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Beauty and the Best - the perils and opportunities of Best Execution in a multi-market structure The third in Fidessa’s series of white papers on Australia examines how the new Best Execution battleground might play out. In previous papers, Fidessa examined Australia’s shift towards multi-market trading of its equities industry. These covered the general landscape (Aussie Rules) and the impact on the sell-side community (Stuck in the Middle with You). Here we explore the implications of Best Execution and how some firms are turning it from regulatory burden into competitive edge. The worldwide replacement of stock exchange monopolies with multimarket structures has now engulfed Australia too. This has fragmented liquidity and spread it across multiple venues with each competing for the same pool of order flow. In recognition of this, regulators have formalised the way market participants navigate this new landscape so as to protect the interests of the end investor community. At the centre of this lies the concept of ‘Best Execution’ or, put another way, achieving the optimum trading outcome for your client. Two broad schools dominate regulators’ thinking: the first is to take a strict, rules-based stance that puts an absolute definition around the concept and its measurement; the second is to take a more relative, principles-based approach that asks market participants to adopt their own procedures so long as execution effectiveness is ensured. This paper examines this idea in Australia, exploring what it means for market participants of every type and how its implementation might play out following the experience of other markets around the world. A noble goal Irrespective of the approach taken, optimised trading has proved an elusive goal and, in some quarters, has © 2012 Fidessa group plc

called into question the very logic of breaking up markets in the first place. Problems of measurement, fairness and policing are just some of the issues that both the buy-side and the sell-side have had to wrestle with. On top of this, Best Execution is now a key competitive battleground for those firms that have taken the basic concept, refined it and turned it into a valuable core competency. Meanwhile, the regulators have shifted the goal posts too, so that market safety and systemic risk have replaced competition and market fairness concerns. Now that Australia has established its own multi-market structure, it is unlikely to be an exception to these issues either although, undoubtedly, it will put its own spin on them too. Setting the rules The difference between taking either the rules-based or the principlesbased approach is like either setting a rigid speed limit or asking every driver to proceed safely along the liquidity highway. Whilst the objective is the same - obtaining the optimum outcome for your passenger - the

Steve Grob Director of Group Strategy @SteveGFidessa

implementation, measurement and enforcement are very different. The US and Canada pioneered the rules-based approach whereby venues are not allowed to execute an order if a better price exists on another venue. This contrasts with the less costly principles-based approach mandated in Europe that compels both the buy-side and the sell-side to define and follow a clear Best Execution policy based upon a range of different factors. The Australian Securities and Investments Commission (ASIC) originally stated in its market structure consulting paper CP 145 that it would adopt a model with “some similarities to that in Europe with a reporting mechanism similar to that in the US to ensure accountability”. Following negative market feedback about the cost of such a regime, ASIC softened its stance and adopted an even more Eurocentric approach whereby market participants should “take reasonable steps to obtain the best outcome for their clients”. (See Diagram 1)

Europe

Australia

For Buy-side and Sell-side firms:

For Market Participants only:

. Establish and implement an order

. Establish, document and implement

execution policy to comply with the Best-Ex obligation . Disclose to clients appropriate information about the order execution policy . Monitor the effectiveness of the policy and make corrections, if needed . Be able to demonstrate that execution took place in accordance with the execution policy, on client’s request . Retain relevant data relating to all transactions in financial instruments for at least 5 years

policies and procedures to comply with the Best-Ex obligation . Disclose to clients certain information about execution arrangements . Review policies and procedures to ensure compliance is maintained over time . Demonstrate execution performance and order transmission, on client’s request . Retain all records that are necessary in order to demonstrate compliance with the policy for at least 7 years

Diagram 1

Beauty and the Best

Who do the rules apply to and exactly what is included? Identifying which investors should benefit from Best Execution is the first challenge regulators face. Typically, they will divide investors into two camps, retail and institutional. And just as elsewhere, Australia defines best outcome for retail consumers as total consideration or the combination of price paid (or received) and transaction cost. The irony is that most retail investors remain blissfully unaware of their entitlement in this regard and retail brokerages seem to do little to remind them. Those brokers with institutional clients need to include additional factors in their Best Execution manual. Speed to market and likelihood of execution are just two such criteria. To make matters harder, either retail or institutional investors can absolve their broker of any Best Execution obligation simply by instructing them to trade on a specific venue. In practice, however, this type of instruction only comes from institutional investors with a clear view of the complete execution landscape. The advent of multi-market structures has also affected how venues reward their members and this, in turn, has complicated the Best Execution dynamic. Traditionally, venues provide a volume discount to those firms that use them the most but this is rarely passed on to the end investor. This is because broker obligation only forms around each individual order. And so conveniently, then, this excludes

any retrospective discounts from the amalgamation of their total order flow.

a substantial (and costly) change in post-trade transparency, looks unlikely to be answered any time soon.

