Recipients of our recent Regulatory Roundup (issue 58) may have read the article on ‘Best Execution and Payment For Order Flow’ following the publication by the FCA of its findings following a series of Thematic Reviews to a total of 36 firms (TR14/13).
In our view the tone of TR14/13 – and the reason we made the above article the very first one appearing in the Regulatory Roundup – is such that the FCA is not only expecting action by all investment firms but will also undertake further visits to such firms to see exactly what has been done; the consequences for any firm not having taken any action will likely be serious. Given this we cannot over-emphasise the importance of investment firms giving this issue urgent consideration.
For this reason we are publishing the below summary of the findings contained within TR14/13, which is largely based upon Complyport’s Regulatory Roundup article, together with additional commentary.
Following the announcement in Market Watch 45 (published in February) that the FCA was undertaking a thematic review of best execution (see Regulatory Roundup 53) the FCA published its findings in July – TR14/13: “Best execution and payment for order flow”. As will be apparent from the title, the FCA took the opportunity to incorporate into the review the practice of Payment for Order Flow (PFOF) to see how firms have responded to the Guidance issued in May 2012.
Complyport comment: Even before the thematic review had been completed the FCA felt the need to put into print the view that firms “may have misunderstood the requirements” relating to best execution. Readers of Market Watch 45 were also informed that brokers in certain markets including CfD, spread-bet firms and rolling spot forex may be failing to recognise that their activities fall within the scope of the best execution rules.
The review did not involve questioning or visiting buy-side firms but the Executive Summary makes it clear that the paper is relevant to all firms ‘including portfolio managers’. For the avoidance of doubt, although the obligations of e.g. portfolio managers are generally set out in COBS 11.2.30 – 11.2.33 they will need to consider COBS 11.2 as a whole should they also execute the decisions to deal on behalf of a client’s portfolio.
Complyport comment: We see the FCA’s comments as a general reminder that the concept of ‘best execution’ is not restricted to the sell-side. Although portfolio managers more often than not do not ‘execute’ orders, but rather pass such orders to a third-party such as a broker for execution, they are still subject to relevant parts of COBS 11 as mentioned above and need a policy governing the selection of executing broker.
The findings from the review, which took in a total of 36 firms ranging from CfD providers to wealth managers, makes depressing reading with the general overview that:
- most firms are not doing enough to deliver best execution
- firms need to improve understanding of the scope of their best execution obligations
Complyport comment: Chapter 4 of TR14/13 is included because, in the words of the FCA, “our review found that many firms do not understand key elements of our requirements and are not embedding them into their business practices”. Although the rules and guidance concerning ‘best execution’ are largely covered in COBS 11 of the Handbook, Appendix 1 provides a useful reference source for not only the appropriate rules in that chapter but also other relevant areas of the Handbook e.g. COBS 2.3 (‘Inducements’) or SYSC 10.1 (‘Conflicts of Interest’) as well as EC Opinion on ‘best execution’ under MiFID (a link is provided below). This material will set out the requirements and obligations and will be an essential part of any review of best execution within a firm – effectively they can be used as a benchmark against current practices and procedures.
We are reminded that ‘best execution’ is not the same as ‘best price’ but instead takes in a range of ‘execution factors’ (albeit that the FCA would expect price to merit a high relative importance for a professional client and ‘total consideration’ – representing the price and the costs related to execution – for a retail client: see COBS 11.2.9 & COBS 11.2.8).
Complyport comment: The basic requirement enshrined in the first rule in COBS 11.2 is to take all reasonable steps to obtain, when executing orders, the best possible result for a firm’s clients taking into account the execution factors. The ‘execution factors’ in the Handbook (price; costs; speed; likelihood of execution and settlement; size; nature or any other consideration relevant to the execution of the order) come from MiFID Article 21(1). A firm’s execution policy should determine the relative importance of each of these execution factors or establish a process by which the firm will determine the relative importance of the execution factors. The relative importance of each of these factors must be designed to obtain the best possible result for the execution of the order. As mentioned above, whilst ‘best execution’ is not simply ‘price’, ordinarily the FCA requires (‘must’) the best possible result for a retail client to be determined in terms of total consideration – other execution factors can take precedence but only insofar as they are instrumental in delivering the best possible result in terms of total consideration. For professional clients ‘price’ would normally be high on the agenda but other execution factors may be more important.
A key risk area identified was firms’ understanding of the application of best execution to quote-driven markets (see COBS 11.2.4) with many firms found to be seeking to limit the application of best execution in such instances without giving due consideration to the ‘legitimate reliance’ test i.e. acting ‘on behalf of the client’ as in whether the client is relying on the firm to protect their interests in relation to pricing etc. For retail clients the assumption is that the client does rely on the firm, with the opposite assumption for professional clients but subject to meeting the EC four-fold legitimate reliance test – see page 44 for further information, which is based upon EC Opinion on best execution (see link).
