RegTech Intelligence 
JWG analysis.
Whilst the most eye-catching changes to the MiFID regime tend to have fallen within the market infrastructure bucket, there have also been many small amendments to the investor protection area (consequently representing a significant regulatory reform).
Overall, the EU has proposed additional layers of regulation to protect investors, in the hope that this will allay fears of another post-2008 scenario.
In part 1 of this article, we discuss 5 of the 10 key characteristics of MiFID II’s overarching obligation (also known as the best execution requirements).
1. Best execution factors
Under MiFID I, firms were obliged to take “all reasonable steps” to achieve the best possible results for their clients. Under MiFID II, firms will instead be required to take “all sufficient steps”.
When implementing best execution, firms must take into account a number of different factors. Article 27 of MiFID II sets out these characteristics under the obligation to execute orders on terms most favourable to the client, where firms must consider “price, costs, speed, likelihood of execution and settlement, size, nature or any other relevant consideration”.
Although these factors have not been altered since MiFID I, ESMA’s Technical Advice to the Commission on MiFID II and MiFIR (ESMA’s Technical Advice) discusses the case of execution of orders and also the decision to deal in OTC products (including bespoke products). ESMA’s opinion on these scenarios is that firms should also check the “fairness of the price proposed to the client”. ESMA has clarified that this could be determined “by gathering market data used in the estimation of the price of such product and”…”comparing with similar or comparable products”.
Overall, the slight change in the wording of the obligation, alongside the inclusion of ‘fairness’ as a consideration when executing orders, implies that firms may have to make changes to current practices and policies. This ‘step-up’ from MiFID I suggests a formalisation of the best execution approach and also underlines that the regulator will be expecting firms to place a greater focus on this requirement.
2. Total consideration
As detailed above, ‘cost’ will remain one of the key integral factors to execution quality for both retail and professional clients. Best execution for retail client orders is also assessed on the basis of ‘total consideration’.
Total consideration is defined as the “sum of the price and the costs incurred by clients” and represents “the price of the financial instrument and the costs relating to execution” including “all expenses incurred by the client which are directly relating to the execution of the order, including execution venue fees, clearing and settlement fees and any other fees paid to third parties involved in the execution of the order”.
The FCA’s thematic review, Best execution and payment for order flow, distinguishes between explicit external costs and explicit internal costs:
- Explicit external costs: include commissions, fees, taxes, exchange fees, clearing and settlement costs or any other costs passed on to the client by intermediaries participating in the transaction. These costs would be subject to the best execution obligation.
- Explicit internal costs: represent an investment firm’s own remuneration (including a commission or spread) for completing a transaction. These internal commissions and costs for executing an order must be taken into account when assessing where to execute the order, where there is more than one competing venue available. Thereafter, when judging whether best execution has been given on an individual transaction, firms can omit their own fees and charges from the assessment.
With the directive stipulating ‘total consideration’ as a factor in the case of retail clients, it seems that firms will again have to prove compliance with the obligation (as was the case with MiFID I). And, when coupled with the other best execution requirements under MiFID II, the measures will be significantly more burdensome for market intermediaries.
3. Disclosure of fees and prices: execution venue costs
When there is more than one venue competing to execute an order, an investment firm’s own commissions and costs for executing that order on each eligible venue should be taken into account to assess and compare possible outcomes.
ESMA’s Technical Advice explains this MiFID II text in more detail. When the fees applied by the investment firm differ depending on the execution venue or entity used, information should be provided to clients to allow them to understand both the advantages and the disadvantages of the firm’s choice of one execution venue or entity over another.
Furthermore, ESMA’s Technical Advice stresses that “where the firm invites the client to choose the execution venue or entity this information shall be fair, clear, not misleading and sufficient to prevent the client choosing one execution venue or entity rather than another on the sole basis of the price policy applied by the firm”.
These disclosure requirements raise questions for affected firms. Firms will need to assess whether the information required under the new rules is available in the required form and, if it’s not, could be subject to new data (and possibly systems) requirements.
4. Client instruction
While firms are required to comply with Article 27 of MiFID II, analysis of the text uncovers a carve-out to the obligation. The text in reference to best execution specifies that “where there is a specific instruction from the client the investment firm shall execute the order following the specific instruction”.
However, ESMA’s Technical Advice states “that investment firms should not induce a client to instruct it to execute an order in a particular way, by expressly indicating or implicitly suggesting the content of the instruction to the client, when the investment firm ought reasonably to know that an instruction to that effect is likely to prevent it from obtaining the best possible result for that client”.
Therefore, it is important to note that this carve-out only applies to specific instructions and firms must be well-versed in their obligations in order to achieve the best possible outcomes for their clients.
5. Routing client orders
Article 27 from MiFID II states that “any firm routing client orders to a particular trading venue or execution venue shall not receive any remuneration, discount or non-monetary benefit”. This is due to these activities breaching the rules surrounding conflict of interests and/or inducements.
In response to the directive, some market participants suggested that third party payments for execution should still be permitted as long as they were disclosed to the client. In response, ESMA “amended the advice to clarify that any third party payment must comply with Article 24(9) of MiFID II”, which confirms the requirements within article 27.
This has been one of the most significant changes to MiFID I’s best execution obligations and echoes the FCA’s approach of specifically banning payments for order flow between brokers and market makers.
Keep your eyes peeled for part 2, where we explore another 5 aspects of the MiFID II best execution obligation, including the requirements to disclose the top five execution venues, execution policy and the increased monitoring requirements.
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