Market Insights

 

Best Execution Requires More than a Midpoint Print and a Low Commission

 

Advisers, managers and brokers need a systematic approach to comply with their ever-growing best execution responsibilities

Michael Earlywine – SVP, Channel Partner Sales, Abel Noser Solutions

 

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The Best Execution Conundrum

 

When confounded by the threshold test for obscenity in 1964, Associate Justice of the Supreme Court of the United States, Potter Stewart, famously remarked “I know it when I see it."  To a great degree, the same is often said about best execution in the securities market.   Traders and managers will often struggle to explain or define best execution but consistently profess “I know it when I see it” or, just as often, “I know it when I don’t see it!”

 

But with last year’s introduction of MiFID II/PRIIPs in Europe, and the Office of Compliance Inspections and Examinations (OCIE) alert memo on best execution, and this year’s restructuring of the 606 broker execution reporting requirements, the days of “I know it when I see it” are certainly past.

 

“The days of ‘I know it when I see it’ are certainly past.”

 

Furthermore, the detail and clarification brought on by the recent regulatory actions have lessened the confusion of who is responsible and at what level. There might be new questions and concerns, but no longer can advisors be without a systematic approach to their best execution fiduciary responsibilities.

 

With this initial look at best execution responsibilities and framework, we offer here some techniques for evaluating and incorporating best execution back into the investment process. We also recap the origin of past confusion, the most common infractions found during inspections as described by the OCIE, remedies to those issues and finally, a three-part plan for meeting best execution responsibilities today and in the future.

 

Who’s Responsible for Best-Execution?

 

Contributing to past confusion around best execution are the differing responsibilities of participants in a transaction. For example, the regulatory responsibilities of brokers to achieve and demonstrate best execution are very much centered on the decision and process at the moment of the trade. In general brokers are required to seek the best execution reasonably available for their customers' orders. Furthermore, they are compelled to consider the current market, competing venues, speed of execution, and likelihood of getting a fill.

 

But a Broker’s responsibility for best execution does not replace a manager's responsibility for the same.  In fact, managers and advisors are tasked with a much broader and holistic best execution mandate.

 

"Brokers and managers have a shared responsibility.”

 

Per the Investment Advisers Act, managers and advisers are  generally required to prove that the client’s total costs or proceeds in each transaction are the most favorable under the prevailing markets.  Additionally, advisors are to consider the full range and quality of a broker-dealer’s services including, among other things, the value of research provided as well as execution capability, commission rate, financial responsibility, and responsiveness to the adviser.

 

The OCIE periodically performs analysis of examinations to highlight the process needed to ensure compliance with managers' obligations under the Investment Advisers Act.  A recent alert by the OCIE highlighted the most common deficiencies found in their auditing process - the majority of which can be attributed to a lack of systematic analysis performed by managers.  An analysis of the OCIE’s concerns follows.

 

Potential Deficiencies and Solutions

 

"Advisers and managers of all types and sizes, along with their brokers, are squarely in the cross-hairs of renewed best execution enforcement."

 

Quoting from deficiencies found during the OCIE’s review of over 1500 examinations:

 

“Not performing best execution reviews“

  • Issue: Inability to show regular and systematic review of brokers and their consideration of best execution when engaging a broker for trading.
  • Remedy: The simple remedy is to create a structure and reporting process that provokes the systematic review of trading and broker measurements on a scheduled basis - daily, monthly or quarterly.

 

“Not considering materially relevant factors during best execution reviews”

  • Issue: Not considering the full range of broker services; regulators require not only a measure of the actual trade but also qualitative considerations like topic expertise and speed of response.
  • Remedy: To evaluate the entirety of your trading work flow requires that trades and associated services be measured in context to industry norms both for cost and performance.

 

“Not seeking comparisons from other broker-dealers”

  • Issue:  Not considering the cost or quality of competing broker dealers.  Utilizing a single or limited number of brokers carries with it risk of relative performance bias.
  • Remedy: Again, it is important to consider industry norms and assure your best execution evaluation is in proper context to the broader market.

 

“Not fully disclosing best execution practices”

  • Issue: Lack of communication about procedures and a further lack of consistency in following procedures once articulated.  Advisers failed to review processes and trades using an established framework that ensured that best practices were maintained and that resulting execution prices fall within an acceptable range.
  • Remedy: Establish a custom best execution measurement process with compliance oversight.  Exceptions to this best execution framework need to be documented and furthermore it is prudent to document that procedures are being followed regularly.

