Capital at Risk

Best execution for whom?

JILL EICHER, MANAGING DIRECTOR, ADAPTIVE ALPHA

No investor wants to lose money. Some may want to preserve capital; others may seek capital appreciation. Neither wants to put capital at risk by paying high prices or unnecessary costs. Yet institutional investors overpay, transaction by transaction, and they don’t know it.

The magnitude of trading overpayments may be as high as 2% or more annually of the typical institution’s portfolio. To attack this murky area, investors must delve deeper into their trading partners’ execution practices. While technology has made transactions faster, tripled execution capacity and enabled strategies of unimaginable complexity, computing power has not yet dispelled the fog around execution.

This disconnect reflects the fact that investors and their trading partners are pursuing different objectives. Investors want capital growth; the sell-side houses that trade for them seek transaction-generated profits. No wonder, then, investors are flooded with reams of material that encourages more activity, not claims about how well each trade was executed. A massive information gap separates investors and their trading partners. Investors holding posthumous market summaries are trading against broker dealers who are fed millisecond details. And if a comparison between investor returns and bank trading profits is indicative, investors are losing.

The two largest US public pension funds reported losing almost $100 billion in the full year ended 30th June while reported trading profits at the two largest US banks approached $20 billion. New regulations that amend best execution standards have further aggravated investors’ information woes. Investors are now required to obtain not only the best price for a transaction but also to consider quality and reliability factors. Unfortunately, regulators did not require disclosure of the requisite transaction execution information needed by investors to meet these new standards, nor address a backlog of other information deficiencies.

This endemic information disadvantage systematically erodes not only $12 trillion of assets subject to best execution standards, but it puts large amounts of capital worldwide at risk every day.

Missing information
Industry practices leave out key pieces of readily available information on standard transaction execution documents.

Trade confirmations, for example, do not indicate how a trade was executed. Was it on a proprietary, agency, or cross basis? Without knowing the execution basis of a trade, it is not possible to evaluate it in the context of best execution.

Without knowing where the transaction was executed, no one can compare the competitiveness and expertise of trading venues across security types or in varying market conditions.

Also missing on trade confirmations is the identification of all agents receiving payment for the execution of the transaction. An executing broker, for example, may be referenced, but a broker receiving a sales credit may not. Investors cannot understand who did what or how much they were paid for it.

Missing information costs investors. Recent concern about counterparty risk highlighted the lack of comparative information on broker-dealers. As fears about counterparty risk heightened, not having real-time information about broker-dealer reliability led investors to mitigate counterparty risk through cash and collateral, thereby reducing their interest income and revenue from securities lending.

Misleading information
Compliance reports and transaction costs analyses are meant to help investors review trading practices, but instead they mislead. Both these information sources suffer from skewed focus and faulty scope, providing investors at best a partial lens on execution.

Compliance information can mislead investors by providing a false sense of security. Complying with best practices is closely monitored and evaluated, yet the effectiveness of these best practices is not. Best practices for price discovery, for example, focus on accessing price sources rather than on actually getting good prices.

In an increasingly fragmented marketplace, compliance programs ideally ought to be raising questions about the effectiveness of price discovery practices and examining whether transactions have been executed at the best price and lowest cost. Unfortunately, instead of arming investors with actionable information, compliance practitioners inundate them with copious key indicators of dubious utility.

As to trading practices, investors have few information resources, other than transaction cost analysis to rely on. The methods used by the top three transaction cost analysts (TCA) vendors are fairly consistent across the industry and focus, strangely, on the performance of investors’ fiduciaries rather than broker-dealers. TCA indifference to counterparty performance and competitiveness is an information deficit that significantly impacts investors’ capital. Without comparative data on broker-dealers (e.g. “which counterparty, at this moment, for this trade, has the highest probability of meeting contractual obligations at the lowest cost?”) buy-side traders cannot select the best counterparty to execute a transaction. As a result, they make sub-optimal decisions on a transaction-by-transaction basis.

This indifference to broker-dealers is particularly surprising given buy-side dependence on liquidity and smart order routing algorithms developed by the sell-side to access the exploding number of new trading venues. These algorithms determine when and where investors’ transactions are executed. TCA services, however, do not evaluate these algorithms. So investors and their buy-side traders are left to wonder if broker-dealers are working in their best interests.

