A brouhaha over ‘best execution’
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A group of leading financial trade associations has condemned the UK financial watchdog’s suggestion that price benchmarking could be used in bond and derivatives trading to ensure investors get fair deals under “best execution” rules.
Three industry associations said on Monday that price benchmarking – comparing the price offered by a dealer to an accepted market valuation – was in the main unnecessary for bond trading and unworkable for over-the-counter derivatives.
But there is a further difficulty that has so far been skirted in the discussions. This is a question that is central to the whole direction of the rest of the debate because it concerns which market participants should be affected, if any.
The Financial Services Authority’s suggestions on price benchmarking come from its recent discussion paper on how to implement “best execution” requirements in the European Union’s markets in financial instruments directive, known as Mifid, which is due to come into force next November.
Best execution relates to the obligation of brokers and dealers to obtain the best possible result of a trade for a client. This takes into account not just price but costs, speed, likelihood of execution and settlement, size, and other considerations.
The International Capital Markets Association, the International Swaps and Derivatives Association and the Bond Market Association, which represent participants in the markets, said they were very concerned at the way the FSA’s paper implied that benchmarking was the only valid means for dealers to consistently achieve best execution.
Bertrand Huet, European Legal and Regulatory Counsel at the BMA, said that there were no robust benchmarks for most fixed income products.
“The FSA needs to recognise that there is no such thing as continuously executable price available from a predominant source of liquidity in dealer markets,” he said.
Some bond and derivatives investors, who might be expected to have most to gain from best execution proposals, have come out in support of this position.
Paul Abberly, global chief investment officer for fixed income at ABN Amro Asset Management, says institutional investors probably do not see the need for best execution provisions. “On the whole, the buy-side in wholesale markets is quite happy without benchmarking.”
Much of the impetus for the changes under Mifid comes from the fact that in countries such as Italy and Germany, retail investors are involved, whereas in the UK they are not.
The involvement of retail investors is pressing a parallel discussion on whether Mifid’s rules on transparency in equity markets ought to be extended to bond markets.
The FSA roundly rejected this proposal this month, saying that bond markets already provided sufficient transparency without further requirements for dealers to provide pre- and post-trade prices.
The FSA said yesterday that it was in markets where transparency was lacking, that benchmarks for best execution would be needed.
However, Jeremy Wheatland, a partner at consultancy LEK, says that price benchmarking is only possible for widely traded products, because in less liquid instruments there was no trading history on which to base benchmarks.
“The question from the FSA is, could you use internal models? You probably could, but the question then is, what is the relevance of the benchmark?”
Many dealers use Black-Scholes models to price derivatives, named after the Nobel prize-winning mathematicians who developed the theory behind them.
“But when a trade is done, the actual price comes down to a number of other things, such as participant’s appetite for risk, or counterparty risk,” Mr Wheatland says.
But the really fundamental question is one yet to be answered. This is how the directive will define what is meant by “executing a client order”, or in other words to which kind of trades among which participants will best execution rules apply.
Nick Paul, financial institutions partner at law firm CMS Cameron McKenna, says that a lot of trading escapes the FSA’s current best execution rules because intermediate customers, such as larger corporates and “expertised” individuals, can waive requirements.
“Under MiFID, however, so-called professional clients cannot waive best execution,” he says. “The FSA [discussion paper] deferred the key scope issue of which principal trades would be subject to best execution.”
This problem illustrates a key difference between equity markets and bond and derivatives markets.
With stocks and other exchange-traded products, markets are centralised and brokers can easily be employed to ensure best execution. In other markets, particularly with derivatives, participants form relationships and conduct business more or less privately.
“The next crucial step is around how the FSA defines ‘executing a client order’, which could have a major impact on market structure,” Mr Huet says.
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