Complyport comment: An important part of the wording of COBS 11.2.4 (‘quotes’) is that in providing a quote, the quote has to meet the firm’s obligations to obtain the best possible result if the firm executed that quote at the time it was provided. Obviously this is not the same as the sometimes held assumption that acceptance of a quote by a client absolves the executing firm from best execution obligations. COBS 11.2.4 then goes on to advise that a firm’s best execution obligations will still be met if it executes its quote after the client accepts it – but only if ‘the quote is not manifestly out of date’. The ‘ legitimate reliance’ test can be accessed by way of the ‘EC Opinion’ link provided (item 8 includes the four-fold cumulative test) and is also reproduced in Chapter 4 of TR14/13. The key here is whether the order is being executed on ‘behalf of the client’ and the client is therefore relying on the firm to protect their interests. The test parameters – which need to be ‘taken together’ and not looked at in isolation – include who initiated the transaction; market practice; the relative levels of price transparency within a market; and the information provided by the firm and any agreement reached.
A further key risk area identified was when a firm deals on its own account with clients; such a firm must not overlook that they may still be ‘acting on behalf of clients’. As such, executing a client order against a firm’s own proprietary position where the firm is making decisions as to how the order is executed (working the order on the client’s behalf) will mean that there is a duty of best execution as the firm is effectively competing with other execution venues. Dealing as a riskless principal on behalf of a client would also give rise to a best execution obligation. In contrast, if the firm was engaging in proprietary trading on a request for quote basis then it is probable that there is no best execution obligation – again the ‘legitimate’ test will need to come into play.
Complyport comment: Items 6 and 7 in the ‘EC Opinion’ provides ‘indicative examples’ – including those mentioned above – of when an order is executed on ‘behalf of a client’, and so best execution applies, and of when an order is not executed on ‘behalf of a client’ and so best execution does not apply. Although the document dates back to 2007 it remains a valid reference source and, of course, is also referenced by the FCA in TR 14/13.
Monitoring also came under criticism with ‘most firms’ lacking effective monitoring capability to identify best execution failures or poor client outcomes. The FCA does not share the view that clients would switch to a competitor if best execution was not being consistently delivered as this placed reliance upon the clients rather than the firm to ensure best execution. Although there was evidence that some sophisticated clients sometimes detected issues before the firm itself this could also mean that the less sophisticated clients are likely to suffer from best execution failures on a disproportionate basis.
FCA expectations are that ownership of best execution monitoring resides with front-office but with an adequately equipped second line of defence to challenge conclusions reached by execution desks.
As for PFOF, the FCA view that the practice creates a conflict of interest between a firm and its clients remains. Although a few of the firms visited in the sample continued to receive PFOF, by the time of publication of TR14/13 all the firms confirmed that they had ceased receiving PFOF. Page 47 details arguments put forward by the Future and Options Association and the Wholesale Markets Brokers Association in favour of the practice but rejected by the FCA.
Complyport comment: The fact that those few visited firms involved in PFOF ceased their involvement by the time of publication of TR14/13 suggests that any firm found to be continuing with this practice, under whatever description, will need to be able to justify this prectice to the satisfaction of the FCA – although this may be unlikely given that the FCA will be keeping this area “under active review” and will take action against any firms “which continue to evade our rules and requirements on PFOF” (TR14/13, page 39).
Firms should note that the findings have led the FCA to include both best execution and PFOF as two of the potential competition areas which the Regulator may study in more detail (see Regulatory Roundup 57 ‘Wholesale Markets: Competition’) so these issues will remain on the FCA radar as part of its wholesale conduct strategy which includes the need for “firms to put their clients’ best interests at the heart of their business strategy”. With this in mind it will be recalled that the FCA has also recently released Policy Statement PS14/7 on the use of dealing commission (see Regulatory Roundup 55) and Discussion Paper DP14/3 on dealing commission unbundling (see Regulatory Roundup 57).
Complyport comment: Asset management and brokerage is under the microscope as part of the Wholesale Markets Review. The fact that the FCA will may look at both best execution and PFOF in more detail is a clear signposting to firms that these two issues are of concern to the Regulator and will not go away. Any investment firm found not having taken on-board this message and not having reviewed existing procedures are likely to be made an example of by the FCA. Firms should remember that even the smallest firms (supervision category C4) will, subject to any intervening thematic review, fall under a four-yearly assessment cycle: further information can be found in Regulatory Roundup 54.
Actions:
All investment firms should review their best execution arrangements (and PFOF if relevant). Note that senior management also have a role to play in demonstrating the delivery of best execution on a consistent basis (TR14/13, page 9).
Chapter 3 contains examples of poor practice e.g. total exclusion from best execution for clients who chose to deal on a quote basis without consideration of the four-fold reliance test or relying on clients to ‘shop around’ before dealing on quotes, and which firms can use as a marker for their own procedures. The review should not overlook the importance of effective monitoring and examples of both poor and good practice are provided e.g. sample size, unsuitable tolerances and an overreliance on VWAP. Providers of CfDs are seen as presenting additional risks and note should be taken of page 18 onwards.
When reviewing current procedures, firms should also consider the implications of MiFID II (Article 27) – which should come into application early 2017 – in respect of best execution. The current requirement to take ‘all reasonable steps’ to obtain the best possible result for the client will be replaced by ‘all sufficient steps’. Article 27(6) will require firms to make public on an annual basis, for each class of financial instruments, the top five execution venues and information on the quality of execution obtained which, for some firms, may mean enhanced monitoring procedures.
