The overarching "best execution" obligation under both MiFID and MiFID II requires firms to take all reasonable steps to obtain the best possible result for their clients. MiFID II materially augments MiFID best execution (now transposed from article 21 MiFID to 27 MiFID II) in a way that is intended to address some of the specific weaknesses observed in the implementation of MiFID. In particular, the Commission is looking to increase firm and execution venue disclosure and improve adequacy of monitoring. These changes are considered to be particularly necessary in view of the wider range of execution venues that have become available since 2007. This e-Alert discusses some of the major changes to best execution obligations proposed under MiFID II.
What does this mean for you?
- Execution policy must be explained in sufficient detail and be easily understandable
- Annual disclosure now required of top five execution venues
- Increased monitoring obligations
- Annual publication by execution venues of data
- No remuneration, discount or non-monetary benefit for routing client orders (i.e. payments for order flow are prohibited)
- Notify clients with whom there is an ongoing relationship of any material changes to their order execution arrangements
Obtaining the best possible result
Best execution factors
Firms will still be required to take all sufficient steps to obtain the best possible result for their clients, taking into account price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order (the "best execution factors"). These concepts are currently the subject of discussion in ESMA's 19 December 2014 Consultation Paper (the "Consultation Paper") and Annex. ESMA's Final Report, also published 19 December 2014 (the "Final Report"), sets out ESMA's opinion that, in the case of execution of orders and decisions to deal in OTC products,1 the firm must be able to check the "fairness" of the price proposed to the client. While the concept of "fairness" was much debated by respondents to its earlier consultation paper, ESMA has explained that this is to be determined "by gathering market data used in the estimation of the price of such products and when possible by comparing with similar or comparable products."
Acting on specific client instructions
When there is a specific instruction from the client, the firm is still required execute the order in accordance with that specific instruction rather than with regard to the best execution factors. However, it is important to note pre-MiFID II FCA guidance (TR14/13) on best execution and payment for order flows (the "FCA Guidance") (echoed in Final Report), which made it clear that firms should not induce clients to instruct them to execute an order in a particular way, whether by expressly indicating or implicitly suggesting the content of the instruction to the client, when the firm ought reasonably to know that an instruction to that effect is likely to prevent it from obtaining the best possible result for that client. This carve-out for best execution will only apply to specific instructions, and not to any other aspects of an order containing client instructions.
MiFID II imports the concept of the best possible result for a retail client being determined in terms of "total consideration" from the MiFID Implementing Directive 2006/73/EC (the "MiFID Implementing Directive") into the text of MiFID II itself. "Total consideration" is the sum of the price and the costs incurred by clients. The FCA Guidance distinguished between the explicit external and internal costs of execution for retail client orders. These are:
- Explicit external costs which include commissions, fees, taxes, exchange fees, clearing and settlement costs, or any other costs passed on to the client by intermediaries participating in the transaction; and
- Explicit internal costs which represent a firm's own remuneration (including commission or spread) for completing a transaction.
In its Guidance, the FCA made it clear that requirement to disclose the "total consideration" does not mean that a firm must reduce its commission to the lowest level in the market in order to deliver best execution when dealing with retail clients. The FCA explained, however, that there are particular implications for explicit cost control in certain markets, e.g. OTC markets, where firms make their money on spreads.
Our view is that this position will remain broadly the same under MiFID II.
Disclosure of fees and prices: execution venue costs
Where there is more than one venue competing to execute an order for a financial instrument, the firm's own commissions and the costs for executing the order in each venue must be taken into account. This is in order to assess and compare the results for the client that would be achieved by executing the order on each of the execution venues listed. This requirement reflects the obligations set out in the MiFID Implementing Directive, which have been transposed wholesale into article 27(1) of MiFID II.
