DP06/3 MAY 2006: IMPLEMENTING MiFID S BEST EXECUTION REQUIREMENTS ABI RESPONSE TO FSA DISCUSSION PAPER

DP06/3 MAY 2006: IMPLEMENTING MiFID S BEST EXECUTION REQUIREMENTS ABI RESPONSE TO FSA DISCUSSION PAPER 1. Members of the Association of British Insurers are large institutional investors managing own funds worth some 1.2 trillion as well as third party funds. Our members have a strong interest in the integrity and efficiency of financial markets and in promoting the confidence of the investing public. Matters relating to MiFID implementation are therefore of fundamental importance. 2. We welcome the opportunity to respond to the FSA s Discussion Paper (DP) on Best Execution. We are particularly pleased the FSA has decided to share its views on how best execution provisions could be implemented ahead of its formal consultation at the end of the year. 3. A guiding principle should be that best execution results in net saving for beneficiaries. Regulatory requirements whose compliance costs exceed the savings achieved are against the consumer interest. General comments 4. Our members agree with much of what is proposed in the DP. We are supportive of Chapter 2 and the concept of the chain of execution, as we believe it accurately illustrates the current process of execution. Both the portfolio manager and the broker/dealer play some part in providing best execution and the sum total should add up to the best possible result for the beneficiary. We have described some practices specific to portfolio management in more detail in our answer to Q2.1. 5. We also agree with the need to review and monitor best execution arrangements and policies as outlined in Chapter 4. We welcome the FSA s emphasis on flexible and proportionate implementation, in line with firms arrangements and their position in the chain of execution. 6. Our members feel there is no need for the FSA to be prescriptive in detailing monitoring and reviewing requirements or in their subsequent supervision. Because fund managers are judged on their overall 1

performance, these are commercially driven practices which should not be turned into a tick-box exercise. It should be left to firms to decide how best to ensure they are satisfying their obligations and to show that the appropriate processes are in place. In particular, extensive record-keeping requirements are likely to provide few benefits for clients while imposing additional costs. 7. However, we cannot support the proposals outlined in Chapter 3 of the DP. Our members have been unanimous in their rejection of benchmarking as an option for satisfying best execution in dealer markets. They do not believe that price is the right yardstick in this context. As the main prospective users of the model, they also do not think the benchmarks would be meaningful, mainly because they would be difficult to construct for illiquid instruments and would not provide the information needed. 8. Benchmarking would also increase costs across the industry. These costs would undoubtedly be passed on to our members clients the endbeneficiaries with little evidence of corresponding benefits. 9. Most importantly, benchmarking would risk disrupting the current market structure. The DP offers no evidence that there is a market failure or information asymmetry that might lead to market failure. 10. In contrast, there is evidence in both the FSA s Feedback Statement DP05/5 (Trading Transparency in the UK Secondary Bond Markets) 1 and the research on European Bond Markets published by the Centre for Economic Policy Research 2 that large parts of OTC markets are functioning well. 11. Our members believe that OTC markets have both size and depth, and are currently functioning well. They would not wish to see a move that could have a negative impact on liquidity and lead to increased costs. 12. We propose an alternative in our response. It is not an alternative to the benchmarking itself but an attempt to outline a different approach to implementation which is based on a copy-out of MiFID provisions. 13. Our proposal applies the analogy of a chain of execution as described in Chapter 2 of the DP but adjusts it to take into account the distinctive features of OTC markets. Best execution for dealers in such a regime would be about process and a description of the way they conduct their 1 http://www.fsa.gov.uk/pubs/discussion/fs06_04.pdf 2 http://www.cepr.org/press/tt_corporatefull.pdf and http://www.cepr.org/press/tt_governmentfull.pdf 2

business, rather than about providing a trade-by-trade proof that best prices have been attained. It is therefore rooted in MiFID requirements to ensure the best possible result for the client by applying the firm s execution policy. 14. We have interpreted the MiFID text as applying the obligation of best execution to dealers dealing on own account when dealing with retail and professional clients. We understand the FSA is going to specify in its forthcoming paper on client classification the circumstances where dealing on own account may not amount to executing client orders. This would provide much-needed clarity and pave the way for an industry consensus on the scope of the obligation. We look forward to commenting on the paper. 15. The FSA will undoubtedly conduct a full analysis of costs and benefits of any proposals put forward. We believe these should be defined as widely as possible, and include the overall costs and benefits to the market and UK financial services industry. They should also consider the unintended consequences of regulation, especially in terms of impact on all the dimensions of market outcome. We are particularly concerned here about the trade-off between liquidity and transparency in OTC markets. 16. Our answers to specific questions are set out below. Answers to specific questions Q2.1: Do you agree with the above analysis which takes a flexible approach to the application of the requirements to firms in a chain of execution, depending on the nature of the activities they perform and the degree of control over the execution of the client orders? 17. We wholeheartedly agree with the flexible approach proposed. The degree of control and the nature of activities performed by portfolio managers whom the ABI represents are different to those undertaken by brokers to whom they may transmit their orders. This is now explicitly acknowledged in MiFID Level 2 Article 45. 18. We therefore welcome the move away from the one-size-fits-all model which would have required an unnecessary duplication of effort. Imposing identical obligations on all investment firms would also have extended the portfolio managers responsibility to the point of actual execution of client orders - an activity some perform infrequently. This is further explained below. 3