 

“Not disclosing soft dollar arrangements”

  • Issue: Lack of full and fair disclosure in a soft dollar program which includes documenting disparities of cost between customers and the proper adherence to safe harbor (28e) requirements for research and services.
  • Remedy:  Establish soft dollar oversight and disclosure policies within the best execution framework and policies.

 

“Inadequate policies and procedures relating to best execution”

  • Issue: The OCIE found a lack of established compliance policies regarding best execution policies all together, a lack of persistent monitoring of broker dealer executions and an inconsistency in policies relevant to securities traded.
  • Remedy:  Underscores the need for a best execution measurement framework, compliance policies with strategic overview to change and evolve along with a firm’s trading products and style.

 

“Not following best execution policies and procedures”

  • Issue:  Where advisers had established policies for best execution, they did not follow those policies, particularly with regard to ongoing monitoring.
  • Remedy:  When a measurement program is in sync with the trade-implementation work flow, compliance is seamless and consistent.

 

Best Execution 2019

 

Best execution in today’s markets requires more than a midpoint print and a low commission; it requires a philosophy, an infrastructure and adherence to a stated process.

 

"A philosophy, an infrastructure and adherence to a stated process"

 

The overall remedy to the deficiencies described by the OCIE and the responsibilities of related regulatory obligations is to institute a comprehensive and repeatable best execution framework which addresses the following three principles:

 

1) Define a best execution program and procedures as part of an effort to maximize returns on behalf of your client; put regulation to work for you and your client:

 

  • Work flow efficiency – Define and monitor slippage from the point where an order enters the system to each event point thereafter, throughout the trade execution timeline
  • Establish and maintain  a process to oversee existing broker dealers and select new ones
  • Use industry-standard benchmarking techniques to establish a baseline for trading performance
  • With the help of external partners/vendors, define an appropriate peer group based either on portfolio strategy or type of trade, to determine relative best execution performance

 

2) Create a trade measurement infrastructure that promotes compliance with best execution obligations:

 

  • Reports delivered and reviewed on a systematic and regular basis – actively monitor short and long-term cost trends
  • Automated exception reporting; pro-actively and preemptively identify and address issues (before regulators or clients)
  • Optimize the use of best execution analyses across business lines, addressing the needs of compliance, portfolio management, trading and regulatory requirements

 

3) Evaluate and monitor your best execution plan and procedures on a regular basis to maintain a best-of-breed process.

 

  • Staying compliant with the spirit of best execution will require regular adjustments to your written procedures and best execution infrastructure
  • Make sure best execution remains an integral part of your evolving work flow, coordinating the requirements across complimentary business lines and obligations

 

Instituting the principles and framework described above has the added advantage of embodying the spirit of best execution responsibilities.  This in turn, has the advantage of immunizing managers from having to make major investments in reaction to our ever-evolving regulatory landscape.

 

What Now?

 

Over the past twelve years, the SEC, ESMA, FINRA and the FCA have established and modified existing regulations to keep pace with markets and their participants.  As MiFID II regulations continue take hold, and as the SEC responds with regulations of its own over the next few years, the market can expect further additions and changes to regulations concerning best execution policies and guidelines.

 

There is a subtle silver lining to the clarification of existing regulations and influence of new regulation in that as the pursuit of best execution continues to be refined, it is becoming more and more useful to the day-to-day and performance side of the business.  The practical benefits of added clarity can guide managers in defining their procedures and processes for best execution and, in turn, refining best practices throughout the trading work flow.

 

Modern regulatory requirements and the complexity of our market structure require unprecedented adherence to a detailed and comprehensive best execution program.

 

 

Further Reading

 

 

For the past 35 years, Abel Noser has been helping firms understand, measure, and monitor their trade data.  As the regulatory hurdles of best execution grow in complexity, we stand ready to help firms embrace their regulatory responsibilities and implement the processes required, from the trading desk to the compliance office.  Abel Noser’s peer benchmarks empower managers with the tools and context needed to define and monitor best execution.

 

- - - -

 

Disclaimer:  This article posted on Abel Noser’s Market Insights page and is created and authored by company staff (the “Author”) and is published and provided for informational and entertainment purposes only.  Under no circumstances does the information presented on this page represent a buy, sell or hold recommendation on any security.  The information in this page constitutes the Author’s or company’s own opinions.  None of the information on this page is intended to provide any tax, legal, investment or trading advice.  Nothing provided through this page whether by the Author or posted by other writers or commenters constitutes a solicitation of the purchase or sale of securities or futures.  In reading this site, you understand that the Author is not advising you personally concerning the nature, potential, value, or suitability of any particular security, portfolio of securities, transaction, investment strategy or other matter.

