Switzerland, 19th October 2016.
The concept of Best Execution was one of the founding principles of the original MiFID and will also be central to MiFID II, as it rightly should be. Executing brokers should always be acting in the best interests of their clients.
But in the fragmented landscapes of today’s electronic markets, there is a common issue that can significantly impact the quality of execution a broker offers. That issue is information leakage. But a day of reckoning is coming for the worst offenders because there is no reason why this needs to occur. So let’s take a look at where information leaks in order flow and why some brokers are more susceptible to it than others.
From the end client perspective, any investment firm that is not a member of an exchange, or does not have direct access to a trading venue, has to execute its orders through a broker or sell-side firm that does have access. So if a fund manager sends a parent order to its broker to buy (e.g.) 10,000 shares of Vodaphone, it would expect the broker to execute the associated child orders on the chosen venue(s) at the best possible price and send the fill(s) back.
However, this simple scenario is very rarely what happens in the real world. In many cases the broker receiving the order is not the same broker that goes on to execute it on the chosen venue(s). This may be because the originating broker is not a member of the venue in question, so needs to execute through another broker that is. Or it may be that the broker is a member, but does not have the necessary trading infrastructure in place (exchange gateways etc.), so again needs to execute through a third party.
This is where the information leakage starts. As the originating broker, you give up control as soon as you pass an order on to another broker for execution. You don’t necessarily know the route your client’s order is taking, or how many other parties might get sight of that order – and how much information about that order leaks out - before it eventually hits the market. This being the case, how can you honestly say you are getting best execution for your client?
It’s a bit like low-cost airport parking when you go on holiday. You drop off your car and keys with the parking assistant and pick them up again two weeks later. You assume everything is fine but you’ve got no way of knowing what was happening with your car during those two weeks.
Brokers can – and should - do more to maintain the integrity of their client order flow by limiting the number of orders they pass onto other brokers for execution. Fair enough, if a broker is not a member of a particular exchange, then it has to route its orders through one that is. However, many brokers do maintain exchange memberships but they continue to use other firms for execution because of their lack of appropriate trading infrastructure.
But not having your own trading infrastructure in place does not mean you have to give up control of your clients’ orders and allow information to leak out to other parties who may be able to capitalise on it. There is a another way. Independent (i.e. not bank or broker-owned) third party algorithmic trading and order routing services enable brokers to use their own exchange memberships for trading, without having to maintain costly trading infrastructures. By using their own memberships in this way, brokers can keep control of their client order flow right the way through from order receipt through to execution, thus preventing any information leakage to other brokers.
Brokers need to pay more attention to this kind of approach if they want to ensure best execution for their clients. But what about the buy side? What can clients do to push for greater transparency around order flow?
First, they could improve their chances of best execution by using brokers with the right skill sets for the orders they’re submitting. So if you’re trading equities on SIX Swiss Exchange for example, use a broker who is a member of that exchange.
Secondly, get lobbying for greater transparency around executions. Currently, there is no industry standard to ensure that orders are tagged with the LEI (Legal Entity Identifier) of the ultimate executing counterparty. Why not? After all, standard FIX tags are used to identify whether the order is executed in an agent or principal capacity (tag 29), which market it was executed on (tag 30) and whether it was active or passive (tag 851). So why is there no standard field for the LEI of the ultimate executing counterparty? If such a tag was to be implemented and enforced, at least end clients would have a better idea of which orders are being executed directly by their brokers and which are being farmed out.
If the buy side were to lobby harder for this, they would be in a much stronger position to see what they are actually paying their brokers for. And with the recent publication of the MiFID II Delegated Acts placing an even greater obligation on brokers to provide greater transparency around their activities, this would surely be a good thing for the industry.