Unpacking ESMA’s technical standards for best execution: A closer look at the latest consultation

Legal background and purpose of the Technical Standards

On 8th March 2024, an amendment to the Directive on Markets in Financial Instruments (MiFID II review) was published in the Official Journal of the European Union. This amendment mandates the European Securities and Markets Authority (ESMA) to develop Regulatory Technical Standards (RTS), aiming to specify the criteria for establishing and assessing the effectiveness of investment firms’ order execution policies.

ESMA’s latest Consultation Paper seeks stakeholders’ views on these proposed standards. Feedback from this consultation will be considered by ESMA, with the final report and draft RTS expected to be submitted to the European Commission for endorsement by December 29, 2024. This blog serves to summarise and contextualise the RTS, providing investment firms with a clear understanding of the new criteria.

Revisiting MiFiD II Article 27 - Best Execution

Understanding MiFID II’s Article 27 is crucial as it contains firms’ current best execution requirements, and is therefore the backbone of the proposed RTS. This article mandates that investment firms take all sufficient steps to achieve the best possible result for client orders, considering factors like price, costs, speed, and likelihood of execution and settlement. For retail clients, it emphasises the importance of total consideration, including all related execution costs. Firms must implement and monitor an effective order execution policy to ensure transparency and consistently optimal outcomes for clients.

Shortcomings in firms’ execution policies

ESMA’s MiFiD II reviews have highlighted shortcomings in firms’ actual implementation of execution policies. Some firms have failed to:

• Provide sufficient documentation to justify their choice of execution venue
• Properly demonstrate that they executed client orders in accordance with order execution policies
• Disclose details other than generic information about order execution policies and their steps taken to obtain the best possible result when executing client orders

As a result, the RTS laid out in the consultation paper are focussed on making sure that order execution policies effectively contribute to enhance the execution quality for retail and professional clients.

Key elements of the proposed draft RTS on firms’ execution policies

1. In their order execution policies and arrangements, firms should distinguish between the different classes of financial instruments they offer.

These classes should be based on ISO Standard 10962, using the first two letters of the CFI to correspond to a class of financial instrument. Additionally, each country of primary listing for equity instruments (CFI code starting with “E”) should constitute a separate class. Firms may, in some cases, cluster several classes of instrument into a single class if it doesn’t impair achieving the best possible result.

ESMA Q1: Do you agree with the proposed categorisation of classes of financial instrument? Could the methodology based on the classification of instruments in the MiFiD II RTS 1 and 2 used in the context of MiFiD II transparency reporting be an alternative?

• The alternative methodology ESMA is referring to: A fixed list of classes could be used, based on MiFID II RTS 1 and 2 classifications.
  • Equities by country: Each country of primary listing for shares in companies would be a separate class
  • Other instruments: Other financial instruments could be grouped into 15-20 classes
  • Clustering allowed: Clustering of several classes into a single class could also be permitted under this methodology

2. Firms should pre-select eligible venues for client order execution according to meaningful criteria determining to what extent the best possible result can be obtained for clients.

Venues are to be selected per class of financial instrument, per category of retail and/or professional clients, and by accounting for certain further factors including:

• Different order frequencies and values for retail and professional clients respectively
• Whether the executed financial instruments are EU or non-EU instruments

Overall, the draft RTS proposes that firms keep an updated list of venues for the execution of client orders. The list must consist of venues authorised by national competent authorities or third-country authorities, and it must be determined according to the firms’ internal governance procedures. The list must include:

• Date of approval, name and capacity of the person or name of the governance body that approved the venue
• Which classes of financial instrument the venue can be used
• Which categories of clients the venue can be used

ESMA Q2: Do you believe that the current wording of the RTS is clear and sufficient with regard to the content of the order execution policy where an investment firm selects only one execution venue to execute all client orders? Or should the RTS provide for specific criteria to be taken into account when assessing if the selected venue achieves the best possible result in the execution of client orders? Please also state the reasons for your answer.

The proposal to categorise venues by class of financial instrument and client type, and to consider order frequency and value, ensures a tailored approach. The requirement for an updated, governance-approved list of venues promotes transparency and accountability. The current wording of the RTS may or may not be sufficient, but including specific criteria for assessing single venue selections would enhance clarity and ensure consistent best execution practices.

3. Firms should distinguish between obligatory and discretionary factors in cases where a client order could be executed at several venues.

Criteria and relative importance must be specified for (i) each class of financial instrument (ii) retail and professional clients and (iii) based on analysis which must include certain factors such as:

• All costs directly related to the execution
• Real-time market or historical data on the relevant financial instrument or class of instrument
• Size and nature of the order

If the firm uses an automotive order routing system, it must describe the main characteristics of the system.

ESMA Q3: Do you agree with the proposed factor of “order sizes” respectively for retail and professional clients, to be considered in investment firms’ selection of eligible execution venues in their order execution policy and internal execution arrangements (see Article 4(1)(d)(i and ii) of the draft RTS)? If not, what alternative factor would you propose?

