Best execution failings.
Issuing a Market Watch before the conclusion of a thematic review is unusual. The Financial Conduct Authority’s decision to highlight best execution issues in its February 2014 Market Watch 45 therefore deserves serious attention, says Anthony Rawlins, senior manager, Financial Services Compliance Consultancy, Moore Stephens LLP
February 2014 Market Watch 45 suggests the FCA has uncovered consistent failings in a substantial number of firms, and that others not included in the review could well be making similar mistakes.
Rather worryingly, some firms may be unaware that they are in fact covered by the ‘best execution’ obligation – the requirement to take all reasonable steps to obtain the best possible results for clients (retail and professional) on a consistent basis when executing orders on their behalf. In particular, the FCA notes that brokers in certain markets such as regulated contracts-for-difference, spread betting firms and those offering rolling spot forex CFDs may be failing to recognise the full extent of the best execution obligation which applies to them.
As the FCA spells out, investment firms are required to take into account the characteristics of their clients and a range of factors, including price, costs, speed, and likelihood of execution and settlement. Firms that execute orders and decisions to deal should establish an order execution policy and monitor the effectiveness of their order execution arrangements, correcting any deficiencies as necessary. Firms that receive and transmit orders for execution should have a policy on how they select executing brokers.
So what are firms doing wrong? Some may not be taking proper account of the sourcing of pricing data. Firms need to make sure they look to appropriate firms on the market when comparing their pricing on a deal, and without performing the comparison in such a way that the results are skewed in favour of the deal. In this context the concept of ‘better than best’, which pre-dates the FCA, still has relevance to firms today. It enshrines the concept that whatever the firm does must be towards the best possible outcome and in the best interests of its clients.
Some firms may also be failing in their best execution obligation in relation to any positive price movements that occur between the submission of an order and its execution. These must be passed on to the client. They cannot be retained by the firm, even if the deal price is within an approved range. Making the range and keeping the change is not acceptable.
It is important to note that when dealing with specific client instructions that these only satisfy best execution in relation to the part or aspect of an order that the trade covers. A firm should not induce a client to give instructions that would circumvent its best execution duty.
If, as seems likely, many firms are failing to comply with at least some aspects of the best execution requirements, there is almost certainly widespread scope for improvement. All firms, whether dealing on the wholesale market or actually trading themselves, need to ensure that they have appropriate best execution arrangements in place. When reviewing this do they actively question those arrangements and the extent to which they are meeting best execution requirements? What are the trigger events that would cause the firm to look at its order execution policies and procedures? Those trigger events will inevitably be affected by the nature of the transactions and the types of trades being undertaken.
The quality of management information on trading activity is important here. For example, timing of trade and volumes are key factors, if a large number of trades are made at a particular point in time, this could be a trigger event to raise a query on why this is happening. The explanation may be perfectly reasonable, but it needs to be established. If an individual is deliberately holding back on client executions, the firm needs to be aware of this and take any necessary action.
Many trading firms will have real-time monitoring of their trading activity, using a variety of software applications. For them, a systems audit may be needed to check that the software and systems are still working as they should. In particular, firms should conduct an interrogation of the system ‘through the system’, not just ‘around the box’. The risk of error is typically higher with bespoke software as opposed to off-the-shelf packages.
When reviewing firms, the FCA will be looking to assess overall compliance with the overarching best execution requirements. This includes, for example, trying to find the best possible price on a financial instrument. The FCA will therefore be looking at factors such as the products being used and types of trade being undertaken, the comparisons the firm is using in the marketplace, and the level of transparency around price comparison data. The FCA will also look at the levels of fees charged for clearing and settlement, market depth and liquidity, market potential speed of execution, and price momentum before and during execution. The regulator is also likely to assess how proactive the firm is being in terms of continually reviewing its own actions.
A recurring theme around all these actions is the management risk. Management information and systems audits are both important aspects of managing risk in relation to best execution failings. But the FCA will also be looking at how firms address conduct risk. For example, do the firm’s training programmes contain ethical dimensions? Has the firm recruited the right people for their roles? Do the firm’s systems and processes ensure that employees are not placed in any situations where there is a conflict between what is best for their own wealth and the client’s wealth? How does the firm identify honest mistakes, which can occur even when employees have the best intentions? How does the firm respond in such situations? Does it provide additional training to individuals as necessary?
In summary, achieving best execution compliance is a complex challenge. Most firms that assess their own performance are likely to find scope for improvement. Given the FCA’s focus on this area, taking action to assess and improve standards is highly recommended.