ART NOT SCIENCE.
Caroline Brotchie, Sales Manager at Algomi, explains why best execution will always be an art and not a science.
For several years now, voices from all corners of the financial industry have opined on how to tackle requirements for best execution. While all broadly agree on the fundamental tenets of investor protection and rigorous codes of conduct for market participants, the reality of putting these into practice, especially in the knottier illiquid fixed income universe, has long caused dissent among the ranks.
At the core of the problem lie two issues. First, the fact that the parties involved in the practice and supervision of the process come from differing standpoints, and each is themselves, trying to bridge an information gap. Second, what exactly that ‘process’ or ‘information gap’ represents is different for each and every trade. Clearly therefore, we are left in a bit of a bind: the winning combination of somewhat abstract concepts trying to unify different perspectives and standardise practice across a wide range situations.
First, it may be useful to identify the parties involved in the debate.
• The end investor
Be they institutional or individual, the end investor is both the focus and beneficiary of all best execution practices, and simultaneously the least able to assess them. Being perhaps a step removed from the workings of the financial markets means that the day-to-day decisions being made with regard to their portfolios, are not always entirely clear. As a result, investors are reliant on regulators to supervise and monitor on their behalf.
• The regulator
MiFiD’s directive on best execution aims to protect the end investor where they may not be best placed to do so themselves. This has come in the form of overarching directives, and indeed, can only be so. Given the gamut of market situations and individual trade requirements more detailed rules are unworkable in practice. A corollary of this is the maintenance of the reputation of the industry as a whole to the outside world.
• The buyside compliance team
Internal compliance departments have the unenviable task of managing the internal implementation of regulations, as well as the external perception of the firm’s conduct in this regard. This is clearly an iterative process, and one which is impacted significantly by discussion with industry bodies and market peers. It can lead to a ‘safety in numbers’ approach: industry practice norms such as the ‘three quote rule’ evolve and become so widespread they can treated as a regulatory requirement rather than simply an interpretation of it.
• The execution desk
Dealers are required to bridge the gap between the requirements of compliance and the realities of trading in an illiquid market. An often-used example of this is the three quote rule as mentioned above. For particularly sensitive trades, seeking out three competing quotes would actively impede best execution because the market, more broadly being aware of a large or illiquid position, would cause spreads to move adversely. What would indeed be ‘best’ in such situations is for dealers to use their expertise and discretion. But how is this auditable by the other guests at the best execution party?
The solution is less than forthcoming. Marrying practice and supervision in a world of limited information is an art rather than a science. But that does not mean the status quo cannot be improved. Indeed, the most obvious way to solve for an information gap is simply to provide more information. That is one crucial piece for sure, but, in a vacuum, it may not be the end of the story. It forgets that ultimately investors select money managers on the basis of a belief in the soundness of their judgment. That is the art. That judgment runs through from the analysts, fund managers and execution dealers. The latter must be enabled to exercise that judgment based on the market he or she sees in front of them. That is their expertise and value.
So the key to improving best execution practices and supervision is in improving information provision and, crucially, using that to assess dealing desks’ quality of judgment. More and better information is the bedrock for good decisions.
Best execution is as much a process as it is an outcome. It begins with the execution dealer being better informed about the market picture by the sellside. As we said before, the information gap varies on a trade-by-trade basis – what is therefore needed for each trade will similarly vary. But broadly, he or she needs to understand exactly how involved a bank is in a specific sector, issuer or bond in order to evaluate the information being sent, and make an informed judgment call. What flows or enquiry is each bank seeing? Is market sentiment shifting? Who has the most relevant distribution channel for this position?
Clearly not every piece of this intricate jigsaw can be communicated up the chain, but even a distilled version must be preferable to existing standards: the inadequate three quote rule, or price on screen covers.
Solutions such as our Honeycomb network and the recently announced JP Morgan Agency division are examples of recent innovation that seek to address this. More specifically, best execution is evidenced by showing that the channel utilized by the execution desk (i.e. which global bank and sales team was selected as counterpart, or which e-platform, or which trading style) was the most appropriate for the trade in question. This additional colour allows compliance teams, and if needed, the regulator, and ultimately the end investor to assess the validity of the judgment calls being made.
Perhaps unsurprisingly, meaningful improvements in market-wide best execution processes begin with the sellside and permeate all the way through to the end investor. Inefficient information flow is a distinguishing feature of the illiquid end of the fixed income space, and where it can be improved, it should be. However, that does not and should not detract from the essential requirement for discretion and judgment that also act as a guardian of value for end investors. Both elements, appropriately balanced, form the optimal way to manage best execution.
© BestExecution 2014