• wblogo
  • wblogo
  • wblogo

Best execution, best interests

Stuart Holman, CCL, Director, London, 5 November 2014

articleimage

Stuart Holman, a director at CCL, the City of London's oldest compliance consultancy, dissects the UK Financial Conduct Authority’s recent thematic review of best execution and payment for order flow, adding some tips for nervous compliance officers.

The UK Financial Conduct Authority’s recent thematic review of best execution (the duty of every stockbroker or other investment service firm to carry out orders on behalf of customers) is relevant for all firms that execute, receive and transmit or place orders for execution, including investment managers. There are, however, wider lessons to be learnt concerning the management of conflicts of interest and how to act in the best interests of clients that are relevant for all firms in the industry, according to Stuart Holman, a director at CCL, the City of London's oldest compliance consultancy.

 

The ‘Thematic Review on Best Execution and Payment for Order Flow’ (TR14/13) identifies and outlines problems that firms have faced when designing 'best execution' policies and procedures, as well as some of the common shortcomings in the areas of implementation, review and oversight. The review also reiterates the FCA’s position on Payment for Order Flow (PFOF) and how this practice sits alongside 'best execution' requirements. The analysis forms part of the FCA’s wider review of wholesale conduct.

 

A passive approach by firms is not acceptable

 

Best execution is a wider endeavour than simply achieving the ‘best price’ for a client and a number of factors must be taken into account, according to the specific criteria and client type. The client itself, as well as the individual order in question, must both be taken into account. Other factors include the financial instrument to which the order relates and the execution venue.

 

Crucially, firms cannot assume that clients themselves will take responsibility for ensuring that 'best execution' takes place; TR14/13 makes it clear that the regulator does not consider a passive approach to best execution (whereby firms assume that clients will leave and find an alternative provider if 'best execution' does not take place), to be an acceptable attitude.

 

Payments for order flow

 

PFOF is the practice of a broker receiving payments from a market-maker in exchange for directing 'market flow' to that market-maker. This practice is often thought likely to bring about conflicts of interest between the firm and its clients, breaking the regulator’s rules regarding inducements and 'best execution' as it does so.

 

TR14/13 identified instances of firms continuing to receive PFOF, despite this being a contravention of an earlier FCA regulation, FG12/13.

 

Using ‘carve-outs’ to limit scope

 

One problematic area that TR14/13 identifies is the question of where 'best execution' applies, which activities it extends to and how ‘carve-outs’ may be used in order to limit its scope. The FCA has found that firms are using such ‘carve-outs’ too frequently.

 

Every firm must apply a four-part cumulative test whenever it is uncertain whether a client falls into the ambit of the FCA's 'best execution' requirements.

 

Internal execution and the management of conflicts

 

In the instances where firms execute client orders internally, or through connected parties, the FCA could find no evidence to suggest that this led to 'best execution' or the effective management of conflicts of interest. It is acknowledged that firms may benefit from internal execution; however there is a danger that, as firms are only accessing a part of the overall market, better execution may be available elsewhere. This can result in a conflict of interests between firms and their clients. Internal execution is permissible under certain circumstances, but firms must ensure that they have secured express consent.

 

Effective management information

 

TR14/13 specifies that the monitoring of 'best execution' ought to cover all aspects of a firm’s activities and must lead to corrective action if that is appropriate. This means a requirement for both pre- and post-trade monitoring, enabling firms to select the best execution venues and effectively evaluate the performance that they have achieved.

 

A common failing in this area, according to the thematic review, stemmed from firms being unable to show the regulators how monitoring had led to their decisions to make changes. It was often found that the information that front office staff gathered during their monitoring exercises was not transformed into management information, with the result that the senior management of the firm in question undertook little or no review.

 

Oversight and accountability

 

Finally, and closely linked to the problems identified in relation to monitoring, the FCA found that there was a lack of certainty within firms about who was responsible for the oversight and review of 'best execution' policies and procedures, both in their establishment and their eventual application.

 

In terms of the practical reviews that firms must undertake annually, there is evidence that this exercise is silo-ridden. There is typically no input from the front office staff; this inhibits communication between the continuing review process and the people whose job it is to make formal changes to policy and procedure.

 

A pro-active approach

 

Firms must ensure that they take a pro-active approach to 'best execution'; a passive approach is likely to incur the wrath of the regulators.

 

Firms need to satisfy themselves that they are obeying the FCA's 'best execution' rules now, in order to prepare for the changes that MiFID II (the second Markets in Financial Instruments Directive) will bring about. The more a firm can do to smooth its transition to the new regime at this point, the better. Firms should also use 'best execution' as a starting point on their long journey towards a comprehensive appreciation of how often, and indeed whether, they act in the best interests of clients. In theory, they should be doing so at all times.

 

* Stuart Holman is CCL's deputy managing director for the UK. He can be reached on +44 207 638 9830.

Latest Comment and Analysis

Latest News

Award Winners

Most Read

More Stories

Latest Poll