There has been much discussion over the impact of the Markets in Financial Instruments Directive ("MiFID"), particularly the application of the Best Execution requirements. Much of this focus has centred on the application of best execution to OTC products and how best execution is demonstrated in situations where the products are closely tailored to client requirements or are traded by a limited number of firms. One of the other more complex areas of the best execution requirements will be their application in dealer markets. There has been some guidance issued through the consultation papers from the FSA and from industry and trade associations, however the FSA has yet to state its final views.
MiFID requires that firms take reasonable steps to obtain the best possible result for the execution of client orders taking into account the price, costs, speed, likelihood of execution and settlement, size and nature. This provision now applies to both retail and professional clients, and eligible counterparties can request best execution, but firms are not required to provide it for eligible counterparties. MiFID requires firms to write best execution policies which cover, for each class of financial instruments, a consideration of the relative importance of the execution factors listed above, as well as the factors affecting the choice of different venues, and the resulting choice of execution venues.
There are certain situations where best execution may not apply. Of particular importance is the scenario where clients give firms specific instructions in relation to the execution of an order, although FSA have made it clear that this should not be used by firms as a general "way out" of the need to provide best execution.
In terms of the FSA’s position when regulated entities are dealing with market rather than client facing business, they have stated that firms can of course choose when dealing with eligible counterparties not to provide best execution. There is however a concern among regulated firms that best execution will become a battle ground for market share in the post-MiFID world, and so not to offer best execution as widely as possible may well have adverse commercial implications. FSA have also suggested may also wish to deal through an intermediary such as an interposed agency broker, or to effect the transaction on a regulated market (RM) or a multilateral trading facility (MTF) where dealing in OTC products.
The good news from the FSA’s discussions with the industry post Discussion Paper 06/3 in May 2006 was that, having initially taken a stance which recommended the use of benchmarks and internal pricing models for firms to use to define the benchmarks for best execution, even in dealer markets. They have since revised these proposals as part of the Consultation Paper 06/19 process in October 2006. Their position is that the use of benchmarking may be useful and they are happy to support it, if the industry does. On the use of internal models by firms to achieve best execution, FSA would expect firms to look at what is available in the wider market and to consider this in arriving at their own definition of best execution.
The FSA discusses the implications of the best execution provisions for dealer markets in CP 06/19 and particularly in respect of quote driven markets. The regulated firm needs to determine who is a client, whether the firm is executing an order on behalf of that client, and whether the firm is providing an investment service (eg. providing discretionary fund management or advisory services) or an investment activity (eg. purely receiving and transmitting orders).
The determination of whether a firm is a client will be partly by reference to the terms of business letter with the client, but other factual indicators such as the communications between clients, any implied client relationships and the intentions of the parties in question.
The FSA considers that where a dealing firm provides ongoing access to published quotes, or a request for quote ("RFQ") service, they may be at least providing a service which could be described as facilitation of transactions or providing an opportunity to trade.
The regulators currently believe that it does not make sense to require dealing firms to comply with best execution provisions where a client is undertaking its own due diligence in deciding whether to buy or sell a financial product to or from a firm. This will apply to those dealing firms publishing quotes on a continuous basis, or those providing a RFQ service.
Despite this, if a client indicates that it is looking for best execution or requests such treatment, a firm will have to decide whether to offer best execution or decline to deal. It may be possible to restrict services like request for quote services on the basis that counterparties do not expect to receive best execution or receive it only for individual specified trades.
The FSA has indicated that it will take a firmer view regarding the application of best execution to dealer markets, along with other areas of the New Conduct of Business sourcebook in their Consultation Paper which is due out in Quarter 2 of 2007. This will have commercial as well as regulatory significance for regulated firms.
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