A key weakness of TCA methods is placing an emphasis on elements that are not drivers of effective transaction execution. By focusing on tick prices instead of the spread, for example, investors may learn the best price at the moment of execution, but they do not learn who got what portion of the spread. Ignoring the key driver of transaction profitability compromises the analysis, and investors cannot be sure whether or not they got a good deal. It detrimentally shifts attention from best execution to best price. It is also misleading not to include all of the transaction costs in a transaction cost analysis. By overlooking bundled service costs and hidden sales credits, investors cannot ascertain their total transaction costs, or what proportion of profitability is represented by these costs.

Framing transaction cost analysis incorrectly also leaves key trends unexamined. Best price is an example. In an environment where each millisecond produces a best price, what does best price mean if everyone can get it at one millisecond or another? Lessening temporal market impact and information leakage has propelled transaction volumes to record levels, but has it benefited investors?

The misalignment of investors’ interests and TCA execution benchmarks results in investors’ fiduciaries competing against each other instead of against broker-dealers. They often must choose between beating TCA benchmarks and serving the investors’ best interest. Moreover, the bulk of TCA information focuses on the simplest investment products with the lowest cost (i.e. equities) and steers clear of complex investment products with highest costs. This blurring of information integrity to emphasize tactical execution elements is a common denominator in the information disadvantage.

Concealed information
The costs of bundled services, like spread determination and clearance and settlement, are deeply embedded in the transaction life cycle. They intentionally obscure meaningful cost per trade information leaving the complexity cartel to plunder at will.

Most alarming, however, is the execution information withheld from investors that routinely puts capital at risk. Broker-dealers profit at investors’ expense without them ever knowing it by concealing transaction details about proprietary trading activity related to execution. The information is readily available but there is no requirement or precedent to disclose it. This legal-but-unfair trading practice illustrates why information disclosure is more effective than regulation or compliance.

The old adage, “buy and hold, avoid churn and burn” seems quaint in a global financial marketplace time-stamping record transaction volumes in milliseconds. But it may be more instructive than all the combined information currently available to investors.

The duty of best execution: how to measure?
Best execution in the financial services industry is the law in both the US and Europe. Under the Employee Retirement Income Security Act of 1974, US pension plan sponsors have a fiduciary duty to obtain the most favourable terms for investment transactions on behalf of the plans they represent. This duty also applies to fiduciaries they hire to perform investment management services. In Europe, the Markets in Financial Instruments Directive (MiFID) requires any firm that performs investment services or activities to take all reasonable steps to obtain the best result in the execution of an order for aclient.

The definitions of best execution are virtually identical, essentially mandating that investors get the best price while factoring in various other considerations such as the quality and reliability of the execution. Best execution was once a simple standard for investors to measure. In executing a block trade, for example, investors negotiated the terms they wanted upfront. Knowing the price and costs, they could easily assess whether or not they were paying too much.

Today, algorithms determine who gets what price and at what cost for the litters of transactions spawned by a block trade. While the speed of the algorithms is unquestionably excellent, determining whether they got the best outcome for the investor is an increasingly mysterious matter. After algorithms divvy up the spread and calculate the various sales credits for each of the executed offspring trades, the investors receive aggregate price information about the execution of the block trade.

Aggregate price information, however, reveals little about the quality of execution involved in the chain of transactions involved in executing the block trade. Without the details of how and where the offspring orders were executed and at what prices and costs, no one can determine whether the best interests of investors were served. While the information is readily available, it is not industry practice to disclose it. This information disadvantage is at the core of the complexity and challenge of best execution for investors.

Conflicting regulatory mandates
Recently issued regulations by both US and European bodies have exacerbated investors’ information disadvantage and introduced conflicting regulatory mandates for investors to navigate. While the new rules were designed to increase competition to improve execution results for investors, unfortunately they have only further handicapped investors.

Prior to the recent implementation of Reg. NMS in the US and MiFID in Europe, national exchanges were the primary sources of price discovery owing to trade execution requirements on national exchanges. This facilitated the process of finding prices, but it also discouraged competition from other trading venues.

