Best Execution – A MiFID II Primer

Best Execution – A MiFID II Primer

Best Execution

So, the FCA outline their findings vis-à-vis Best Execution and people are complaining. In a thoughtful piece, Daryn Kutner complained of a lack of clarity on what constitutes Best Execution:

‘Despite all the best intent that presently exists within the industry to fulfil its Best Execution obligations a universal understanding as to what is Best Execution is completely lacking…Best Execution is a concept devoid of meaning and lacking in substance , unworthy of being used to police the market in the way its being presently used.’[sic.]

‘No participant in the transaction process ( buy side or sell side ) is motivated to deal at anything other than the best price…’

Whether they are motivated to deal at the best price is not as important as their demonstrating they are actually doing the required actions to achieve this legal requirement.

The FCA complained that,

‘much of the poor practice we outlined in our thematic review had not been addressed.’

And while noting,

‘[o]n the equity side there had been improvements’

the overall tone was downbeat with complaints of firms adopting a ‘tick box’ exercise. In this post I shall address the FCA’s findings and industry complaints and set out Market FinReg’s stance.

Starting point

Let’s be clear what the FCA is complaining of in its recent comments following on from its Best Execution and Payment For Order Flow thematic review of 2014.

  • Most firms  are  not  doing  enough  to  deliver  best  execution  through  adequate management focus, front-office business practices or supporting controls.
  • Firms need to improve their understanding of the scope of their best execution obligations, the  capability  of  their  monitoring  and  the  degree  of  management  engagement  in execution strategy, if they are to meet our current requirements.
  • A small number of firms continued to receive PFOF.

Given that a one basis point of cost saving could translate into a £263 mn in additional client returns, Best Execution is far from philosophical musing.

Back to basics

So what does MiFID II say about best execution, whom does the obligation fall upon, and is there genuinely a lack of clarity as to its definition?

Broker crossing networks (formally, Organised Trading Facilities), Systematic Internalisers (Investment Firm counterparty that transacts client orders against its own book on an organised, frequent, systematic and substantial basis) and Investment Firms (INVFs) that execute client orders are all obliged to fulfil Best Execution obligations.

The key phrases are INVFs must take ‘all sufficient steps’ to obtain the ‘best possible result’ for clients when executing orders.

For professional clients best possible result is defined by six concrete factors:

  1. price,
  2. costs,
  3. speed,
  4. likelihood of execution and settlement,
  5. size,
  6. nature of order, and finally
  7. any other relevant consideration.

Best possible result is defined differently for retail clients, but for the sake of brevity we’ll stick to professional clients.

We will return to this definition later.

Unfortunately we continue to observe uninformed opinion among many clients who believe their obligations end at this.

This is incorrect, and a dereliction of legal obligations. In the final analysis it will lead to litigation.

For INVFs, MiFID II Best Execution obligations are far more encompassing than order routing. Best Execution ultimately feeds into different aspects of MIFID II. Let’s deal with the main process, in summary form:

  1. It starts with client onboarding. All clients must now be categorised into retail, professional, or Eligible Counterparties – implications for best possible result definition.
  2. There must be a suitability test to understand the client’s needs, investment objectives, risk tolerance, ability to bear loss etc. (precise details differ according to retail/pro.)
  3. The firm must understand the client’s execution priorities, perhaps on a class of instrument basis and document these ideas in an order execution policy document which must be agreed prior to order execution. This links in to the above 7 best possible result discussion and is an opportunity to define the relative importance.
  4. For OTC and bespoke instruments, the INVF must check the fairness of the price by gathering market data and comparing the price, perhaps augmented by FV calculations.
  5. INVFs must monitor the effectiveness of the order execution and execution policy, in particular whether execution venues included in the order execution policy provide the best possible result with the client.
  6. There must be a client limit order policy to handle unexecuted orders in equities.

