Análisis descriptivo

MiFID (Art. 19.1) requires that an investment firm act “in accordance with the best interests of its clients” to ensure a high level of investor protection. Besides the general clause, which de facto sets an important fiduciary duty, the article sets a dynamic obligation of ‘results’ (Giraud & D’Hondt, 2006), which calls for investment firms to ensure best execution when they offer: • Execution of orders on behalf of the clients (Art. 21, MiFID);

• Reception and transmission of orders in relation to one or more financial instruments (Art. 45.4, Impl. Dir.); and

• Portfolio management (Art. 45.4, Impl. Dir.).

These duties apply to all financial instruments, except spot foreign exchange instruments. Best execution obligations, should therefore be achieved by:

1) Taking “all reasonable steps” to obtain the best net result for the client, “taking into account price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order.” (Art. 21.1, MiFID);

2) Drafting an effective and detailed order execution policy that includes the execution venues and the parameters of choice, and then getting the client’s agreement (Art. 21.2, 21.3, MiFID);

3) Demonstrating, at the request of the client, that execution has been carried out in accordance with the existing execution policy, which allows the achievement the best possible result (Art. 21.3, 21.4, MiFID). From these detailed requirements, some argue that the Directive aims at imposing an obligation of ‘means’. So far, however, regulators have not

clarified yet whether MiFID’s original spirit was towards ‘results’ (dynamic approach) or ‘means’ (static approach).

Firstly, MiFID draws up a comprehensive definition of best execution, which takes into account all potential factors that can affect a financial transaction (as there is not a universal definition of best execution). Such factors can have different meanings that should be then considered.215 _For instance, costs can be seen as ‘implicit’ or ‘explicit’ and they can assume different forms according to multiple factors, such as the nature of the client.

In this regard, the criteria to be considered by investment firms when performing best execution of an order are the following (Art. 44.1, Impl. Dir.): i) Specific instructions given by the client;

ii) Nature of the client (retail or professional); iii) Nature of the financial instruments; and iv) Nature of the execution venues.

What should be considered as best execution for retail clients (typically price and costs) may not be the same for professionals (Art. 44.3, Impl. Dir.). The difficulty of drawing up a precise definition of what is best execution is obvious in today’s financial markets. Accordingly, the Directive does not give an easy-to-enforce definition of best execution either. The legal text tries to grasp all factors influencing a financial transaction, but does so in a general manner. However, this situation is not necessarily a detriment to final investors for two reasons, which should always be verified. On the one hand, general clauses are typically set to define a fiduciary duty, which should by definition fill gaps in incomplete contracts, i.e. when it is too costly and difficult for the contracting parties to specify all relevant terms. This situation does not call for detailed provisions in the law, but rather requires stronger enforcement tools and judicial review and the flexible application of best execution requirements (Macey & O’Hara, 1997 & 2005). On the other hand, when transaction costs are sufficiently low, a broad definition allows counterparties to bargain and ‘contract around’ the duty of best execution or customise it (even ‘opt out’) . In addition, technological developments (Smart Order Routers, SORs) support the customisation of best execution policies, even in a context of great market fragmentation where best execution cannot be easily verified.

Nevertheless, a strict regulatory definition can increase verifiability but the quality of the execution (investment) service would be potentially lower, with ultimately potential negative effects on demand. A too precise definition of best execution may exacerbate ex ante commitment and so inefficient investments. Current legal text sets the boundaries in which competing investment firms tailor execution policies in line with clients’ interests. More should be done to increase verifiability by improving the content of execution policies and the quality and depth of market data.

Definition

Secondly, as said, a loose contract may provide enough flexibility to contract around (or opt out) at the risk of distorting ex ante commitments. Pre-contractual investments, however, are primarily based on execution

Execution policies

policies. By improving the quality of execution policies, the contract therefore becomes less vague. In particular, by promoting:

• Quality of execution policies; and

• Observability and verifiability of best execution (through better and more data).

