Viewpoint : Impact of regulation : Mark Pumfrey

CONFLICTS OF INTEREST MODELS UNDER PRESSURE.

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Mark Pumfrey, CEO for EMEA at Liquidnet, examines the issue.

Following the global financial crisis, greater regulatory scrutiny globally is curtailing once ubiquitous financial products and practices and fundamentally changing market structure as we know it today. Recent high profile probes by the New York Attorney General, the SEC and FINRA into the practices of broker-owned dark pools have ignited the issues that are inherent in conflicts of interest models. The overarching issue for regulators is to create a more level playing field in the best interest of all market participants. Not an easy problem to solve.

In an industry where all participants are forced to co-exist, conflicts of interest inevitably arise. While we are far from seeing an environment where the interests of every market participant are fully aligned with its clients, increased regulatory scrutiny and global directives are forcing the industry to evolve and to place a far greater emphasis on transparency. As a result, we are seeing an institutional shift towards trading venues in which the trading model is transparent and where conflicts of interest can be minimised.

This point is important because it is conflicts of interest, inherent in some business models, which have been called into question recently. In particular, the extent to which broker owned dark pools are being transparent about the involvement of high frequency trading firms’ activity in those pools and on what basis client flow is internalised.

Trust in venues and quality of execution relies on a buyside firm’s ability to clearly know what liquidity they are accessing, where their trades are executed and how their data is used. The trading community has taken for granted that the information they access belongs to their clients and should be used at the discretion of their clients.

It is now more important than ever for institutional clients to understand the clear differences between the trading venues they use and the performance they achieve. Today, only a handful of entities which label themselves dark pools can genuinely claim to add value above and beyond what is found on lit markets in terms of execution size and price improvement. Block crossing networks such as Liquidnet complement lit markets by offering size discovery alongside the exchange’s price discovery. This can add and give market participants access to deeper liquidity and the choice of where to execute their trades and with whom, creating a market that is more aligned to the interests of its investors

For the long term investor, with obligations relating to the performance of its funds and therefore to the underlying investors, three items stand out as being of particular importance. These are: sourcing liquidity, reducing market impact and minimising information leakage. Transparency, and execution quality, should not only be a concern to the trader; it should be on the radar of the entire firm.

A trader’s fiduciary obligation when navigating this complex trading landscape is to achieve best execution. However, they face daily challenges relating to the need to reduce the conflicts that stem from the simultaneous pursuit of best execution and the need to manage commission spending. The FCA is calling for greater transparency on payments by asset managers for brokers’ execution and research services. The regulator recently conducted a review and found that firms are still using dealing commission to pay for these services and that too few firms properly assess the value added and cost of research paid for using client dealing commission.

Since the launch of the FCA review, we have seen an increasing trend among our asset management members and the broader community seeking to understand the cost of research and execution and the value of it. The FCA recently calculated that the UK asset management industry may be leaving as much as £264m in annual client returns on the table for every basis point that could be saved due to the lack of monitoring of how efficiently brokers are managing their trades*. With the FCA’s suggestion the savings are as high as 16 basis points, translating into £4.2bn. This trend is potentially a game-changer in the industry, which could bring to an end the conflicts of interest on the sellside and removing some of the over-capacity in the system – both on the research and execution side. What we are seeing is a return to a simpler model where asset managers take greater control over the research and execution, paying only for true value, thus protecting their clients from the potential conflicts of interest that are inherent in the current model.

The world is now moving to greater levels of transparency, and there seems to have been a seismic change in the view of the issue and conflicts that exist, causing the industry to ask new questions. This is driving the investigations into the dark pools we are seeing today. Regulators are right to look at venues in detail and these dark venues will need to be more transparent than they have been in the past. At the same time, as the trader requiring anonymity to protect trade order information, they also need assurances and transparency from trading venues around what happens to their order information, where their trade is routed and executed, on what basis, and with which (type of) counterparty.

Abel Noser, a global TCA provider, analyses broker’s performance in an annual study. They mine over $7.5trn equity trades to determine which brokers provide the best execution for institutional members. The common denominator among the brokers that topped this year’s list was they only traded on behalf for their clients. These results are further proof that the aligned interest model provides increased value to the buyside.

*FCA Thematic review: Best Execution and payment for order flow, July 2014 
 

© BestExecution 2014

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