The Markets in Financial Instruments Directive (MiFID), with its obligation for managers to demonstrate they have obtained ‘best execution’ from brokers, pushed analysis of securities dealing costs to the forefront.
Known as transaction cost analysis (TCA), a debate still ensues about how fund managers should do this, as Richard Tibbetts, chief technology officer of StreamBase, a technology provider, indicates.
“Fund managers know that a certain percentage, say 20%, of their transaction costs are excessive but it’s very difficult to identify which 20% that is.”
When fund managers measure something they need to know what exactly they are measuring and against which benchmark, so it could be the case that TCA cannot be relied upon until the best execution obligation is more precisely defined – although not everyone agrees with this.
As it stands, the definition of best execution, according to MiFID, is quite broad. The directive states that firms have: “An obligation to execute orders on terms most favourable to the client. Member states shall require that investment firms take all reasonable steps to obtain, when executing orders, 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.”
Michael Sparkes, senior consultant, analytical products, at ITG, says: “MiFID is a set of guidelines as opposed to rules but it says everyone should have a best execution policy. For example, your best execution policy could state that you’re only going to use the primary market and are not going to measure your results. It’s not a particularly intelligent modus operandi to have but it could be your policy... MiFID doesn’t tell you what your policy should be, it just says that you should have one.”
But Jean-René Giraud, director of development of the Edhec Risk and Asset Management Research Centre, believes that the non-specific guidelines set out by MiFID has led to a certain inertia regarding TCA.
He says: “The way the best execution obligation is defined is a clear regulatory hole. It’s in the middle of nowhere, between an obligation of means and obligation of result. It mixes a number of different criteria and factors and everyone can therefore measure things the way they want. In the end, no-one is doing anything that can be considered as relevant, comparable and objective.”
Andrew Allwright, business manager, MiFID solutions, at Thomson Reuters, says: “MiFID is very principles based and makes reference to other factors such as cost of execution, cost of connection, cost of settlement and so on.
“While from an abstract point of view one can appreciate that it makes some sense, when you actually try and build a process that takes all of those factors into account you end up with something that is either unachievable or at best is extremely complex and expensive to implement.”
Giraud claims that the industry doesn’t want a definition. “Having a definition would force them to actually have to do something about it,” he says.
The breadth of the definition of best execution could be a positive trait. Frederic Ponzo, managing partner with GreySpark Partners, a consultancy, says: “I think it’s better than having a one-size-fits-all approach. You can consider best execution as being the best price for filling a trade, but what if you can only get that best price by filling half the trade? That might constitute best execution for a given investor.
“On the other hand, you could have an investor who cares only about making sure that his or her quantity is entirely filled. Such an investor would be a little less price sensitive.”
He explains that for some investors best execution constitutes the speed with which the trade is carried out if speed of execution is what they want.
Giraud, of Edhec, does not agree. He says: “My view is that price, the total proceeds, the total cost, is the only important criterion. The reason is that an investment is only justified by its economic performance and the economic performance can only be improved by having the best price.”
According to Allwright at Thomson Reuters, price should be a starting point for firms looking to validate best execution. He says: “The response from firms in Europe has been them recognising that, as a minimum, they should be looking at price. Then, if they can factor in other elements that’d be great. But they realise that they should be doing something and looking at price is a good starting point.”
Richard Balarkas, CEO of Instinet Europe, thinks that defining best execution as the best visible price is far too simplistic. He says:Ã¢â?¬Ë?“Simple prescriptive definitions do not work and distort behaviour. It completely ignores the potential offered by dark liquidity and ignores factors such as negative selection and price impact, which can vary by venue.”
Giraud says that other criteria regarding best execution in MiFID also boil down to price. He gives an example: “Take speed of execution. No-one is trading to trade fast. Fast trading is not the objective, it’s the means. You trade fast in order not to face slippage, which would result in an unbalanced price… so speed of execution is not a criterion that should be measured, it is a way of achieving the best price.”
Ponzo, at GreySpark, says there are many reasons why speed is important, such as in arbitrage strategies or volatility trading.
“You want to take your chosen position at the current price. If the price moves a lot and that order is executed later in the day, the trade may not be what you want anymore.”
Tibbetts of StreamBase says that a definition of best execution based solely on price doesn’t take into account the difficulty of a trade.
“For example, if I have a big trade in an illiquid stock I might see slippage on the price, but what’s more important than price to me is that the trade is entirely filled.”
Giraud of Edhec thinks Europe should take a leaf out of the US’s book, where the best execution obligation is solely based on price.
He says: “In the US the best execution obligation is much simpler. It’s a reference to the price on the exchange. If you execute at a price and that price is different from the price on the exchange, then you were wrong.”
Some claim this approach is unfair because it doesn’t take into account the size of trades and other considerations, but Giraud says: “At the end of the day there’s one measure – the price. This is a tough statement on the best execution obligation.”
Tibbetts, who is based in the US, says that looking at price is a very simple way of measuring transaction costs. “You can get a very macroscopic view of any particular transaction. You can then add those transactions up and average them out to get your transaction cost with a particular dealer. Technically, you can use those to compare dealers,” he says.
But he adds that there are myriad reasons why those transaction averages may be misleading and why the average doesn’t give enough granularity.
“Trying to choose a dealer this way is like trying to choose a hospital based on their error rates – the dealers with whom you do your most difficult trades are going to look the worst because those trades are going to cost more to execute,” he says.
So how do you obtain best execution? Ponzo, at GreySpark, says that using real-time data can help managers to produce more reliable TCA.
He explains: “For example, I’ve got a client, a fairly sizable hedge fund, that splits its trade execution to multiple brokers. They measure the performance of the various brokers intra-day, then use that data to fit an algorithm which directs more flow to the best performing brokers.”
Sparkes, at ITG, says: “TCA, by definition, gives a snapshot of what you have done after the event and gives an indication of what you can do in the future, rather than giving you the ability to change what you’re doing.
“For that process to work better you need to have pre-trade analysis and intra-day TCA. This will give you an idea of what results you might expect before you actually trade. Therefore you will be able to measure whether you’re still on track in the light of changing market conditions and to see if you’ve achieved what you set out to achieve.”
Tibbetts, at Streambase, says: “You want to make sure each trade is made as well as possible at the time it is made. This requires bringing together sophisticated market data to understand how hard the trade is going to be. You want real-time analysis of the market conditions and historical analysis of the performance of your brokers.”
As one expert put it: “The reality of it is that TCA is a tool for fund managers to make sure they’re not being cheated by their brokers.”
©2010 Funds Europe