On the quality of execution policies, MiFID obliges investment firms to make a list of execution venues where the intermediary is going to execute the orders, and a list of the factors affecting the choice of a specific trading venue (19.3 and 21.3, MiFID).216 _{Best execution policies should receive the client’s} consent, and firms must review their policies once a year or whenever a ‘material change’ occurs, for instance when “a significant new execution venue emerges” (FSA, 2006a, p. 34), and assess them on a regular basis (Art. 45.6 and 46, Implementing Directive). In addition, member states should require investment firms to monitor the effectiveness of execution arrangements (Art. 21.4, MiFID) and national authorities may expressly ask investment firms to be able to demonstrate to clients that the transaction is compliant with their execution policy and so with best execution requirements (Art. 21.5, MiFID). To facilitate disclosure to clients about the execution policy, the Commission (2010b) has therefore proposed to introduce a template for policies.

MiFID also allows for different types of best execution policies, especially in relation to the selection of the venue for diverse asset classes and clients. Execution policies do not need to be defined on an order-by-order basis (dynamic approach) but in general (static approach).217 _{However, the} regular review of best execution policies currently provides some space for introducing dynamicity in the way investment firms provide best execution. The interpretation of what ‘dynamic’ means is perceived differently by the market. Some argue that dynamism refers to the obligation to modify execution policies on an order-by-order basis (led by a general obligation of ‘results’). In this sense, dynamic order execution may be more efficient and convenient for clients than static approaches, which only meet the minimum legal requirement (Ende et al., 2008). Some others believe that ‘dynamic’ generally means reviewing the execution policy if major events occur and assessing the effectiveness of execution arrangements periodically as required by MiFID. In this respect, in their view, there are no pending issues with regard to execution policies, besides a need for a proper implementation of current MiFID requirements and the lack of high quality data to verify best execution.

Thirdly, broad legal definitions call for greater enforcement of execution Observability

216 _{This list must be reviewed periodically, taking into account “execution venue fees, clearing and settlement fees} and any other fees paid to third parties involved in the execution of the order” (Art. 44.3, Impl. Dir.). Effective barriers to add new venues can be (among others, CESR, 2010h, p.5): (1) The lack of interoperability between clearing houses, so the inability to choose a ‘clearer of choice’; (2) Local rules which prevent remote membership of exchanges or complex re-registration processes; (3) Different regulatory regimes and clearing and settlement requirements in several countries, creating obstacles to competition between venues; (4) Absence of a central counterparty continues to be a clearing problem for some venues; (5) Distance – speed (or latency), mitigated by new facilities, e.g. hosting facilities, IT developments etc.; and (6) System costs, integration to back office and settlement systems.

policies by national financial authorities. However, current legislation leaves gaps that make enforcement difficult, such as the difficulty to assess factors other than price and speed, and the current design of best execution duties, which allows exemptions and do not make directly accountable specific trading practices.218 _{Moreover, the lack of quality data on execution for} financial instruments makes comparability of post-trade information complicated.219 _{MiFID requires firms to act in their clients’ best interest (Art.} 19.1), which constitutes a good-faith clause that should allow judges the necessary discretion to decide whether best execution has effectively taken place. However, since MiFID also defines what constitutes the client’s ‘best interests’, it impairs judiciary discretion and rather favours the principle of caveat emptor. This principle is not satisfactory either, due to the lack of verifiability, which means investors have to choose among execution policies that may not always be implemented properly. Observability and verifiability are considered minimal informational requirements for an event to define a contractual contingency (Hermalin et al., 2007). Best execution is characterised as a contractual term but it is not verifiable, even though observable (monitoring costs that are too high). It is therefore fundamental to improve the available quantity and quality of execution data (CESR, 2010b), which can also reduce the transaction costs of contracting ‘around’ the best execution requirements, as set by the Directive. Bargaining something that is not verifiable does not make any sense ‘contractually’. The Commission (2010b) also believes that better and more data should be combined with an effective civil liability for the investment firm.

and verifiability

Best execution duties influence two different areas: market structure and investor protection (Macey & O’Hara, 1997). Best execution de facto is only the one that the market is willing to provide, thus order flow markets must be competitive. Best execution is synonymous with low transaction costs. It is achieved when the least number of resources are lost in intermediation, for the execution services industry (Harris, 1996). Best execution policies must ensure that, when the abovementioned conditions are met, the investment firm screens the whole market, in particular those execution venues that can offer best execution to clients. On the one hand, the duty of best execution may sustain a competitive environment between trading venues, as incumbents are indirectly forced to deliver better quality of execution (in terms of lower implicit and explicit trading costs), due to the investment firms’ commitment to deliver best execution. This pressure reduces the incentives to define an oligopolistic setting with newcomers to the market, and among investment firms (as they ought to compete around quality and dynamicity of execution policies). On the other hand, this duty comes from a more important recognition of a fiduciary relationship between client and investment firm and aims at protecting end investors. Strong

Market structure

218 _{For instance, the US case law recognises as ‘industry practice’ - therefore not considered violation of the best} execution duty - accepting a rebate for directing order flow to a particular broker or trading venue; see Macey & O’Hara (1997), pp.195-196.

