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Round table report: A qualitative approach to best execution

Wed, 15 Feb 2017 11:59:42 GMT           

Progress has been made to improve counterparty due diligence and best execution ahead of MiFID II, but the industry must find more efficient ways to exchange information


An increasing volume of information is being exchanged between the buy side and the sell side to meet regulatory requirements on best execution, but firms need better systems and processes to manage the flow of intelligence, according to senior market participants.


Speaking at a roundtable event hosted by Trade Informatics in London on February 9, head traders from several large buy and sell-side firms agreed that more needs to be done to address the challenges associated with counterparty due diligence ahead of the recast Markets in Financial Instruments Directive (MiFID II), due for implementation in Europe in January 2018.


Opening the event, Trade Informatics’ chief operating officer Allan Goldstein cast the spotlight on Article 27 of MiFID II, which requires that investment firms must take “all sufficient steps to obtain, when executing orders, the best possible result for their clients”.


The challenge for market participants, Goldstein pointed out, is that while much of MiFID II is highly prescriptive, the language that defines best execution in Article 27 is much more vague, leaving individual firms to define what constitutes ‘sufficient steps’ when drafting their order execution policies.


Transaction cost analysis is a well-established discipline in equities markets to deliver quantitative support of best execution, using trusted benchmarks to analyse factors such as price, cost and speed of execution that MiFID II identifies as being relevant. But qualititative measures are also necessary when analysing, selecting and reviewing counterparties, and some regulators have indicated that existing practices are not satisfactory.


After reviewing the best execution policies and procedures of 36 firms in 2014, the UK Financial Conduct Authority (FCA) published a paper on the topic, expressing concern that there was insufficient scrutiny of brokers and review of order execution arrangements. More could be done to understand and deliver on best execution obligations, the regulator warned.


Some progress has been made since the FCA review, however. The Equities Electronic Order Handling Questionnaire, launched in March 2016 by the Investment Association and the Association for Financial Markets in Europe, is the best example of an industry-led initiative to formalise and standardise counterparty due diligence.


But this is only the starting point, and sell-side officials at the event recognised that the questionnaire is too narrow – it covers only electronic trading – and should evolve to reflect the new market structure under MiFID II. Investment firms will soon need to know, for example, whether a counterparty can carry out trade reporting and transaction reporting on their behalf, so the questions should extend to this.


The buy side however may resist moves to extend a survey that already runs to more than 70 questions and consumes significant resources if the exercise is carried out properly and the information updated regularly. One trader complained that responses to questionnaires and requests-for-proposal often become very verbose and impenetrable when they have been through sell-side legal and compliance reviews.


But while legal and compliance may sometimes slow the process and lengthen the answers, some of the issues covered in the survey are complex and cannot always be answered concisely, brokers argue. Participants need to find a balance between completing due diligence exercises thoroughly and not over-burdening the buy side with information that may not be relevant.


Another trader suggested that the majority of the questionnaire is a box-ticking exercise and it is only the answers to a select few questions, such as trading venue selection, that are really relevant to the trading desk. His firm is in the early stages of establishing a counterparty management team, which will be responsible for any changes to the panel of brokers used for both execution and research. The team will also be tasked to review the panel on a semi-annual basis and to feed their decisions back to the trading desk and senior management.


Such changes are driven not only by the demands of MiFID II, but also by a growing recognition that counterparty management and the documentation of broker reviews and selections have been a weak point in many firms in the past, leaving them vulnerable to poor decision-making and increased risk.


There is also widespread demand for better technology to manage the exchange and maintenance of counterparty information. While the electronic order handling questionnaire represents a major step forward, the questions are typically answered by email at this stage, and users have recognised the benefits that could be gleaned from a central information sharing platform such as Trade Informatics’ Plia solution, which hosts all of the questions and responses in one place and houses information on each counterparty, bringing together records of all of the correspondence, meetings and due diligence that has taken place so that it is easily accessible when needed. 


In concluding the discussion, Goldstein pointed out that counterparty due diligence is not the only area where greater consistency and automation of information sharing might be beneficial. Both cyber security and vendor assessment also require large standardized sets of information to be shared between parties, although sell-side participants warned that the sensitivity of technology protection may create challenges of confidentiality.