Before the “Big Bang” of deregulation in 1986, which led to a period of self-regulation, there had been little specific financial services legislation. We can look back to the Prevention of Fraud (Investments) Act 1939, various adjustments in 1958, the authorisation of insurance companies in 1967, and the licensing of banks under the Banking Act of 1979. There had been several industry codes, but there was little, if anything, in the way of legislation regarding best execution.
Reporting statistic: Did you know that the introduction of MiFID II increased the number of transaction data points from 24 to 65?
At the time, self-regulation within a predefined structure offered the best of both worlds for the financial services industry: flexibility within a recognised framework protecting investors and markets. However, it soon became apparent that in a changing world, with a significant increase in trading volumes and the growing influence of financial giants, self-regulation would eventually be replaced.
There was significant movement on the regulatory front at the turn of the century, which resulted in:
- Implementation of MiFID I in 2007
- Expansion under MiFID II in 2018
- Post-Brexit adjustments from 2016
Immediately following Brexit, the UK and EU authorities appeared to be moving in the same direction regarding best execution legislation. However, there has been a degree of divergence in recent times, most notably with RTS 27 and RTS 28 reporting.
Divergence in reporting
As of 2021, UK firms and execution venues operating under UK financial services regulations are no longer required to produce RTS 27 and RTS 28 reports. The guidance from ESMA was slightly different, advising firms and venues to “deprioritise” the reports from 2020 and 2022, respectively. There was also some conflict in the way that ESMA recognised CFD platforms and services as trading venues, even though they did not have access to the required information to produce the statutory reports.
The RTS 27 report covered a number of execution quality metrics enabling investors and third parties to compare and contrast trade execution standards across different venues. RTS 28 was focused on the five main venues at which individual firms carried out the majority of their trade execution activity.
US regulatory adjustments
Looking further afield to the USA, SEC Rule 606 was introduced in 2000 and amended in 2018 and 2023 to reflect an evolving market structure. Changes to Rule 606 have enhanced transparency for investors and also brought an array of different revenues under the umbrella of best execution regulations.
Key elements of best execution legislation
In essence, best execution legislation obligates firms carrying out investment business to obtain the best possible result for their clients when executing client orders. This obligation relates to transactions carried out by the firm or passed to others to execute. There are numerous factors, the most basic of which are:
- Price
- Cost
- Speed
Beyond these three core factors, there are also more complex considerations such as likelihood of execution under the prevailing market conditions, prompt and efficient settlement, the size of the transaction, and the nature of the business. All of these factors come together to create a transparent trading procedure that gives clients confidence and assists with market efficiency.
The European Securities and Markets Authority (ESMA) published a consultation paper on 16 July 2024 covering order execution policies and obligations under MiFID II and MiFIR. The deadline for comments is 16 October 2024, and the final draft report must be submitted to the European Commission by 29 December 2024.
Details of the consultation
The consultation paper was the result of research carried out by ESMA, which revealed several common issues in the best execution strategies of financial firms, such as:
- Limited documentation to justify the choice of execution venue
- Only disclosing generic information about order execution policies
- Limited clarity that company execution policies were followed
Under the consultation, investment firms will be encouraged to revisit their order execution policies to include the following:
- Details of trading venues which ensure continuous best execution
- Identifying particular venues for different financial instruments/types of client
- Information used when seeking best execution with different venues
- Further details of automated trading services
In relation to the ongoing assessment of an investment firm’s order execution policies, they will need to set out clearly:
- The frequency and methodology used to monitor their order execution policy
- If monitoring is delegated to a third party, the process must be regularly assessed
- Policies must be reviewed at least annually
- The annual review process must include consideration for new execution venues
The consultation also includes reference to execution policies about client instructions and the execution of client orders through the company’s own account dealing. Individual firms must set out:
- Arrangements for dealing with specific instructions from clients
- Identify how orders with specific and non-specific client instructions are executed
- Document how client instructions might impact the venue used for best execution
- Detail instances where client transactions may be executed via the company’s own trading account
- How potential conflicts of interest are identified, managed and prevented
It still remains to be seen whether the FCA will follow in ESMA footsteps, or if we will see a further divergence of policy and approach with regards to best execution legislation.
Challenges in implementing best execution legislation
Historically, financial markets have been relatively adept at responding to emerging trends and new financial instruments. However, the exponential increase in the complexity of financial services over the past 20 years has caused serious challenges for global financial regulators. .