219 _{CESR is also looking to define an appropriate execution metric in order to measure execution (on a quarterly} basis) in shares (for other financial instruments it has been postponed to a future discussion) and it may ask execution venues to produce reports on execution quality using metrics set by CESR. CESR (2010), “Investor Protection and Intermediaries”, op.cit., pp. 18-26.

information asymmetries between client and investment firm may impede the definition of what precise factors should be taken into account to achieve best execution for a specific client (McCleskey, 2004).

The lack of an immediately applicable definition of best execution and the fear of undermining the structure of the US national market system led the SEC to impose a strict definition of best execution (around the best available price, i.e. National Best Bid and Offer, NBBO) and require brokers to report execution performance statistics (SEC, 1962). In this regard, the US regulators decided to fix an enforceable requirement (price) under securities regulation and to leave to markets, under competition, the provision of related services that help to achieve best execution (such as speed, multi- market trading, etc).

For non-equity financial instruments, traded OTC or on inter-dealer platforms, best execution may rely on other relevant aspects such as national legal rules, counterparty risk, products and market feasibility. In particular, it may be relevant to consider the volumes traded on a specific platform, as well as the type of organised venue or the details of the dealer that represents the counterparty in an OTC transaction. In line with the type of venue where the transaction is executed, execution policies should consider the most appropriate approach.

Nevertheless, it may be difficult to find comparable data for some complex derivative or credit product, or to see pre-trade information on prices. The kind of transparency obligations adopted for equities may not be as beneficial as for other types of markets and products (see Section 4). For instance, buying a bond that is only traded OTC for a retail client may not be compliant with the price factor of best execution since the counterparty would only agree to sell at a specific price set unilaterally (due to the low size). There is no space for negotiation and it is not verifiable if the trade could have occurred with a different dealer (the information is simply not available). In a RFQ trading model there is more chance that the investment firm can choose between few competing bid/offer prices and therefore to apply best execution obligations.

Non-equity markets

Conclusion # 22

Best execution duties lie at the foundation of the fiduciary relationship between service providers and clients. Execution policies and data are essential aspects of the effectiveness of these legal requirements. MiFID tries to grasp all factors influencing the best execution of a financial transaction, and does so in a very general manner. A strict legal definition (price- only) would assume that other services needed to achieve best execution (such as speed, transaction cost analysis, etc) would be efficiently provided by the market itself under competition, with no need of a formal legal protection. A broad definition, however, is not necessarily detrimental for final investors as long as execution policies are properly implemented and data allows sufficient verifiability of execution. Conflicting views emerge between those who argue that execution policies should be designed around a ‘dynamic’ obligation of ‘result’, i.e.complying with the minimum legal requirements is not enough in their view to achieve best execution. Other participants however challenge the view that issues with best execution come from execution policies, which are MiFID-compliant. Investors themselves receive full information about their execution policies. Both recognise that those issues emerge from a consistent lack of data on execution quality from trading

platforms, which are under discussion within the debate on the new transparency regime. Overall, MiFID requires firms to act in their clients’ best interest (Art. 19.1), which constitutes a good-faith clause that should allow judges the necessary discretion to decide whether best execution has effectively taken place. However, since MiFID also defines what constitutes the client’s ‘best interests’, it impairs judiciary discretion and rather favours the principle of caveat emptor. This principle is not satisfactory either, due to the lack of verifiability, which means investors have to choose among execution policies that may not always be implemented properly. Observability and verifiability are considered minimal informational requirements for an event to define a contractual contingency.

Best execution also impacts on market structure. Best execution de factois synonymous of low transaction costs and is achieved when the fewest resources are lost in intermediation. Best execution policies must ensure that, when the abovementioned conditions are met, the investment firm screens the whole market, in particular those execution venues that can offer best execution to clients. Hitherto, the duty of best execution sustains a competitive environment between trading venues, as incumbents are indirectly forced to deliver better quality of execution, due to the investment firms’ commitment to deliver it.