Following a thematic review of best execution (see Regulatory Roundup 53) the FCA has now published the results of its findings – 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.
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.
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
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).
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).
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.
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.
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).
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 (see 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 (a link to MiFID II appears in Regulatory Roundup 57). 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.