Differentiating order sizes for retail and professional clients aligns with the principle of best execution by ensuring that larger, more complex orders are handled with the necessary sophistication, while smaller orders receive appropriate attention to detail. Some alternative factors include liquidity conditions or market impact considerations to further refine the execution quality.

4. Firms must continuously monitor their execution quality, triggering reviews of their execution policies and venue selection if significant events impact quality or if performance is deemed to be insufficient.

Firms are to specify the frequency and methodology of their monitoring within their execution policies, allowing them to assess all transactions or representative samples for each class of financial instruments. Monitoring performance against specific thresholds can prompt venue reviews if performance falls below predetermined levels. Firms may use third-party monitoring but must carefully evaluate the third party’s processes.

Firms are also required to conduct regular reviews of their execution policies and arrangements, assessing venues at least annually or upon material changes. Reviews must consider new venues and services, and firms must update their policies and correct deficiencies promptly, within three months at most. Assessments should compare transaction prices against reference data and distinguish between execution-related fees and venue membership costs. Third-party analysis is permitted but must be thoroughly reviewed by the firm to ensure it represents the firm’s client base accurately.

ESMA Q4: Do you agree with ESMA’s proposals for the specification of the criteria for establishing and assessing the effectiveness of investment firms’ order execution policies?

ESMA Q5: Do you agree with ESMA’s proposal that investment firms may rely on monitoring and assessments performed by third parties, such as independent data providers, as long as firms assess the processes of these third parties?

Continuous monitoring and regular review of execution policies are vital for maintaining best execution standards. ESMA’s proposals to specify monitoring frequency and methodology ensure consistent oversight and prompt action when performance falls below set thresholds. Allowing third-party monitoring and assessments is practical, provided firms rigorously evaluate these processes. This balance of internal and external oversight helps firms stay compliant and adapt to market changes effectively.

5. Firms must outline how they handle specific client instructions, detailing the impact on venue selection and best execution criteria.

Within their order execution policies, firms must differentiate between orders with and without specific instructions, explaining that specific instructions involve choosing from multiple options or directing the firm to handle the order differently from the policy. Only the instructed part of the order is treated as specific instruction, with other parts processed normally. Additionally, if firms allow clients to choose execution venues, the policy must explain measures to avoid inducing venue choices and include a warning about the potential impact on achieving the best possible result.

ESMA Q6: Concerning the specific client instruction, should it be possible for an investment firm to pre-select an execution venue in the order screen, where the firm invites its clients to choose an executing venue out of multiple options? And if so, do you agree that only if the client chooses a different venue than the one pre-selected by the firm, the choice of execution venue does constitute a specific instruction?

Allowing clients to choose execution venues requires clear measures to prevent undue influence and ensure clients are aware of the potential impacts on execution quality. The proposal for pre-selecting venues streamlines the process, but it’s essential that any client deviation is explicitly treated as a specific instruction to maintain transparency and regulatory compliance. This approach balances operational efficiency with client autonomy and regulatory standards.

6. Investment firms’ order execution policies must ensure the best possible result for clients when executing orders on their own account.

Firms must specify that “own account dealing” is allowed only if it is expressly provided for in the policy and results in the best outcome for clients. The policies must also address conflict of interest management and ensure fair pricing for OTC products, complying with organisational and methodological disclosure requirements.

ESMA Q7: Where an investment firm executes client orders by dealing on own account (including back-to-back trading), in light of the specificity of this execution model and since it is bound by the rules governing best execution, do you believe the current text is clear with regard to what kind of obligations an investment firm applying such models should comply with? Or do you believe it would be useful to provide in the RTS list and explanations of information that should be included in the order execution policy, such as related to the method and steps to be taken by the firm to establish the price of client transactions in back-to-back trading, or the methodology for the firm’s application of mark-ups or mark-downs in such order executions?

Dealing on own account inherently involves conflicts of interest, as firms may prioritise their own profits over clients’ best interests. Specific guidelines in the RTS for price setting and applying mark-ups or mark-downs would mitigate these conflicts by ensuring transparent and fair pricing practices. These guidelines would provide a clearer framework for firms to follow, potentially enhancing compliance and protecting clients from unfair practices

Conclusion

The proposed RTS under MiFID II aim to elevate the standards of best execution by requiring investment firms to adopt a granular and data-driven approach to order execution. But while the new rules should drive better client outcomes, they present operational challenges for firms reliant on more manual, spreadsheet-based evaluation.

eflow Global’s TZBE system is specifically designed to meet these demands, automating the analysis of cost, speed and likelihood of execution, broken down by asset class. The platform is entirely customisable and firms are able to tailor the system to account for organisation-specific requirements and client instructions, ensuring ongoing compliance with the detailed stipulations of the RTS.

The ESMA consultation serves as an opportunity for investment firms to have their voices heard in the development of the RTS. But with a limited feedback period and a likely short implementation window, it’s important that firms are proactive in evaluating their current execution policies and surrounding technology stack to ensure they are prepared for more rigorous standards. By embracing advanced solutions like TZBE, firms can not only navigate these regulatory changes but also position themselves at the forefront of industry standards, ensuring they deliver the best possible outcomes for their clients in an increasingly competitive market.