UK regulator the FCA recently published findings from supervisory work in relation to best execution of client orders at investment management firms in the UK. This followed on from an FCA thematic review into best execution in 2014. The FCA’s findings were that these firms were still failing to ensure effective oversight of best execution and they had largely failed to take on board the findings of the thematic review.
In this piece, I outline what best execution is, what the FCA would like investment managers (IMs) to improve on and the key changes to the best execution obligation under MiFID II.
What is Best Execution?
Under MiFID I as implemented in COBS 11.2 of the FCA Handbook, the overarching best execution obligation requires firms, when executing client orders, to take all reasonable steps to obtain the best possible result, taking into account a range of execution factors – price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order. Where a firm executes an order on behalf of a retail client, the best possible result must be determined in terms of total consideration (total price and all costs).
The FCA’s Questions for Improvement
The FCA expects IMs to have a strategy to ensure that all relevant parts of their business are compliant in ensuring best execution. There should also be clear management responsibility and co-ordination between the Front Office and Compliance to ensure a robust monitoring framework.
In order to improve their approach, the FCA now wants IMs to consider the following 7 questions in relation to best execution and make improvements where necessary:
- Who would the FCA hold responsible if the firm fails in its obligation to ensure it consistently achieves best execution?
- Do we have a comprehensive strategy for overseeing best execution?
- Have we tested that funds and client portfolios are not paying too much for execution? Where we identified they have paid too much did we compensate the investors?
- Does our order execution policy accurately reflect our firm’s business model rather than being a generic policy?
- What trades or trends have been identified as deficient through our regular monitoring?
- Is our gift and entertainment policy in line with the guidance set out in the FCA’s Finalised Guidance 14/1 and the 2012 guidance re conflicts of interest?
- Have our staff been adequately trained to ensure they understand what best execution means and its consequences? How can we evidence this to the FCA?
Interestingly, IMs were not looked at as part of the FCA’s 2014 thematic review on best execution, which focussed more on sell side firms. The FCA has conducted a separate study into the asset management industry in 2016 although this is still at an interim report stage and only contains passing references to best execution.
The thematic review is worth reviewing in detail not least because it contains many informative examples of good and poor practices at firms in relation to best execution.
Best Execution and MiFID II
The EU Markets in Financial Instruments Directive 2014/65/EU (MiFID II) will apply from 3 January 2018 and places a specific obligation (Article 27) on firms to execute orders on terms most favourable to the client.
Best execution: key changes under MiFID II, Level 1, Article 27:
- Firms will be required to take all sufficient steps to achieve the best possible results (Article 27(1)), rather than all ‘reasonable’ steps as currently required;
- There is an explicit prohibition of remuneration for executing client orders which is contrary to the rules on inducements or conflicts of interest (Article 27(2));
- A requirement for all trading venues to publish data on the execution quality obtained (including price, costs, speed and likelihood of execution for individual financial instruments) at least annually, which will assist firms in delivering their monitoring requirements (Article 27(3));
- Requirements for firms to provide information to clients on execution of different classes of financial instruments, detail on how they have applied the execution factors and obtain the prior consent of clients to the order execution policy (Article 27(5));
- A requirement on all firms to publish data on the top five trading venues where they executed client orders and information on the quality of execution obtained on an annual basis (Article 27(6)).
MiFID II Article 27 will also be supplemented by Level 2 measures: Regulatory Technical Standards (RTSs) No. 27 on execution quality data to be provided by trading venues and RTS No. 28 on the annual report by firms on the quality of execution on identified trading venues.
Next Steps and Conclusion
The FCA says it will revisit best execution in 2017 to see what steps IMs have taken to assess gaps in their approach and how they can evidence that funds and client portfolios are not paying too much for execution. If it finds that IMs are still not fulfilling their best execution obligations, the FCA will consider making more detailed investigations into specific firms, individuals or practices.
Such an investigation would be the last thing an IM would want and so it would be prudent for IMs and other firms to consider the questions for improvement outlined above, the detailed findings of the thematic review, the changes being brought by MiFID II and to then take the appropriate steps in relation to best execution.