While the recent introduction of Consumer Duty Regulations has attempted to put client protection front and centre with the emergence of new checks, procedures and legal undertakings, a number of ongoing challenges still persist.
Data capture
The use of cutting-edge technology has facilitated the capture of in-depth trading data, which is required to monitor best execution practices. This has also expanded the amount of data reviewed and analysed compared to years gone by. The increase in the number of data points from 24 to 65 required systems to be adjusted, but this certainly won’t be the last significant change.
Potential conflicts of interest
As we mentioned above, regarding the ongoing ESMA consultation, financial firms are now obliged to disclose how they identify and manage potential conflicts of interest. This doesn’t change the focus on best execution for clients, but it does address potentially unavoidable conflicts of interest.
Regulatory complexities
In the immediate aftermath of Brexit, EU and UK financial regulators seemed to move in the same direction and appreciate the broader consequences of any significant diversions. Recently, there have been signs of slight divergence, although this is unlikely to be too dramatic as UK firms regularly trade with their EU counterparts and vice versa.
Technology infrastructure
In the past, many large financial institutions retained monitoring and regulatory activities in-house. As the regulatory landscape became more cluttered, in-depth, demanding, and expensive, implementing solutions from third-party vendors has become the preferred approach. This allows financial services firms to avoid the investment of time, money and human resources required to implement and maintain best execution monitoring systems in house.
The growing number of outsourcing options has allowed financial institutions to focus on their core operations, enhance their business, and increase income. Due to the technological nature of best execution monitoring services, they are easily scalable and have significant capacity.
How can eflow help you meet your best execution legislative obligations?
TZBE is eflow’s Best Execution and Transaction Cost Analysis (TCA) tool, that can accommodate a variety of trading platforms, financial instruments and asset classes. The combination of a considerable increase in trading volumes and regulatory obligations in recent years means that manual best execution testing is no longer an option.
Beyond simply monitoring for best execution, TZBE also provides:
- Automated and streamlined best execution testing
- Potential cost-saving insights into trading procedures
- The ability to evolve/grow with your business strategy
- Strengthening of regulatory responses, avoiding penalties and fines
- Automated record-keeping saves time and enhances accuracy
- The opportunity to tailor the system to your specific requirements
Other benefits include automated data enrichment, testing against industry benchmarks and the archiving and indexing of historical data. There’s much more to consider than just a best execution monitoring service.
Trading statistic: As of 2024, 80% of trades in UK markets are executed electronically, helping brokers achieve best execution more efficiently.
The future of best execution legislation
Amid broader regulatory changes and enhanced obligations for financial services companies, it’s important not to lose track of the core focus: market integrity and client protection. The globalisation of investment markets has increased cross-border trading and could (potentially) bring different best execution regulations into play. In reality, it is in the best interests of regulators to work together, creating compatible regulations and reporting requirements to minimise the cost of monitoring best execution and maximising regulatory protection.
Rather than individual financial institutions constantly investing in new technology and seeking global regulatory interconnection, eflow can react to changes and, working with third parties, encourage cooperation between regulators. This means that all clients benefit from this ongoing investment, not to mention the experience and expertise built up over the years.
Case studies
It is not difficult to see how conflicts of interest may emerge when it comes to best execution; it may be useful to look at practical case studies from recent times.
Barclays Capital’s $2 million fine
Between January 2014 and February 2019, US regulator FINRA discovered that Barclays Capital routed all customer orders through its own trading system, LX, before rerouting to competing venues where applicable. The regulator found evidence of a lower fill rate on the LX platform, which was detrimental to clients.
Deutsche Bank fined $2 million
FINRA was again headline news in 2022, delivering a $2 million fine to Deutsche Bank for best execution violations. Unless otherwise requested by clients, the default routing path for client orders was through the company’s ATS trading platform, known as SuperX. Whether transactions were executed through the platform or rerouted to alternative venues, the regulator found inherent delays and occasions where orders were not fully executed.
GlobaLink Securities issued $200,000 fine and a restitution order
In addition to the $200,000 fine, GlobaLink Securities was ordered to pay nearly £400,000 in restitution payments to customers. The company was found to have charged markups and markdowns ranging from 2.3% to 9.34% on 137 corporate bond transactions. This was despite the fact that the company’s clearing firm carried out the client transactions with no additional costs to GlobaLink Securities.
