MiFID “best execution” requirements are likely to affect current UK market practices, though the UK Markets have already been alerted to prospective changes in best execution through one of the stream of FSA consultation papers in 2002. This acknowledged that best execution should and does in fact depend on factors over and above price.

Under article 21 of MiFID “a firm must take all reasonable steps to obtain the best possible result, taking into account price, costs, speed, likelihood of execution and settlement, size nature or any other consideration relevant to the execution ...”

This must be complemented by:

• Effective arrangements for complying with the MIFID best execution requirements.
• An execution policy explaining factors which a firm will consider when execution orders and providing information about “execution venues” which it will use.
• Informing customers about the firm's execution policy and obtaining their consent.
• Assess the execution venues in its execution policy at least annually and consider including other execution venues.
• Monitor the effectiveness of its execution arrangements.
• If requested show that a customer's order has been executed in line with the firm's execution policy.

In their consultation paper on Implementing MiFID ‘best execution' requirements the FSA has, amongst other matters, critically focussed on the key challenges for implementation. The FSA has identified possible options to meet the challenges; outlined a further option for providing best execution in ‘dealer markets’ based on the use of benchmarks and invited comments on the potential costs and benefits of different options for complying with the new MiFID requirements. Finally, the FSA has included several questions to draw out specifically difficult implementation issues without further clarification from the financial regulators.

This article focuses on the challenges and issues with a technology focus and content.

Execution policies and arrangements

There is an implicit assumption amongst legislators and regulators, yet to be proved, that MiFID will encourage competition amongst “trade execution” venues and increase fragmentation. Accordingly MiFID is seeking to establish an improved and, for some regulatory regimes, a new regulatory framework for operation of best execution policies designed to protect customers, business and retail, but not “eligible counterparties”.

Development of large scale algorithmic trading capabilities across all instruments covered by MiFID would provide the most comprehensive process for measuring and demonstrating best execution to customer and regulatory satisfaction. Indeed, MiFID will stimulate more extensive deployment of algorithmic trading for high volume lines of business, where it may be justified on a cost and efficiency basis, but it is costly and uneconomic for many firms and lines-of-business. More immediately, implementation of such systems and integration of them with order management systems would be impossible within the current MiFID implementation timetable.

The FSA, recognising that a plethora of different and variable criteria beyond transaction price make for best execution, has proposed that benchmarking may be the most appropriate method on which firms may base their policies to establish, monitor and evaluate best execution. IBM's extensive benchmarking work for the FSA has demonstrated that this is probably the most pragmatic approach to meet the spirit of the regulations but does demonstrate that even benchmarking is something of a ritualistic exercise when benchmarking less liquid and esoteric instruments.

The costs of accessing, collecting and evaluating the benchmarking data present an opportunity, albeit, as yet, a commercially unquantified opportunity, for information and software vendors to provide benchmarking services. At the same time they provide an opportunity for exchanges/MFTs/Systematic Internalisers with new opportunities for exploiting the data with the result that the costs of complying with best execution may actually result in an increase in transaction costs for customers and an unrecognised cost of consumer protection.

Dealer markets

While the dealer market may seek to restrict their dealings to the customer classification “eligible counterparties”, the only customer classification which may waive their rights to operate under the conduct of business rules including best execution requirements. The FSA appears to be of the view “that under MiFID there may be demand from retail and professional clients for best execution in relation to financial instruments typically available from dealers. This may pose a dilemma to the dealer market because the MiFID appears to restrict retail and some professional customers from agreeing to designation as ‘eligible counterparties’."

Dealers may limit their dealings to eligible counterparties but that is a commercial decision. However, where dealers wish to provide a service on a best execution basis the challenge is to manage the conflict of providing market liquidity by dealing on its own accounts through trading its inventory and at the same time providing customer protection by best execution.

Again the FSA is proposing deployment of benchmarking, albeit through “extraction of particular characteristics of reference prices, which make them suitable benchmarks for particular instruments or in particular circumstances”. However, the FSA seems to be aware that it has a statutory duty to maintain the UK's position and reputation as a major financial dealing centre. Its consultation seeks comments from the dealing community about the economic impact and cost impact of best execution. Clearly, the FSA would not wish to drive any markets away to other geographic centres for the sake of heavy-handed implementation of best execution on the dealing community.

While commercial opportunities also present themselves to information vendors and software community in providing relevant benchmarking services, the cost and efficiency demands may erode the commercial margins, detracting from the business case.

Reviewing and monitoring best execution

MiFID leaves firms to establish their own arrangements or reviewing and monitoring that it is meeting standards for best execution but does require that:

• Firms review (“Assess on a regular basis, whether execution venues enable the firm to obtain the best possible execution results for clients on a consistent basis”)
• Firms monitor (“Monitor the effectiveness of its execution arrangements in order to identify and where appropriate, correct any deficiencies”)

Information on execution quality is at the core of “meaningful assessment of both execution venues and ensuring that customer orders are executed in line with each firm's policy”. This requires firms to capture data from trading venues. Of course, transparency varies across markets and instruments influenced principally by their liquidity. More fundamental to the review and monitoring processes is the inclination of the market venues to make all information available to the firms and at what price to enable them to review and monitor best execution and demonstrate this to their customers (and the regulators). This is an issue, which the FSA recognises is not entirely within the control of firms.

The dangerous, underlying assumption in this complex regulation is that MiFID will, indeed, succeed in breaking down the concentration rules, which currently require trades to be executed on particular markets, specifically national securities exchanges. There is no guarantee this will happen or that it will happen quickly. In the circumstances, firms should be pragmatic and selective in their approach to data collection, refraining from excessively sophisticated large scale and complex technology projects. Thus it may be appropriate to invest in enhancing high volume order management systems for highly liquid instruments through capturing substantial highly granular amounts of data from major venues. Equally, a manual periodic scrutiny of information in respect of highly illiquid instruments and their venues should suffice.

The FSA has clearly performed a relatively exhaustive analysis of the consequences of MiFID best execution implementation in the short time since the publication of the MiFID following the so-called level II process in February. The concern is that the FSA's own questions recognise some of the issues, which cannot be answered without certainty of national regulatory rules. How are less sophisticated regulatory regimes to address best execution issues in the same way as the FSA? If they do not, MiFID is unlikely to produce a best execution level playing field. If the timeline to MiFID implementation is to be adhered to across the European Economic union, best execution implementation will initially be broadly a manual, judgmental review and monitoring process. Application of sophisticated technology to the review and monitoring process may prevail if and as firms see both a MiFID level playing field and fragmentation of markets through competition by other national exchanges, MTFs and Systematic Internalisers.