Alternative venues have favoured a different fee structure, however, and one that rewards passive (or maker) liquidity over aggressive (or taker) liquidity. This type of maker-taker tariff has been widely adopted as it encourages brokers to join new venues, creates momentum and disrupts the status quo. In Australia Chi-X has adopted just such a pricing mechanism and the Australian Securities Exchange (ASX) has done the same with its new PureMatch platform. In other regions this has now led some venues to offer rebates to traders that rest liquidity with them rather than a competitor. Whilst this is yet to happen in Australia, the point is that any maker-taker tariff requires a much more real-time, order-specific deliberation and so it gets much more easily entangled in the best execution debate.

You cannot manage what you cannot measure

US and European venues are still experimenting wildly with different combinations of volume and makertaker incentives although no definitive result has appeared so far. What seems likely, though, is that both will prevail as each appeals to a different customer group. The problem this gives the best executioners, however, is that their sums just got harder. For its part, ASIC sits uncomfortably on the incentive fence saying that such benefits should be passed on to the end investor but only if this is practicable. So, in Australia, the question remains neatly parked and, without

Australia will inherit an even bigger challenge of measurement by following a principles-based regime. Assessment of overall execution quality depends upon there being one yardstick which everyone can use. In Europe there is no official record of time and sales data consolidated across all venues and so no such standard exists. This makes any meaningful comparison between brokers and their smart algos very difficult. The fact that brokers are not obliged to consider every possible venue and that not all venues list every stock only makes matters worse. The opacity that results is regarded as one of the key failings of the MiFID regulations and, for some, punctures the whole notion of Best Execution entirely. Five years on, this remains a significant issue for European regulators. In light of this failure, it is surprising that ASIC is taking a similar laissezfaire attitude. As in Europe, it is leaving it to market data vendors to produce their own competitive - and therefore different - solutions. One reason for this may be that, for now, Australian stocks are traded on just three venues (ASX’s TradeMatch and PureMatch platforms and Chi-X) and so the potential for European-style confusion is less likely. In addition, ASIC’s current tack also avoids the headwinds of designing or providing

The evolution of Best Execution Fiduciary Duty

Regulatory Burden

Competitive Edge

Market conditions

Single market trading

Multi-market trading

Complex interaction between lit & dark venues

Requirements

Reasonable endeavours

Defined approach

Real-time execution consulting services

Obligations

Compliance with corporate legislation

Documented procedures

Respond and adapt to range of client needs

Adherence to primary exchange market integrity rules

Client categorisation Post-trade proof (but only if requested) Reluctant investment in SOR or use of 3rd party brokers

Real-time electronic conversations with clients over execution performance Proof plus “what if” scenarios Ability to modify SOR/internalisation dynamics Ability to identify most and least profitable clients

None

Minimal

Active empowerment (e.g. TCA)

Diagram 2

Beauty and the Best

such a tape directly. Experience from around the world, however, shows that venue complexity only ever increases and that it is almost impossible to get everyone to agree once the fragmentation party has begun. ASIC should keep its fingers crossed on this one, then, especially as there are at least two other alternative venues in the works. A view from the sell-side The formalisation of Best Execution has created specific challenges for Australia’s sell-side community but also reveals significant opportunities too. The key lies with ASIC which, just like other regulators, has toughened the commitment the sell-side must make to execution quality. When Best Execution became law in Europe market participants focused on smart order routing (SOR) technology that would allocate orders according to whatever Best Execution policy they had in place. Because these brokers were free to adopt any such policy many were tempted to ignore any venue that proved tricky (or expensive) to reach!

In the US and Europe the more progressive firms have developed this whole concept of proof way further than the rules require them to. This had led to the creation of new types of execution consulting services that improve client relationships and attract new customers. This requires traders to have a new execution toolkit that can do some, or all, of the following: • Filter and organise actionable data and present this in a relevant way to clients • Monitor trading performance in real time against consolidated views of the whole market • Communicate this electronically to clients in real time • Interpret trading performance and adjust execution decision making on the fly • Create timely and independent validation of execution quality for clients

• Batch-analyse client trade files against the consolidated view of the market • Provide execution snapshots with the ability to drill down into best and worst trades These tools should also be able to identify new opportunities and redirect the balance of an order in response to how the execution process is going. As markets have become more complex and lit and dark liquidity continues to coalesce, this type of facility has become a powerful source of differentiation and customer acquisition/retention. Naturally, it requires commitment to more intelligent workflow and so it is more easily adopted by the larger flow monsters. Yet, as mentioned in our previous paper, Stuck in the Middle with You, even smaller firms can develop this niche, especially by rating the smart (or otherwise) performance of larger firms and guiding their clients accordingly. (See Diagram 2)