 

The page may present excerpts from articles, interviews, SEC documents, company filings, electronic databases and conversations which express opinions on companies, people, investments and/or related matters.  The Author will link to sources of information or other websites.  Links from this site to another site in no way constitute an endorsement of the opinions or advice contained therein.

 

From time to time, the Author and/or the Author’s clients may hold positions or other interests in securities mentioned in the page and may trade for their own account(s).   When the Author and/or the Author’s clients hold an interest in the securities discussed on the page, the Author will disclose that position.  This page contains opinions of the author and such opinions are subject to change without notice.  The posts on this page are distributed for informational and entertainment purposes ONLY.  Forecasts, estimates and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.  The Author in no way guarantees any specific outcome or profit.  Investments can lose money over short or even long periods of time.  You should consult your financial advisor before making an investment decision.

 

NO GUARANTEE CAN BE MADE IF YOU INVEST BASED ON THE INFORMATION PROVIDED ON THIS PAGE.  WE MAKE NO WARRANTY OF ANY KIND REGARDING THE PAGE AND/OR ANY CONTENT, DATA, MATERIALS, INFORMATION, PRODUCTS OR SERVICES PROVIDED ON THE PAGE.  THE AUTHOR DISCLAIMS ANY WARRANTY AS TO THE ACCURACY, COMPLETENESS, TIMELINESS OF ANY CONTENT OR INFORMATION FOUND ON THE PAGE.  THE DATA AND INFORMATION PRESENTED ON THE PAGE IS BELIEVED TO BE ACCURATE BUT SHOULD NOT BE RELIED UPON BY THE USER FOR ANY PURPOSE.  THE PAGE AND THE CONTENT ARE PROVIDED “AS-IS” AND THE AUTHOR DISCLAIMS ANY AND ALL REPRESENTATIONS, WHETHER EXPRESS OR IMPLIED, INCLUDING IMPLIED WARRANTIES OF TITLE AND MERCHANTABILITY, IF APPLICABLE, AND FITNESS FOR A PARTICULAR PURPOSE OR NON-INFRINGEMENT.  ANY AND ALL LIABILITY FOR THE CONTENT OR ANY OMISSIONS FROM THE PAGE, INCLUDING ANY INACCURACIES, ERRORS, OR MISSTATEMENTS IN SUCH DATA OR INFORMATION IS EXPRESSLY DISCLAIMED.

 

 

 

 

 

 

 

The Best Execution Conundrum

 

When confounded by the threshold test for obscenity in 1964, Associate Justice of the Supreme Court of the United States, Potter Stewart, famously remarked “I know it when I see it."  To a great degree, the same is often said about best execution in the securities market.   Traders and managers will often struggle to explain or define best execution but consistently profess “I know it when I see it” or, just as often, “I know it when I don’t see it!”

 

But with last year’s introduction of MiFID II/PRIIPs in Europe, and the Office of Compliance Inspections and Examinations (OCIE) alert memo on best execution, and this year’s restructuring of the 606 broker execution reporting requirements, the days of “I know it when I see it” are certainly past.

 

“The days of ‘I know it when I see it’ are certainly past.”

 

Furthermore, the detail and clarification brought on by the recent regulatory actions have lessened the confusion of who is responsible and at what level. There might be new questions and concerns, but no longer can advisors be without a systematic approach to their best execution fiduciary responsibilities.

 

With this initial look at best execution responsibilities and framework, we offer here some techniques for evaluating and incorporating best execution back into the investment process. We also recap the origin of past confusion, the most common infractions found during inspections as described by the OCIE, remedies to those issues and finally, a three-part plan for meeting best execution responsibilities today and in the future.

 

Who’s Responsible for Best-Execution?

 

Contributing to past confusion around best execution are the differing responsibilities of participants in a transaction. For example, the regulatory responsibilities of brokers to achieve and demonstrate best execution are very much centered on the decision and process at the moment of the trade. In general brokers are required to seek the best execution reasonably available for their customers' orders. Furthermore, they are compelled to consider the current market, competing venues, speed of execution, and likelihood of getting a fill.

 

But a Broker’s responsibility for best execution does not replace a manager's responsibility for the same.  In fact, managers and advisors are tasked with a much broader and holistic best execution mandate.

 

"Brokers and managers have a shared responsibility.”

 

Per the Investment Advisers Act, managers and advisers are  generally required to prove that the client’s total costs or proceeds in each transaction are the most favorable under the prevailing markets.  Additionally, advisors are to consider the full range and quality of a broker-dealer’s services including, among other things, the value of research provided as well as execution capability, commission rate, financial responsibility, and responsiveness to the adviser.

