One of the key themes of MiFID II has been to enhance regulation in order to better protect investors within the financial services industry, and regulators continue to propose more and more stringent regulations for financial institutions.
Following on from part 1, this article explores five more significant characteristics of best execution under the new rules which will arrive in 2017.
6. Disclosure of execution policy
The MiFID II regulations require investment firms to establish and implement an order execution policy, which should allow the best possible result for client orders to be obtained. This execution policy must be disclosed to clients and, in addition, firms are required to obtain clients’ prior consent.
Although this requirement was present under the original directive, MiFID I, there is a key difference between the two versions. Under the new rules, the appropriate information from the execution policy provided to clients must explain clearly, “in sufficient detail and in an easy to understand way”, how the investment firm will execute orders for the client.
ESMA’s Technical Advice to the Commission on MiFID II and MiFIR (ESMA’s technical advice) provides further details on what information should be provided to clients:
- The information must be customised dependent on each class of financial instrument and type of service provided
- A list of factors used to select an execution venue or other entity for execution and the relative importance of each factor must be disclosed
- Investment firms shall also provide information addressing how the best execution factors are considered as part of all sufficient steps
- Such information shall also summarise: how venue selection occurs, specific execution strategies employed, the procedures and processes used to analyse the quality of execution obtained and how the firm monitors and verifies that the best possible results were obtained for their clients.
These requirements suggest that firms may need to undertake a large repapering process when updating execution policies and obtaining consent from clients. These extra requirements surrounding the disclosure of the execution policy reinforce just how transparent the regulator is expecting financial institutions to be towards their clients.
7. Disclosure of data relating to execution quality
Trading venues and systematic internalisers (trading shares on a regulated market or trading venue) and other execution venues (trading alternative financial instruments, such as specific derivative contracts) are required to make data relating to the quality of execution of transactions available to the public, without charge.
Although, under MiFID II, investment firms were obliged to publicise the identity of execution venues annually, RTS 6 from ESMA’s Consultation Paper on Regulatory technical standards on MiFID II/MiFIR states that the data on execution quality should “be published without charge within one month at each quarter end”.
The regulators are keen to increase transparency with respect to the execution quality of venues and believe that this will be of significant benefit to investors but the venues will face both the initial implementation cost and raised marginal costs from the increased frequency of publication.
8. Disclosure of top five execution venues
A key change to the MiFID I regulation on best execution, is the obligation for “investment firms who execute client orders to summarise and make public on an annual basis, for each class of financial instruments, the top five execution venues in terms of trading volumes where they executed client orders in the preceding year and information on the quality of execution obtained”.
Although the implementation of this new rule appears to be straightforward, this may not necessarily be the case. In order to establish the top five execution venues per financial instrument on a 12-month rolling basis, execution venues will need to collect a large amount of data. In addition, there has been no clarification on whether there will be a ‘transition period’ when migrating from MiFID I to MiFID II and, therefore, firms would be wise to start reviewing their systems to ensure that the required data is available and to start capturing that data sooner rather than later.
9. Monitoring obligations
MiFID II also requires “investment firms who execute client orders to monitor the effectiveness of their order execution arrangements and execution policy in order to identify and, where appropriate, correct any deficiencies”.
The regulations are particular in what specifically they want firms to assess; “whether the execution venues included in the order execution policy provide the best possible result for the client or whether they need to make changes to their execution arrangements”, and this must be carried out on a “regular basis”.
Investment firms must also notify clients of any “material changes” to their order execution arrangements or execution policy, for as long as they hold an ongoing client relationship.
These regulations will require detailed monitoring processes to be established, yet it is not yet clear what ESMA means by the term ‘regular basis’ within this context. It is hoped that further clarification will be provided later this year, when the final RTS are published.
10. Material changes
Article 27 of the Directive obliges “investment firms to notify clients with whom they have an ongoing client relationship of any material changes to their order execution arrangements or execution policy”.
ESMA’s technical advice provided some clarity as to what might constitute a material change; “a significant event of internal or external nature that could impact parameters of best execution”. The parameters the text refers to are the best execution factors discussed in part 1 of this article. Changes to the cost, price, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order would be considered a material change.
The difficult task of assessing whether or not a material change has occurred has been left to the firms. ESMA’s technical advice suggests that, in order to decide, firms may have to “consider making changes to the relative importance of the best execution factors or to the execution venues or entities on which it places significant reliance in meeting the overarching best execution requirement”.
The key issue here is that the regulations appear to be intentionally broad in order to capture a wide range of scenarios. In this case, firms will have to carefully determine policies and procedures to identify when a material change occurs.
The changes to best execution proposed by MiFID II will likely lead to large costs driven by business as usual (BAU) policy changes that will also have a knock-on effect on systems, training and data. The delegated acts are currently being finalised and are going to the European Commission this month. Although it is possible that we may come across a few leaks, it is imperative that market participants start implementing based on what they currently know.