The Perils and Opportunities of Best Execution in a Multi-market Structure

With a multi-market structure comes fragmented liquidity and competition, and at its core lies the concept of best execution or, put another way, achieving the optimum trading outcome for your client. Two broad schools dominate regulatory thinking on the subject of best execution:

  1. A strict, rules-based stance putting an absolute definition around the concept and its measurement, as seen in the US.
  2. A more relative, principles-based approach as seen in the UK that asks firms to adopt their own procedures so long as execution effectiveness is ensured.

The difference between the rules-based or the principles-based approach is like either setting a rigid speed limit or asking every driver to proceed safely along the liquidity highway. While the objective is the same – obtaining the optimum outcome for your passenger – implementation, measurement and enforcement are very different.

 
A Noble Goal

Irrespective of the approach taken, best execution has proved an elusive goal and, in some quarters, has called into question the very logic of breaking up markets in the first place. Problems of measurement, fairness and policing are just some of the issues that both buy-side and sell-side firms have to wrestle with. However, some firms have taken the basic concept of best execution, refined it and turned it into a valuable competitive differentiator. At the same time, regulators have shifted the goal posts so that market safety and systemic risk have replaced competition and market fairness concerns. Now that Australia has established its own multi-market structure, it is unlikely to be an exception to these issues.

After a slight change of heart, the Australian Securities and Investments Commission (ASIC) is now planning on following a principles-based regime requesting market participants “take reasonable steps to obtain the best outcome for their clients”. In doing so, Australia will inherit the same measurement challenges faced by its European counterparts where there is no official record of time and sales data consolidated across all venues. This makes meaningful comparisons between brokers and their smart algos very difficult. The fact that brokers are not obliged to consider every possible venue and that not all venues list every stock only makes matters worse. The opacity that results is regarded as one of the key failings of the Markets in Financial Instruments Directive (MiFID) regulations and, for some, punctures the whole notion of best execution entirely. In light of this failure, it is surprising that ASIC is taking a similar laissez-faire attitude.

 
The Views from the Buy- and Sell-side

With the formalisation of best execution, specific challenges have been created for Australia’s buy- and sell-side community as they find themselves more responsible for execution quality.

When best execution became law in Europe, the sell-side focused on smart order routing (SOR) technology that would allocate orders according to whatever best execution policy they had in place. Because these brokers were free to adopt any such policy many were tempted to ignore any venue that proved tricky (or expensive) to reach. Australia has made a similar obligation and, as seen in Europe, these systems must be reviewed regularly to ensure they continue to achieve the optimum outcome for their clients.

Understanding why your SOR made a particular decision can present a real problem, particualrly in today’s split-second trading environment. A bigger issue, however, relates to the imperative to audit and prove (for up to seven years in Australia’s case) the efficacy of any particular execution. Good procedures simply aren’t enough without access to the underlying state of the market as well. While this represents another level of investment for market participants it also helps pinpoint where the real competitive edge lies.

In the US and Europe the more progressive firms have developed this whole concept of proof way further than the rules require them to. This had led to the creation of new types of execution consulting services that improve client relationships and attract new customers.

As markets become more complex, and lit and dark liquidity continues to coalesce, this type of facility has become a powerful source of differentiation and customer acquisition/retention. Naturally, it requires commitment to more intelligent workflow and so it is more easily adopted by the larger brokers. Yet even smaller sell-side firms can develop this niche, especially by rating the smart (or otherwise) performance of larger firms and guiding their clients accordingly.

In general, the buy-side faces the same form of best execution jeopardy as their sell-side counterparts: they must understand the execution quality they are getting and then prove it both to their customers and the regulator. Australia is different to other regions, however, as the formal best execution obligation only extends one step out from the market participant to its direct client.

For buy-side firms that trade relatively infrequently the key to best execution lies in broker selection, but this exposes a fundamental flaw in the whole process. The buy-side needs to reward its brokers for their research in commission dollars, and yet those brokers that provide the best research may not necessarily have the flashiest smart routing kit.

Best execution presents a different challenge for those buy-side firms that trade more actively. Because they are accessing liquidity more frequently, execution quality has a greater impact on overall portfolio performance. They therefore need to understand the performance of their brokers on almost a trade-by-trade basis. Those that use multiple brokers (as most do) end up with multiple execution reports each compiled using different metrics that renders any effective comparison almost useless.

The solution, obviously, is for buy-side firms to equip themselves with their own tools. By investing in independent transaction cost analysis (TCA) tools the buy-side can really understand the impact that execution quality has on portfolio performance, set effective execution goals and select the most appropriate broker for different situations.

 
Beauty or Beast?

Under a principles-based regime, key measurement challenges exist that make meaningful broker comparison an illusion. Best execution is, however, inextricably linked to multi-market trading and so for Australia, just like other markets, it is very much here to stay.

This presents firms with a stark choice. One route is to see it as a burden reluctantly driven forward by the wish to minimise cost and avoid procedural change. Alternatively, firms can fully embrace the changes and break through into a world of opportunity and competitive advantage. And, if the experience of the rest of the world is anything to go by, this should pay dividends as the focus on achieving optimum trading outcomes intensifies.

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