 

The OCIE periodically performs analysis of examinations to highlight the process needed to ensure compliance with managers' obligations under the Investment Advisers Act.  A recent alert by the OCIE highlighted the most common deficiencies found in their auditing process - the majority of which can be attributed to a lack of systematic analysis performed by managers.  An analysis of the OCIE’s concerns follows.

 

Potential Deficiencies and Solutions

 

"Advisers and managers of all types and sizes, along with their brokers, are squarely in the cross-hairs of renewed best execution enforcement."

 

Quoting from deficiencies found during the OCIE’s review of over 1500 examinations:

 

“Not performing best execution reviews“

  • Issue: Inability to show regular and systematic review of brokers and their consideration of best execution when engaging a broker for trading.
  • Remedy: The simple remedy is to create a structure and reporting process that provokes the systematic review of trading and broker measurements on a scheduled basis - daily, monthly or quarterly.

 

“Not considering materially relevant factors during best execution reviews”

  • Issue: Not considering the full range of broker services; regulators require not only a measure of the actual trade but also qualitative considerations like topic expertise and speed of response.
  • Remedy: To evaluate the entirety of your trading work flow requires that trades and associated services be measured in context to industry norms both for cost and performance.

 

“Not seeking comparisons from other broker-dealers”

  • Issue:  Not considering the cost or quality of competing broker dealers.  Utilizing a single or limited number of brokers carries with it risk of relative performance bias.
  • Remedy: Again, it is important to consider industry norms and assure your best execution evaluation is in proper context to the broader market.

 

“Not fully disclosing best execution practices”

  • Issue: Lack of communication about procedures and a further lack of consistency in following procedures once articulated.  Advisers failed to review processes and trades using an established framework that ensured that best practices were maintained and that resulting execution prices fall within an acceptable range.
  • Remedy: Establish a custom best execution measurement process with compliance oversight.  Exceptions to this best execution framework need to be documented and furthermore it is prudent to document that procedures are being followed regularly.

 

“Not disclosing soft dollar arrangements”

  • Issue: Lack of full and fair disclosure in a soft dollar program which includes documenting disparities of cost between customers and the proper adherence to safe harbor (28e) requirements for research and services.
  • Remedy:  Establish soft dollar oversight and disclosure policies within the best execution framework and policies.

 

“Inadequate policies and procedures relating to best execution”

  • Issue: The OCIE found a lack of established compliance policies regarding best execution policies all together, a lack of persistent monitoring of broker dealer executions and an inconsistency in policies relevant to securities traded.
  • Remedy:  Underscores the need for a best execution measurement framework, compliance policies with strategic overview to change and evolve along with a firm’s trading products and style.

 

“Not following best execution policies and procedures”

  • Issue:  Where advisers had established policies for best execution, they did not follow those policies, particularly with regard to ongoing monitoring.
  • Remedy:  When a measurement program is in sync with the trade-implementation work flow, compliance is seamless and consistent.

 

Best Execution 2019

 

Best execution in today’s markets requires more than a midpoint print and a low commission; it requires a philosophy, an infrastructure and adherence to a stated process.

 

"A philosophy, an infrastructure and adherence to a stated process"

 

The overall remedy to the deficiencies described by the OCIE and the responsibilities of related regulatory obligations is to institute a comprehensive and repeatable best execution framework which addresses the following three principles:

 

1) Define a best execution program and procedures as part of an effort to maximize returns on behalf of your client; put regulation to work for you and your client:

 

  • Work flow efficiency – Define and monitor slippage from the point where an order enters the system to each event point thereafter, throughout the trade execution timeline
  • Establish and maintain  a process to oversee existing broker dealers and select new ones
  • Use industry-standard benchmarking techniques to establish a baseline for trading performance
  • With the help of external partners/vendors, define an appropriate peer group based either on portfolio strategy or type of trade, to determine relative best execution performance

 

2) Create a trade measurement infrastructure that promotes compliance with best execution obligations:

 

  • Reports delivered and reviewed on a systematic and regular basis – actively monitor short and long-term cost trends
  • Automated exception reporting; pro-actively and preemptively identify and address issues (before regulators or clients)
  • Optimize the use of best execution analyses across business lines, addressing the needs of compliance, portfolio management, trading and regulatory requirements

 

3) Evaluate and monitor your best execution plan and procedures on a regular basis to maintain a best-of-breed process.