In the Final Report, ESMA further explains that where fees differ by execution venue, the firm must provide the clients with sufficient information to allow them to understand both the advantages and the disadvantages of the choice of one execution venue or entity over another made by the firm. ESMA adds that where "the firm invites the client to choose the execution venue or entity this information shall be fair, clear, not misleading and sufficient to prevent the client choosing one execution venue or entity rather than another on the sole basis of the price policy applied by the firm." Retail clients should be provided with a summary of the execution policy, focussing on total costs and providing a link to the most recent execution quality data (which will be published according to certain technical rules to be set in 2015 by ESMA).
No benefit for routing client orders
A new provision in MiFID II is the assertion that firms may not receive any remuneration, discount or non-monetary benefit for routing client orders to a particular trading venue or execution venue which would infringe the requirements on conflicts of interest or inducements. This provision echoes the FCA's position in respect of "payment for order flow" arrangements, which, while not strictly prohibited, have up to now been viewed very unfavourably as creating a "clear conflict of interest between the clients of the firm and the firm itself […] it is unlikely to be compatible with [the FCA's] inducements rule and risks compromising compliance with best execution rules."
Execution venues to publish annual data on execution quality
Trading venues and systematic internalisers (in respect of shares that have been admitted to trading on a regulated market or are traded on a trading venue) and other execution venues (in respect of certain specified derivative contracts) must disclose, without any charges, data relating to the quality of execution of transactions on that venue on at least an annual basis. Following execution of a transaction on behalf of a client, the firm must inform the client where the order was executed. The execution venues should publish periodic reports including details about price, costs, speed and the likelihood of execution for individual financial instruments.
Firm disclosure of execution policy to be sufficiently detailed
As required under MiFID, firms will remain obliged to disclose their execution policy to the client and to receive prior consent from these clients. In respect of each class of financial instruments, firms must provide information on the different venues where the firm executes its clients' orders and the factors affecting the choice of execution venue. This information shall "at least" include details of venues that allow the firm to obtain, on a consistent basis, the best possible result for the execution of client orders. The difference between MiFID and MiFID II is that firms are also now required to explain clearly "in sufficient detail and in a way that can be easily understood by clients", how orders will be executed.
In its Final Report, ESMA requires that this information is customised according to the class of financial instrument and type of service provided, and the relative importance of each factor should be explained. In addition to explaining how the best execution factors are taken into consideration, ESMA requires that firms also summarise: how venue selection occurs; the specific execution strategies employed; the procedures and processes used to analyse the quality of execution obtained; and details of how the firm monitors and verifies that the best possible results were obtained for their clients.
Firms to disclose top five execution venues
Investment firms must summarise and make public, for each class of financial instrument, the top five execution venues (in terms of trading volumes) where they executed client orders in the preceding year, as well as information on the quality of execution obtained. In the Consultation Paper, ESMA suggests that to provide clients with adequate and useful information, firms shall also publish the number and volume of orders executed on each venue as a percentage of the investment firm's total executed orders. ESMA further notes that where client orders that are executed OTC are trade reported to a third party, the identity of the firm submitting the trade report (which is the firm executing the order OTC) should be included as a venue in the list of top five venues, where relevant. This is in order to provide clients with adequate context on the investment firm's order execution behaviour.
Increased monitoring obligations
Firms must monitor the effectiveness of their order execution arrangements and execution policy to identify and correct any deficiencies. This will involve an assessment, on a regular basis, of whether the execution venues provide for the best possible result; under MiFID II, this assessment must take into account the best execution factors as well as the information published in respect of the firm's top five execution venues. MiFID II imposes a new obligation that firms must notify clients with whom they have an ongoing relationship of any material changes to their execution arrangements or execution policy. ESMA requires firms to conduct this review "at least annually" and defines "material change" as "a significant event of internal or external nature that could impact parameters of best execution."
The FCA has previously found that most firms lack effective monitoring capability to identify best execution failures or poor client outcomes, and has stated that monitoring should cover all relevant asset classes, reflect all of the execution factors which firms are required to assess, and include adequate samples of transactions. It should be clear how monitoring is captured in management information, and firms should not rely on clients monitoring their own execution quality.