Lessons from America
In order to accomplish best execution in Europe we should consider the US perspective argues Samuel Lek, Chief Executive Officer at Lek Securities.
What are the obstacles to best execution in Europe?
MiFID requires that a broker obtain “Best Execution” for its customers. Without a doubt, this is a most laudable goal. The term sounds admirable and why would any customer be satisfied with anything less than best execution?
But in Europe, how to accomplish best execution and demonstrate to a client that he received the very best price available creates a lot of uncertainty due to markets being less transparent.
What can we learn from the US experience?
In the United States, Congress mandated a Consolidated Quote System (CQS). All exchanges are required to publish their bids and offers to a centralised location and anyone subscribing to the system can see which exchange is publishing the highest bid and the lowest offer. This transparency is a good thing, because markets work best when all interested buyers and sellers come together in a centralised location. Since ancient times, almost every European town and village was built around a market in the centre of the community where buyers and sellers could meet to trade their wares. The same is true for the financial markets.
Fragmentation, the establishment of many markets with poor communication between them, makes it difficult to find the best price. For many years, this was the reasoning that the London and New York Stock exchanges used to justify their monopolies in trading stocks.
However, allowing the major stock exchanges to operate as monopolies has been shown to have its own problems. As one might expect, monopolies result in high trading fees and an unwillingness to embrace new technology. The Consolidated Quote System is an elegant solution which attempts to address the seemingly conflicting goals of centralising the financial markets, without creating monopolies.
Exchanges compete to display the best possible prices, and because clients have a choice in where to send their orders, given the same displayed price, the client will have an incentive to send the order to the market that charges the lowest fees. This accomplishes centralisation of price discovery whilst maintaining competition between exchanges. The client can obtain the best price, across all market centres.
How can things be improved in Europe?
In Europe, quote publication is more fragmented and knowing where the best price can be obtained is more difficult to determine. Undoubtedly, the establishment of a pan European Consolidated Quote System would be a major improvement, but it’s not likely to become a reality in the near future. In the absence of this however, brokers should closely monitor available prices on major exchanges, before deciding where to send a client’s order. Clients can hardly be expected to do this themselves as having access to multiple quote feeds is not realistic for a retail client, but their brokers can provide a valuable service here. As a broker, this is certainly one of our top priorities.
In the absence of a CQS what else should we be looking out for?
Clients should also be aware of signs of what we believe are red flags which can be highly suggestive of something less than best execution. Payment for order flow is, in our opinion, something indicative of the possibility that the client’s interests are not being served in an optimal way. When a market maker is willing to pay a broker for the opportunity to sell stock to a client, this is highly suggestive that the market maker is not giving the client the best possible price. In fact, the market maker is probably reasonably sure that he can sell stock to the client and subsequently buy it back for his own account at a cheaper price and thus pocket a profit. In fact, he is so confident of this that he is willing to offer the broker compensation for routing the client’s order to him. I consider this to be a conflict of interest. At my firm we do not seek payment for order flow and when we nevertheless receive it, we believe that this compensation belongs to the client. We believe that the broker owes the client a fiduciary duty and that we should not place our own interest in receiving payment for order flow ahead of our clients’ interest in obtaining Best Execution.
What advice would you give potential clients in Europe?
Caveat Emptor! Clients that cannot self-direct their orders should ask their brokers where their orders were sent and whether or not the broker received compensation. i.e. payment for order flow for the order. Clients should consider selecting only those brokers that place the clients’ interest first and that seek only to obtain best execution, even if this means paying a slightly higher commission.
We are proud to offer a bespoke service that accomplishes just this goal. As an agency broker and clearing firm, we are able to ensure best execution for our clients. In addition, our agency-only approach removes any conflict of interest that many banks with proprietary desks face. By using a broker that allows clients to self-direct orders, traders and managers know that they are achieving best execution for their clients.