• Analyse principal risk and corresponding returns

Australia places a similar obligation on its market participants that leaves them free to adopt any policy they like. But, just as in Europe, these firms must review them regularly and confirm that they continue to achieve the optimum outcome for their clients. To make this simpler ASIC introduced a one year waiver so that best outcome could be achieved just by trading on the primary book of the ASX (TradeMatch). This waiver expires in November 2012 and so some firms may find themselves playing an uncomfortable game of catch-up with those that took the challenge head on. Understanding why your SOR made a particular decision can present a real problem, especially in today’s split-second trading environment. A bigger issue, however, relates to the imperative to audit and prove (for up to seven years in Australia’s case) the efficacy of any particular execution. Good procedures simply aren’t enough without access to the underlying state of the market as well. Whilst this represents another level of investment for market participants it also helps pinpoint where the real competitive edge lies. © 2012 Fidessa group plc

Diagram 3

Beauty and the Best

A view from the buy-side In general, buy-side firms face the same form of Best-Ex jeopardy as their sell-side counterparts. First, they must understand the execution quality they are getting and then they must also prove it both to their own customers and to the regulator. Australia is different, however, as the formal Best Execution obligation only extends one step out from the market participant to its direct client, be it an investor or another broker (See Diagram 3). In this sense, then, Australia’s buy-side community might be deemed luckier than their overseas counterparts. Making sense of a fragmented landscape is just as important from a commercial and investor confidence perspective however, and, without an agreed framework, is even more open to interpretation. The issues that arise for the buy-side differ according to how actively a fund or investor trades. For firms that trade relatively infrequently the key to Best Execution lies in broker selection, but this exposes a fundamental flaw in the whole process. The buyside needs to reward its brokers for their research in commission dollars, and yet those brokers that provide the best research may not necessarily have the flashest smart routing kit. This is compounded by the extra dimension presented by multiple markets and so reopens the debate around unbundling and commission sharing. Unbundling - where the buy-side pays in real terms for research rather than by directing its order flow - just creates another problem. How should a buy-side firm pay for research: by the page, the number of reports, the success of any subsequent investment decisions, or in some other way? Paying in commission is the buy-side’s preference anyway, as the money comes out of its fund(s) rather than its own pocket. Commission sharing agreements attempt to solve the problem another way by directing (best) executing brokers to share commissions with good research houses. Unfortunately, though, this discourages this community just at a time when it needs to invest in new ways to navigate the more complex landscape that it finds itself in.

Best execution presents a different challenge for those buy-side firms that trade more actively. Because they are accessing liquidity more frequently, execution quality has a greater impact on overall portfolio performance. They therefore need to understand the performance of their brokers on almost a trade-bytrade basis. Those that use multiple brokers (as most do) end up with multiple execution reports too, with each compiled using different metrics that renders any effective comparison almost useless. The solution, obviously, is for buyside firms to equip themselves with their own tools. Whilst a wide variety of transaction cost analysis (TCA) products are available most of these are provided by brokers or firms that otherwise have a vested interest in the result. This highlights an area where the buy-side can generate real competitive edge in a multi-market environment. By investing in independent TCA tools the buy-side can really understand the impact that execution quality has on portfolio performance, set effective execution goals and select the most appropriate broker for different situations. (See Diagram 4) Beauty or Beast? A number of studies have attempted to assess the impact of multimarket structures on overall execu-

tion quality. The evidence shows that bid-ask spreads have narrowed which, in theory, means lower execution costs. Narrower spreads mean smaller trade sizes, however, and this is not the preferred outcome for those institutions wishing to trade in size. This highlights a key failing of rules-based Best Execution - different investors have different priorities and so a one size rule cannot fit all. Principles-based regulation fares no better as problems of measurement make meaningful broker comparison an illusion. Lack of awareness also means that most investors aren’t even asking the right questions. Best Execution is, however, inextricably linked to multi-market trading and so for Australia, just like other markets, it is very much here to stay. This presents brokers with a stark choice. One route is to see it as a beast of burden reluctantly driven forward by the wish to minimise cost and avoid procedural change. Alternatively, firms can fully embrace the changes those that do will break through into a beautiful new world of opportunity and competitive advantage. And, if the experience of the rest of the world is anything to go by, this should pay dividends as the focus on achieving optimum trading outcome only ever intensifies.

Source: Fidessa Tradalyzer

Diagram 4