Reg. NMS and MiFID eliminated this protection and forced the national exchanges to compete for business with other trading venues. The process precipitated consolidation among the exchanges and gave rise to the bevy of new trading venues.

The proliferation of new sources for price discovery fragmented the marketplace, making it significantly harder to source and access price information. The emergence of dark pools, trading venues competing as discrete marketplaces where prices are not displayed, further complicated the task. Regulatory efforts to increase competition in the financial markets ironically added new challenges to price discovery and greater import to the duty of best execution for investors.

One of the unanticipated conflicts set off by MiFID is the impact of variable clearing and settlement costs on satisfying the best execution standard. Clearing and settlement costs are part of bundled services and opaque to investors. These costs are becoming increasingly significant as new trading venues emerge offering competitive prices on securities but without the clearing and settlement cost advantages of the more established exchanges. What is best when the price is attractive, but clearing and settlement costs are not?

Another conflict arose from the trade-through rule of Reg. NMS, which requires the execution of a trade in the market showing the best price without regard to any other factors. This is curiously at odds with the duty of best execution, leaving investors to reconcile the trade-through best price rule with the requirement to include other factors such as quality of execution.

The trade-through rule is particularly difficult for investors who place a high value on market depth because the size of their orders often exceeds the quantity available to them at the best price offered. Since they may not be able to obtain the best price for an entire order, market depth is a better determinant of best execution than best price for them. Other situations where it may be difficult to reconcile the trade-through rule with the duty of best execution include finding better prices after orders have been sent, or losing out on best price to another order that arrives first.

The duty of best execution is challenging investors as liquidity sources, market structure, and technology advances produce ever-changing dynamics without giving them access to more or better information. Conflicting regulatory mandates further strain investors and underscore their information disadvantages.

While regulators strive to induce market participants to act in accordance with public interests, ultimately they too have limited information and their actions do not always produce the desired result. Rules can be misinterpreted. Directives can fail to clarify.

More importantly, regulation does not prevent capital loss and penalties do not benefit investors. Eliminating the information disadvantage crippling investors would be more effective than an army of enforcement actions and compliance programs. It would level the playing field for investors and better the outcome of execution strategies.

In the zero sum game of investing, the quality of information is the key determinant of success. High quality pre-trade comparative counterparty and transaction execution information is the key to achieving best execution for investors. Once broker dealers can be selected on the basis of effectiveness, competitive pressures will improve execution results for investors. As the complexity of transaction execution dynamics intensify, the use of this information will be crucial to investor capital appreciation.

Call for innovation and initiative
Until now, investors had placed little emphasis on execution, a poorly understood domain which has long been entrusted to the sell-side. Recent events exposed a mysterious execution underworld. Reports of record proprietary trading profits raised the question: best execution for whom?

Broker-dealer failures revealed that transactions are cleared and settled in relative obscurity by a small number of broker-dealer-owned consortiums. High frequency trading practices brought into focus the high cost of execution technology that only a few on Wall Street can afford. As concerns about fairness increase, transparency in price, quality, reliability and costs are becoming differentiators for investors as they take a more hands on approach to directing transaction flow.

This creates an opportunity for innovators to develop information resources and tools to help investors better compete in the global financial markets. Innovators can apply new technology-enabled analytic methods such as predictive analytics, small world network mathematics, and complex adaptive systems to glean information advantages for investors. They can mine information advantages across the execution horizon from pre-trade to portfolio review and drill down into measuring effectiveness of broker dealers, algorithmic tools, trading venues, and execution strategies. This also creates an opportunity for investors to accelerate the development of information resources to level the playing field. Here are some starting points:

• Encourage buy-side traders to demand complete execution information on trade confirmations, including details about clearance and settlement costs as well as specific execution details for all parent/child trades.

• Open discussions with industry trade groups, such as SIA, ISDA and FINRA, to propose and promote transparency initiatives in trading practices.

• Establish an industry working group to coordinate better disclosure of execution information.

• Lobby regulators to require disclosure of all execution information and transaction fees and apply best execution fiduciary standards to broker dealers.

Once investors gain full command of the information they need to evaluate the execution of their trades, they can transform a global sellers market driven by short-term trading profits into a buyers’ marketplace that focuses on capital appreciation.