MiFID. Best Execution

Transcription

1 MiFID Best Execution Summary of Key Requirements for Implementing MiFID s Best Execution IMS Consulting - June 2006 The requirements around Best Execution are some of the most significant in MiFID and likely to have a large impact on firms that execute clients orders as well as the behaviour of the underlying markets. The Best Execution requirements will apply to those firms that undertake the MiFID activities of reception and transmission of orders and portfolio management. Where an investment firm executes an order on behalf of a client, it needs to take all reasonable steps to achieve the best possible result by reference to the price of the instrument and the costs of execution, unless they are following the specific instructions of the client. IMS Consulting Ltd 1

2 MiFID - Summary of Key Requirements for Implementing MiFID s Best Execution Table of Contents: Introduction.. 3 Current Requirements. 3 New Requirements...5 Summary. 6 IMS Consulting Ltd 2

3 Introduction The Markets in Financial Instruments Directive ( MiFID ) comes in to force in November 2007, replacing the Investment Services Directive ( ISD ) that has been in place since MiFID is the result of the development of a comprehensive set of conduct of business requirements for the European Economic Area ( EEA ). The ultimate aim of MiFID is to ensure that investors and intermediaries can transact freely with clients in all EEA Member States on the same terms as in their home country. The majority of MiFID s contents are entirely new for Continental European investment management firms, although they cover familiar ground for UK firms. The requirements around Best Execution are some of the most significant in MiFID. They are likely to have a large impact on firms that execute client orders as well as the behaviour of the underlying markets in which the trades are transacted. The requirements will apply to those firms that undertake the MiFID classified activities of: Reception and transmission of orders; and Portfolio management. Where a firm executes an order on behalf of a client it needs to take all reasonable steps to achieve the best possible result by reference to the price of the instrument and the costs of execution, unless they are following the specific instructions of the client. The obligation to provide best execution is central to the structure of MiFID and to investor protection. This note outlines some of the key requirements and considerations for investment managers with regard to Best Execution following the publication of Discussion Paper 06/3 in May 2006 Implementing MiFID s Best Execution Requirements. Current Requirements The current FSA Rules on Best Execution are contained in Conduct of Business Rule ( COB ) 7.5. They apply to firms that execute customer orders in designated investments. There are exceptions where an intermediate customer has agreed to waive best execution or where the firm relies on another firm to provide best execution. To meet Best Execution a firm is required to: take reasonable care to ascertain the best available price for the order in the market considering the type and size of the transaction; and execute the transaction at a price which is no less advantageous to the customer unless it would not be in the customer s best interests to do so. Taking reasonable care could include: passing on to the customer the price at which it executes the transaction; execution (if it is in the best interests of the customer) at the best price, if competing exchange and trading platform price sourcing data is available; IMS Consulting Ltd 3

4 disregarding any charges and commissions that are disclosed to the customer; not taking mark-ups or mark-downs from the price at which the customer order is executed (unless disclosed to the customer); application of Best Execution requirements to each individual transaction within programme trading activity. The monitoring of Best Execution is normally undertaken in-house with usually no agreed policy statement in place with clients. Fund managers are bound by the constraints of the portfolio guidelines set by each individual client but with the underlying objective of obtaining and maximising the optimum return on the portfolio. It is, of course, in the clients best interest to buy at the lowest possible price and sell at the highest possible price in order to generate maximum returns. If the fund manager executes trades directly with the market, there is a direct link with the underlying portfolio and the best possible price obtained. If the order is being passed by the fund manager to a centralised dealing team, there is a formal passing of control over trading and Best Execution, but with the same objective of achieving the best outcome for the client. Within the rules and in-house standards, Best Execution can be described as: intrinsically tied to the portfolio decision making process; a concept that cannot be measured with certainty; enmeshed with various practices and relationships both within and external to each firm. To this extent, it goes to the core of the business and effectively defines the duty of investment managers to work in the best interests of each client in managing their money. Monitoring Best Execution Monitoring can take place in a variety of ways, combining micro/trade level trade analysis with macro level portfolio performance returns across asset classes or the client base. These can include: Independent, post-trade price monitoring, performed on a daily basis, and using external data or days range techniques (ensuring trades undertaken at the right end of the range), with exceptions reported to line management. Portfolio performance review to ensure consistency of returns across asset classes and industry peer groups. Close liaison between traders and fund managers on a pre- and post-trade basis to ensure that market dynamics and trade levels are discussed, clarified and understood by all parties enabling an assessment of prices achieved to be made. Monitoring of market counterparty trading levels and volumes periodically. This can be reviewed with the Gifts and Entertainments register as a broader indicator of overall appropriateness of counterparty activity. Reviews of settlement issues at a counterparty and at a market level which might have a detrimental effect on the best price being obtained over a period of time. IMS Consulting Ltd 4

