Part of the European Commission’s Financial Services Action Plan, the Markets in Financial Instruments Directive (MiFID)1 is aimed at establishing comprehensive regulations for investment services and financial markets in the European Union. The goal is to create a single, pan-European financial market by establishing uniform rules that make it easier for companies authorized to operate in one member state’s market to operate in the other European countries as well.
The Commission expects that MiFID will significantly lower capital costs for European companies and, at the same time, ensure strong investor protection by introducing an extensive set of new rules governing the relationship investment firms have with their clients.
MiFID is set for implementation in November 2007 and will be adopted in different steps following the Lamfalussy process2, and sanctions for non-compliance will range from fines to suspension of trading rights. Even so, investment services haven’t been gearing up to apply MiFID’s rules, which will probably change a number of times after their initial introduction.
MiFID has provisions for many areas, including conflict of interest, conduct of business, best execution, passporting rights, equity markets transparency, record keeping, client reporting and outsourcing. Best execution is generally the area regarded to be the most complex, as highlighted in a recent survey conducted by IBM where 75% of the respondents identified best execution as the most challenging part of MiFID implementation.
Article 21 of MiFID defines ‘best execution’ as the obligation for firms to obtain the ‘best possible result for their clients’ when executing orders in the absence of specific instructions from the client. In seeking to deliver best execution, a firm should take a wide-range of factors into account, such as price, costs, speed, likelihood of execution and settlement, size, and the nature of the order and other relevant considerations. The obligation on firms requires them to establish a policy to achieve ‘best execution’. It is not an order-by-order requirement to ensure (and prove) that ‘best execution’ has been achieved in relation to any given order to which the overall obligation applies.
Concrete Steps to Best Execution Implementation
Let’s examine the steps to implementation of a fictional investment bank – EUFIB. The chief compliance officer of EUFIB will have to ensure and to prove that best execution has been achieved. Proving best execution compliance requires proving compliance across a cycle of activities3. These can be laid out in the following clearly identified steps: prioritisation of factors, analysis and selection of execution venues, linkage to execution venues, creation of best execution policy, agreement of client to ‘best execution’ policy, execution of orders, periodic review of factors and venues.
Firstly, the EUFIB compliance officer must document the prioritisation factors per client/client group. Factors to prioritise include: price, cost, size of order, nature of order etc. The order of importance must take into account the needs of their clients for obtaining the best possible result. Where another factor may override apparent price and costs, the circumstance leading to this must be clear.
Secondly, the EUFIB compliance officer must document the analysis and selection process for execution venues. This should include what venues are available, such as regulated markets, e.g. multilateral trading facilities (MTFs) and systematic internalisers (SIs). For each venue he or she must ensure the performance of the venue against the factors defined for the client. This will include costs of execution and settlement for a venue, as well as other considerations such as pricing quality (e.g. ensuring a comparative pricing model for non-unique OTC derivative contracts, referencing market values of building blocks).
Thirdly, EUFIB must document why particular execution venues were not selected, showing the consideration of connection costs and other reasons. EUFIB must also document the process of regular review of quality of execution and execution venues. The EUFIB IT team must ensure that EUFIB is linked to appropriate execution venues either directly or via an intermediary.
Fourthly, EUFIB needs to document the agreement of the best execution policy with each client. This needs to include prior agreement for off-market trades. The best execution policy needs to cover each class of instrument, otherwise the execution of orders will be documented per trade. EUFIB IT needs to be able to provide an audit trail that enables validation that the policy was applied. In addition, EUFIB must document any client instruction that overrides best execution policy.
Finally, EUFIB needs to document and implement the process for monitoring and review the best execution policy. This process must be at least annual, and every time a material change occurs that could affect the firm’s selection of execution venues. This will mean that rules governing that policy will potentially have to be changed regularly.
Consequences for IT
The consequences for EUFIB’s IT are not trivial. It must ensure the following three key points are addressed to avoid the risk of regulatory breach:
- The coherence of the published policy and the implementation. This will be challenging because policy may need to be implemented across the range of EUFIB order management systems and trade execution systems.
- The maintenance of the policy with the implementation. This will create more work for IT department to implement these changes and the process could quickly prove over-costly both in terms of time and human resources.
- The ability to demonstrate the best execution. This requires keeping pricing and policy for a given period of time and client group and demonstrating that the policy was executed for any given order.
Conclusion
MiFID will facilitate trading but business will get more complex as it deals with new regulations. Companies need to find easy ways to implement MiFID and to manage best execution policy on a sustainable and flexible way, while also managing policies across the entire organization and enhancing business agility and competitiveness.
References
1See “The European Commission on MiFID”:
https://europa.eu.int/comm/internal_market/securities/isd/mifid2_en.htm.
2See “The application of the Lamfalussy process to EU securities markets legislation”: https://ec.europa.eu/internal_market/securities/docs/lamfalussy/sec-2004-1459_en.pdf.
3See “Background Note: Draft Commission Regulation implementing the Markets in Financial Instruments Directive 2004/39/EC (MiFID) “: https://ec.europa.eu/internal_market/securities/docs/isd/dir-2004-39-implement/dir-backgroundnote_en.pdf
7Note that there is on obligation to include a venue if cost of connection is disproportionate.