The EC’s Markets in Financial Instruments Directive will affect buy-side firms from April 2007, obliging them to create a policy for best execution. But as Dan Barnes reports, many of them are still not taking the change seriously.
The impact of the EC’s Markets in Financial Instruments Directive (MiFID) upon the sell-side has been discussed ad infinitum, but those on the buy-side should also be aware of the changes that the directive will make to their business. The pan-European regulation comes into force in April 2007 and it will have a host of implications for the buy-side.
Clare Vincent-Silk, principal at consultancy Investit, says that this has not yet been fully taken on board. “On the whole, you get comments, such as ‘we’re waiting for the Financial Services Authority to tell us what to do’ or ‘It will affect the sell side, it shouldn’t impact us’. Generally, there is a head-in-the-sand attitude, with people not realising that they’re involved,” she says.
Best execution
The Level One discussions at which the principles of MiFID were confirmed have been concluded. The ongoing Level Two discussions are dealing with the implementation detail. Concerns raised from these are essentially around the concept of best execution and market fragmentation.
The term ‘best execution’ was an issue in the US when discussing the ‘trade through’ rule, meaning that a best price had to be found for a deal by checking prices across multiple exchanges. The argument against it was that time taken checking all the prices gave them time to change, thus invalidating the check and preventing the trade from taking place. This, it was argued would result in ‘no execution’ rather than ‘best execution’.
In the current environment, best execution for the customer is vital for creating differentiation within the marketplace, argues Anthony Kirby, director, financial services at Accenture. “We’ve gone through a climate of unbundling transactions so there is no softing any more, in principle there is no research any more to keep the ‘stickiness’,” he says. “So the only way that investment banks and asset managers can improve the quality of the service is through the numbers, through the metrics evidencing best execution. If you can provide the proof to a client that you provide best execution they will come back for more. So the model is self re-enforcing.”
MiFID regulations
MiFID directs a buy-side firm to create a policy for best execution that is provided to and must be provable to the client. For some, interpreting this has been a challenge. When formulating MiFID, the Committee of European Securities Regulators (CESR) had three working groups chaired by different regulators. Adam Kinsley, director of regulatory strategy at the London Stock Exchange (LSE), notes: “Callum McCarthy [Financial Services Authority chairman] chaired the part that dealt with the conduct of business rules, which is the issue that hits the firms the most. The best execution rules were based upon the FSA’s consultation of about five years ago, CP 154.”
With consultation by the regulators ongoing, certain myths have begun to spring up. ‘Best execution’ has been interpreted by some as checking with a certain number of venues (including brokers) to ensure that the best price is found. However, it is currently not as fixed as that, says David Lawton, head of markets policy at the FSA. “The MiFID Level One article that deals with best execution sets out a range of variables that a firm could take into account when determining its best execution policy. That is not just price but other factors such as cost and speed,” he says. “Part of the Level Two process has been to say ‘How should firms weight these different dimensions of execution according to different clients?’ and there are some who argue that for retail clients it is really price and cost that matter most where others would disagree.”
Mr Lawton is forthright about those predicting an obligatory check with a set number of venues. “There is no requirement in MiFID to make any phone calls. It has been reported in a number of articles that there is a requirement to get five quotes – that is not the case. MiFID simply says you have to establish a policy, as part of that policy you have to select the execution venues that you think will offer your client the best possible result on a consistent basis and you have to tell your client what those venues are.”
This openness could conceivably leave a firm deciding to use a stock exchange as its one venue if it believed that would offer the best result consistently. However, this will still have to be agreed with clients, requiring research into the various potential venues and possibly additional purchase of technology, as Ms Vincent-Silk points out.
“There will be a greater need for pre-trade and post-trade transaction cost analysis tools that allow you to analyse the liquidity, price and likely market impact of trading this particular order on a trading venue. Therefore, you are looking at the purchase of additional systems for the buy-side to show that you are giving your clients best dealing performance,” she says.
Fragmentation
Another change affecting asset managers will be the fragmentation of the marketplace. MiFID allows off-market trading to occur through systematic internalisation. A systematic internaliser is defined as “an investment firm which on an organised, frequent and systematic basis, deals on its own account by executing client orders outside a regulated market or an multilateral trading facility”. As such, the firm does not have to report trading to a central exchange but rather in a format that is easily consolidated – a big step for countries with a concentration rule or exchanges in smaller countries.
This creates a dual problem, as Simon Thompson, managing director, head of equity portfolio trading, at Barclays Global Investors points out.
“One issue is about trying to reconsolidate the data from various venues to get a full picture of what has happened. The second issue is created around assessing the validity and integrity of that data.”
The LSE’s Mr Kinsley does not think that aggregation of the data should present too much of a problem. “People are probably overestimating the number of venues at which prices are going to be published. There will be fewer than people are suggesting,” he says.
The current providers of market data are name-checked as the main sources for the future by many, but the extra services may come at a price for the buy-side, says Ms Vincent-Silk.
“Of course, this is an opportunity for them to put their costs up as they provide more information. Over-the-counter instruments are now going to have to have quotes. With more instruments covered and a more fragmented market the likelihood is that your market data costs are going to go up.”
Validation vs consolidation
The real concern is the latter issue around validation, suggests Mr Kinsley. “Today we [the LSE] not only publish trade data, we regulate that data. We are able to ensure that the tape that people see is a clean one,” he says. “For trades that are run through us, we can carry on doing that. There is a challenge – and I think it is one for the regulators and the community at large – to ensure that the current level of scrutiny is applied to all trading activity.”
However, as part of that community Mr Thompson does not see an easy resolution. “It has been suggested that Reuters and Bloomberg may be interested in providing the service of taking this data and not charging for it – they would also have to take on the regulatory role of verifying this data. Both have specified they have no interest in taking on that role. They want to consolidate the data but they don’t want to be market monitors.”
Given the commercial implications, for those with their heads in the sand, it is time for them not just to look up, but to start making their voices heard.