5 New Requirements MiFID requires that firms, when executing customer orders, take all reasonable steps to obtain the best possible result taking in to account price, costs, speed, likelihood of execution and settlement size, nature or any other relevant consideration. Firms must develop and establish a written Best Execution policy and review it on an annual basis. If the policy permits orders to be executed outside regular markets, then prior approval of the policy being implemented must be obtained from the underlying customers. Firms must monitor the effectiveness of their policy in order to correct deficiencies, and to demonstrate that the policy is being followed. The main changes to the Best Execution rules under MiFID in comparison to the FSA s COB are: a formal Best Execution policy is required with a specific conflict disclosure requirement; application to all clients, rather than to private customers with intermediate opt-in; prior consent from clients is required to the Best Execution policy; clients cannot waive Best Execution as they can for intermediate customers currently; applies to firms that execute client orders, undertake portfolio management or receive and transmit orders, rather than to firms that execute customer orders; the standard of all reasonable steps replaces reasonable care ; the best possible result requirement replaces the COB price driven rule; there are no safe harbours thus removing the existing LSA and SETS safe harbours; and firms must be able to demonstrate, at their clients request, that their orders have been executed according to the firm s policy. This replaces the current informal in-house approach. Next Steps Firms will need to assess the nature and scope of the new requirements. Current monitoring practices and procedures should be reviewed in order to assess whether they are robust enough to meet the new formal policy and adherence requirements. Additionally, consideration should be given as to the extent that existing trading strategies meet the new requirements. Other important steps include: Preparation of a Best Execution policy and implementation through the compliance and procedures documentation and manuals. This policy should consider factors such as price, costs, size, speed of execution, likelihood of execution and settlement, nature of the order and other relevant factors when determining the execution venue. The value and importance of each factor to the relevant client will vary and so, a range of approaches may be appropriate. IMS Consulting Ltd 5

6 In executing trades, firms will need to consider the different trading venues where the firm could execute client orders, and choose such venues on a consistent basis. Current informal practices and procedures at each step in the investment process should be identified and reviewed against the new practices and procedures. Arrangements with intermediaries, where reliance for Best Execution is placed, should be reviewed, due diligence updated and documentary evidence maintained. IT applications will need to be assessed and enhanced where appropriate. Summary Best Execution has, on the whole, been based on outline rule requirements and informal monitoring processes. Prior to the Big Bang revolution in financial markets and screen based trading activities, the London Stock Exchange worked on the informal principle of my word is my bond. Investment processes have since evolved on similar lines where the requirement of Best Execution has existed as a basic client right. MiFID moves the practice to the next stage, where the informal is fully formalised and firms will need to justify their practices to show that they have taken all reasonable steps to obtain the best possible result. A paper summarising the key implications of MiFID as a whole can be found on the news page of our website: If you would like to discuss this paper or the wider challenges of MiFID please contact: Ian Allison, ia@imsconsulting.co.uk, Stephen Burke, sjb@imsconsulting.co.uk, or Martin Kelly, mk@imsconsulting.co.uk. IMS Consulting Ltd Tenterden House 3, Tenterden Street Mayfair London W1S 1TD Tel: Fax: IMS Consulting Ltd 6