The expectation that market participants should exercise care when negotiating and executing transactions in order to promote a robust, fair, open, liquid and appropriately transparent FX market is identified as one of the six main principles of the FX Global Code.
The Bank for International Settlements' foreign exchange working group suggests that they should make clients aware of the factors that might affect execution, such as positioning, whether the market participant is taking on the associated risk, and prevailing liquidity and market conditions.
Cristina Dolan, head of content at TradingScreen, observes that without best-execution rules, market participants would still review observable explicit costs such as commissions and fees but would be less inclined to assess the hidden or implicit costs incurred due to impact, timing and sizing of trades.
Recent guidance from the European Securities and Markets Authority is a step in the right direction, according to Markit managing director of trading services David Weisberger: “For example, the guidance for MiFID II calls for measuring the ‘likelihood of trade execution’ as well as just obtaining best price in routing, which is particularly important since measuring this is key to evaluating routing practices.”
FlexTrade UK buy-side FX product manager Glen Sargeant reckons best-execution rules of engagement under MiFID II Article 27 provide enough information to enable executing agents to document their policies in a more transparent manner.
“The obligations are clear – provide evidence that you have a policy that delivers, over time, the best outcome for your client,” he says. “There may be some uncertainty in how you determine the best outcome, considering the situation of the markets and the client, though.
"Many managers will have clients or funds with strict requirements allowing no tolerances for process – which may include specifying the timing of a transaction where the best outcome is only to comply with the directive – while others may allow discretion on strategy but limit the pool of liquidity to one or two counterparties.”
'No clear target'
Global Trading Analytics president John Halligan observes that there is no clear target that the trading community can hit to demonstrate that best execution has been achieved. “However, a clear best-execution target is not necessary and nor is it in all likelihood desired by regulators. Engaging in the process of best execution is what ultimately leads to lower trading costs and the process should be ongoing.
"A specific target might encourage firms to pay less attention to the process once that target was attained, with less effective results over time.”
The Bank for International Settlements acknowledges that the guidance on good practices underlying execution principles will probably be revised in the final version of the code.
Andrew Woolmer, managing director of New Change FX, reckons the definition of best execution is deliberately rather open so as to avoid the case of managers being able to use the 'but you said…' defence towards the regulator.
“This means that managers must arrive at an interpretation of the rules for their own business, focusing on trade size, delivery requirements, market conditions and so on,” he says. “From a regulatory point of view, the recognition that managers differ in what will define best execution for them means that the rules must be somewhat open and assessed differently from manager to manager.”
The Greenwich Associates report Diversifying Liquidity: Attaining Best Execution in FX Trading refers to best execution being increasingly scrutinized via more intelligent transaction cost analysis.
Such analysis should ideally include as wide a variety of market data sources as possible to determine the market landscape before, during and after a given trade, says Michael Sparkes, head of analytics at ITG Europe. “To rely on the best three quotes is increasingly being questioned as an adequate summary of the overall market.”
Weisberger agrees that the optimum mechanism for enabling best execution is to estimate cost before trading and compare those estimates with the actual cost incurred. “Over time, such a process will lead to two important benefits,” he says.
“First, portfolio managers will be able to choose more appropriate position sizes relative to the alpha they predict. Second, managers will have a more statistically valid basis for evaluating trading strategies and brokers.”
A robust measurement framework must ensure that execution is measured against reference rates that are not influenced by the execution activity itself, says Woolmer. “Once a clear and independent measurement framework has been established, the asset manager is able to define the size of their ‘wallet’ from the market's point of view and then start making decisions about platforms, technologies, banks, brokers and so on.”
Complying with best-execution policy demands an order management system that supports the nuances of different client needs, including permitted venues according to credit and exposure monitoring, adds Sargeant.
“You also need an execution system that is agile enough to adapt to market situations and able to demonstrate where and how the liquidity was sourced prior to and during execution,” he says.
“Receiving best-execution exception alerts in real time is essential for identifying when policies are not being adhered to, so a trading desk can provide immediate and pertinent feedback.”