Most of the debate in relation to best execution under MiFID II has focussed on the new requirements for firms to publish data on execution quality and to revise their order execution policies. In this blogpost, we instead consider how MiFID II may affect the core obligation to obtain best execution.
Factors to take into account when obtaining the best possible result
Under Article 27 of the MiFID II Directive, investment firms must take into account the following factors when taking all sufficient steps to obtain the best possible result for their clients:
- likelihood of execution and settlement;
- nature; or
- any other consideration relevant to the execution of the order.
These factors should already be considered by firms when seeking to obtain best execution under MiFID I. However, Article 64 of the MiFID II Delegated Regulation provides new detail on the best execution obligation, stating that, in order to determine the relative importance of these factors, firms should take into account:
- the characteristics of the client (that is, whether the order is for a retail or professional client);
- the characteristics of the client order (for example, whether a securities financing transaction is involved);
- characteristics of the financial instruments involved; and
- characteristics of the execution venues being considered.
There are several points to consider when assessing how to achieve the best possible result:
Best execution for retail and professional clients. Where a firm is executing an order for a retail client, Article 27(1) of the MiFID II Directive states that the best possible result is determined by the total consideration (that is, the price of the investment and any associated costs, such as execution venue fees, clearing and settlement fees, and other third party fees) for the order.
This implies that, in contrast, when a firm is executing an order for a professional client, there may be circumstances where other factors are more important than the price. Nevertheless, price will still be important because the firm is unlikely to be acting in the best interests of its client if it gives low importance to the price of the product concerned.
Using more than one venue for execution. Article 27(1) also clarifies that, where there is more than one competing venue for execution, the firm must take into account both its own commissions and the costs for executing the order on each of the venues. According to Article 66 of the MiFID II Delegated Regulation, where there is a fee differential between competing execution venues, firms must provide detailed information to allow clients to understand both the advantages and disadvantages of one execution venue over another. This should allow the client to make an informed decision rather than simply relying on the firm's pricing policy.
Best execution when executing specific client instructions. Article 64 of the MiFID II Delegated Regulation confirms that a firm will meet the best execution obligation if it executes an order by following the specific instructions of a client relating to that order.
Best execution of OTC products. Article 64 of the MiFID II Delegated Regulation requires firms to check the fairness of the price proposed to the client when executing orders or taking decisions to deal in OTC products. To ensure the fairness of price, firms must gather market data used in the estimation of the price of the product and, where possible, compare with similar or comparable products.
Achieving best execution for more sophisticated products
Taken together, the requirements in MiFID II should make firms reconsider how they should achieve best execution for their clients. In particular, this is more likely to affect more sophisticated products that are traded OTC on behalf of non-retail clients and which may be relatively illiquid. As noted above, for such products, price and associated trading costs may not always be the determining factor when seeking to obtain best execution.
By way of example, some exchange-traded funds (ETFs) may have a more complex execution process than other less sophisticated products. Although it may sometimes be straightforward to buy and sell units in a particular ETF, there may be other occasions when the units must be "created and redeemed" by a firm buying the underlying assets used to make up the ETF and delivering those assets to the ETF provider in order to receive a block of ETF units of equivalent value, which can be delivered to the client.
The complexity and diversity of ETFs, which may contain a range of asset classes, or be traded in different time zones or currencies, mean that the underlying assets may not always be available, or easily available, for trading. As a result, a firm executing an ETF trade for its clients may need to consider whether it would be more appropriate for the firm to execute the trade over a period of time in order to ensure that the underlying assets can traded when they are more liquid and hence better priced. Depending on the circumstances, and the client's intentions, executing the ETF trade over a period of time might be better aligned with the obligation to obtain best execution than, for example, instantaneous execution of the ETF via a request-for-quote (RFQ) platform, which may require the firm to pay a higher risk premium.
Requirement to take "all sufficient steps"
Firms are currently required to take "all reasonable steps" to obtain the best possible result when executing a client order. Under MiFID II, this requirement will be strengthened so that firms must take "all sufficient steps".
In Q&A earlier this year, the European Securities and Markets Authority (ESMA) confirmed that the requirement to take "all sufficient steps" sets a higher bar for compliance than the existing requirement.
According to ESMA, firms must ensure that the intended outcomes can be successfully achieved on an on-going basis. ESMA believes that this will require firms to monitor not only the execution quality obtained but also the quality and appropriateness of their execution arrangements and policies on an ex-ante and ex-post basis to identify whether or not changes may be appropriate.
The requirement to monitor best execution on an ex-ante and ex-post basis means that firms should consider what kinds of analytical tools may help them to compare the quality of execution available from competing execution venues ahead of the trade, as well as post-trade analytics in order to assess the quality of the execution actually achieved.
Authored by Michael Thomas and James Roslington