate strands of uniquely valuable information on every counterparty, combining it with the results of questionnaires and compliance checks so that traders have all of the necessary information at their fingertips when selecting brokers, making execution decisions, and measuring execution performance.   

 

Plia manages the distribution and response of the standard ETQ as well as customized questionnaires.  It houses the results of all of periodic due diligence exercises and formal questionnaires, while also allowing front-office staff to log relevant information in the same registry on an ad hoc basis. This leads not only to more informed execution, but also creates a clearer audit trail that can be used internally and with regulators to show that best execution is being actively pursued. 

 

It is still early days in the evolution of modern buy-side due diligence for best execution, but there is no doubt that having a central systematic platform to manage the flow of information will be critical to the progress that is made in the years ahead.

 

Allan Goldstein is COO and CFO at Trade Informatics