This is a high-level summary of some of the tasks involved in the overall ambit of Execution and Best Execution. As is apparent, this is far cry from a low-touch, allocate a set of execution algorithms to a client and sit back approach.  It is a continual process that must involve front office, back office, trading desks to name a few parties.


When the FCA’s complaints are set against these legal obligations, we at Market FinReg find ourselves sympathetic to the regulators view:

Firms need to improve their understanding of the scope of their best execution obligations, the  capability  of  their  monitoring  and  the  degree  of  management  engagement  in execution strategy, if they are to meet our current requirements.

Only when INVFs truly appreciate the breadth of their obligations and embrace the change, rather than adopting a minimalist ‘tick-box’ approach, will they be on the path of genuine compliance.

Let’s return to the definition of Best Execution which industry participants complain lacks clarity. So, does it? Well, yes and no. That’s not a fudge – here’s why. Taken in isolation, those seven categories do not form a precise definition – but in such a fragmented market (especially in the non-equity space) it would be impossible to define Best Execution with scientific precision. As stated, when drawing up the Order Execution Policy, firms must push their clients to define their relative priorities. We advised one client recently to consider establishing a mathematical matrix that ranked the relative importance of the seven factors against different asset classes. This allows firms to define more precisely what the best possible result means for a particular client in a manner that is congruent with MiFID II. Given the mathematical nature of a matrix, it lends itself to feeding into execution algorithms. We think it’s a useful idea, but it’s just that – an idea. Other firms may adopt different approaches.

The key is the have it defined, agreed upon, documented, regularly reviewed and remedial action taken following the review. And this brings me to the final point. Given the relative subjectivity of best possible result, will a firm ever be able to demonstrate it has taken ‘all sufficient steps’ in achieving Best Execution all the time. The answer to this is an emphatic, no. Does that mean you are failing in your Best Execution obligations? No. Through discussions we have had with the FCA, as well as ESMA’s level III guidance, it is clear that what the regulators want to see is a pro-active approach along the lines of our defined, agreed upon, documented, regularly reviewed and remedial action taken following the review strategy where firms are iteratively improving their results. Firms that adopt a static tick-box approach can and should be fined as, ultimately, this is investors’ money at stake. Firms that can demonstrate the aforementioned approach will be viewed sympathetically by the regulators, as ESMA noted:

…When designing their execution policies and establishing their execution arrangements, firms will have to ensure that the intended outcomes can be successfully achieved on an on-going basis. This is likely to involve the strengthening of front-office accountability and systems and controls according to which firms will ensure that their detection capabilities are able to identify any potential deficiencies. This will require firms to monitor not only the execution quality obtained but also the quality and appropriateness of their execution arrangements and policies on an ex-ante and ex-post basis to identify circumstances under which changes may be appropriate…

This overarching requirement should not be interpreted to mean that a firm must obtain the best possible results for its clients on every single occasion. Rather, firms will need to verify on an on-going basis that their execution arrangements work well throughout the different stages of the order execution process…

Best Execution needs to sit within an overall framework of MiFID II compliancy in order to work.

Final Thoughts

The precise mechanisms that OTFs/brokers or INVFs adopt will naturally differ. The purpose of this article was to elucidate some of the misconceptions regarding best ex.

In terms of which algorithms, procedures and level of human intervention must be adopted, there is no silver bullet. Solutions must be tailored to individual firms in response to the type of instruments and needs of their clients.

Notwithstanding occasional deficiencies in knowledge, our view is the FCA has approached MiFID II in a reasonable manner. Hits to bottom line due to funds being allocated to PnL-sapping regulatory compliance projects are the bane of any firm, but 2008 taught us the perils of light-touch regulation (any ex-Lehman’s reading this?). MiFID II Best Ex. is like perfection – impossible to achieve, but demonstrably you have to be trying.

Brokers, investment firms, software providers and end clients should be discussing Best Execution arrangements regularly.


Please contact Market FinReg should you require help in achieving MiFID II compliancy.