 

  • Staying compliant with the spirit of best execution will require regular adjustments to your written procedures and best execution infrastructure
  • Make sure best execution remains an integral part of your evolving work flow, coordinating the requirements across complimentary business lines and obligations

 

Instituting the principles and framework described above has the added advantage of embodying the spirit of best execution responsibilities.  This in turn, has the advantage of immunizing managers from having to make major investments in reaction to our ever-evolving regulatory landscape.

 

What Now?

 

Over the past twelve years, the SEC, ESMA, FINRA and the FCA have established and modified existing regulations to keep pace with markets and their participants.  As MiFID II regulations continue take hold, and as the SEC responds with regulations of its own over the next few years, the market can expect further additions and changes to regulations concerning best execution policies and guidelines.

 

There is a subtle silver lining to the clarification of existing regulations and influence of new regulation in that as the pursuit of best execution continues to be refined, it is becoming more and more useful to the day-to-day and performance side of the business.  The practical benefits of added clarity can guide managers in defining their procedures and processes for best execution and, in turn, refining best practices throughout the trading work flow.

 

Modern regulatory requirements and the complexity of our market structure require unprecedented adherence to a detailed and comprehensive best execution program.

 

 

Further Reading

 

 

For the past 35 years, Abel Noser has been helping firms understand, measure, and monitor their trade data.  As the regulatory hurdles of best execution grow in complexity, we stand ready to help firms embrace their regulatory responsibilities and implement the processes required, from the trading desk to the compliance office.  Abel Noser’s peer benchmarks empower managers with the tools and context needed to define and monitor best execution.

 

- - - -

 

Disclaimer:  This article posted on Abel Noser’s Market Insights page and is created and authored by company staff (the “Author”) and is published and provided for informational and entertainment purposes only.  Under no circumstances does the information presented on this page represent a buy, sell or hold recommendation on any security.  The information in this page constitutes the Author’s or company’s own opinions.  None of the information on this page is intended to provide any tax, legal, investment or trading advice.  Nothing provided through this page whether by the Author or posted by other writers or commenters constitutes a solicitation of the purchase or sale of securities or futures.  In reading this site, you understand that the Author is not advising you personally concerning the nature, potential, value, or suitability of any particular security, portfolio of securities, transaction, investment strategy or other matter.

 

The page may present excerpts from articles, interviews, SEC documents, company filings, electronic databases and conversations which express opinions on companies, people, investments and/or related matters.  The Author will link to sources of information or other websites.  Links from this site to another site in no way constitute an endorsement of the opinions or advice contained therein.

 

From time to time, the Author and/or the Author’s clients may hold positions or other interests in securities mentioned in the page and may trade for their own account(s).   When the Author and/or the Author’s clients hold an interest in the securities discussed on the page, the Author will disclose that position.  This page contains opinions of the author and such opinions are subject to change without notice.  The posts on this page are distributed for informational and entertainment purposes ONLY.  Forecasts, estimates and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.  The Author in no way guarantees any specific outcome or profit.  Investments can lose money over short or even long periods of time.  You should consult your financial advisor before making an investment decision.

 

NO GUARANTEE CAN BE MADE IF YOU INVEST BASED ON THE INFORMATION PROVIDED ON THIS PAGE.  WE MAKE NO WARRANTY OF ANY KIND REGARDING THE PAGE AND/OR ANY CONTENT, DATA, MATERIALS, INFORMATION, PRODUCTS OR SERVICES PROVIDED ON THE PAGE.  THE AUTHOR DISCLAIMS ANY WARRANTY AS TO THE ACCURACY, COMPLETENESS, TIMELINESS OF ANY CONTENT OR INFORMATION FOUND ON THE PAGE.  THE DATA AND INFORMATION PRESENTED ON THE PAGE IS BELIEVED TO BE ACCURATE BUT SHOULD NOT BE RELIED UPON BY THE USER FOR ANY PURPOSE.  THE PAGE AND THE CONTENT ARE PROVIDED “AS-IS” AND THE AUTHOR DISCLAIMS ANY AND ALL REPRESENTATIONS, WHETHER EXPRESS OR IMPLIED, INCLUDING IMPLIED WARRANTIES OF TITLE AND MERCHANTABILITY, IF APPLICABLE, AND FITNESS FOR A PARTICULAR PURPOSE OR NON-INFRINGEMENT.  ANY AND ALL LIABILITY FOR THE CONTENT OR ANY OMISSIONS FROM THE PAGE, INCLUDING ANY INACCURACIES, ERRORS, OR MISSTATEMENTS IN SUCH DATA OR INFORMATION IS EXPRESSLY DISCLAIMED.