19. Instead, our members agree with the FSA that the chain of execution is the most appropriate analogy to describe the execution process. It clarifies that there is a division of responsibility (DP p.10) between portfolio managers and broker/dealers which can be configured in different ways, rather than residing with one or the other participant. 20. The nature of obligation for portfolio managers will depend on the amount of control they retain over the execution process. This will vary between trades and will depend to some extent on the venue chosen. In some cases, portfolio managers will delegate most of the execution and therefore control - over factors specified in Article 21(1) to a broker. In others, they will be much closer to the trade and deliberately leave brokers little room for discretion. For example, in the case of direct market access (DMA), although a broker has a seat on the exchange and ultimately concludes the trade, he does not actively mediate it in any way beyond configuring the system used for trading. This means the portfolio managers best execution obligation is correspondingly more onerous. 21. We would, however, caveat our general support for Chapter 2 by expressing our members concern that the examples outlined and the description of portfolio management in the DP are somewhat cursory and may signal a lack of understanding of portfolio managers obligations and how those differ from other market participants. 22. The typical trading process from the portfolio manager s perspective is more complex than the examples suggest and can include more links in the chain of execution. They have a choice of external venues to which they transmit their orders: regulated markets, MTFs and crossing networks, and broker/dealers - or a combination of some or all of the above. Brokers further extend the chain by transmitting orders to different venues. 23. Portfolio managers can also execute trades themselves by crossing them internally. Internal crossing represents a sizeable portion of some portfolio managers trading though its importance has decreased in recent years. Some of our large members can internally cross almost 1bn worth of trades every year but many put an increasing proportion of these trades through the market by giving them to brokers to execute at specified prices. Q2.2: Do you agree with our views on the relevance of the specific factors in Article 21? 4

24. We agree with the factors highlighted and with the notion that their relevance will vary between clients and instruments. As explained above, it will also vary according to the role a firm plays in the execution chain. 25. Because portfolio managers send most of their trades to brokers or dealers, the factors that inform the choice of those venues are likely to form a large proportion of their execution policies. 26. The selection of brokers is usually a two-stage process. Initial assessment is based on a wide variety of factors including credit risk, likelihood of settlement, strength of relationship and consistency of execution. This is often done annually or semi-annually. Although the process contributes to how portfolio managers discharge their best execution obligations, it does not form a part of a more focused trading decision that takes place at a dealing desk. Factors such as size, speed and nature of the order are usually more important at the point of trade. 27. Execution policies define a set of parameters investment managers use to trade but cannot be a template for every trade undertaken: a policy cannot in advance configure a set of variables applicable to every situation. We believe the emphasis should be on processes rather than on trade-bytrade obligations. 28. This is particularly acute when assessing costs. Explicit costs are easy to take into account and many of our members are already transparent about their commission charges and other fees and accountable to their clients through the Pension Fund Disclosure Code. 29. Implicit costs are more problematic and the DP acknowledges in footnote 21 that they are inherently hard to assess. As far as we are aware, there is no commonly accepted methodology for estimating costs of, say, market impact or the opportunity cost of failing to get a fill. They can only be measured with some accuracy after the event. 30. It is these costs that are important to large investors. Our members confirm that they do not always choose brokers with lowest commissions or counterparties offering the lowest prices. Instead, what matters to them are factors such as confidentiality, speed, commitment of capital and the ability to deal in volume required or execute large orders smoothly all of which are instrumental in minimizing implicit costs. 31. However, although an execution policy will only be able to assess implicit costs in a general way and not ascribe them monetary values, it should be sufficiently detailed to explain to clients how those costs are managed. 5

Q2.3: What additional costs will the requirements to have an execution policy and execution arrangements impose on your firm? 32. Many of our members firms already have commercially driven execution arrangements in place. The implementation of MiFID means they will formalize them in execution policies, if they have not done so already. Many have already put in place relatively sophisticated arrangements as a result of the IMA/NAPF Pension Fund Disclosure Code. They have already absorbed some of the initial cost. We therefore do not anticipate that the additional costs of creating policies will be significant though the application in dealer markets depends on the final shape of the proposals. 33. Some firms might consider increasing the number of brokers they use if they feel that would better satisfy their best execution obligations. This would increase their costs, both initially and on an ongoing basis but these ought to be offset by better execution quality. Q2.4: Do you agree that price and cost are the most important factors for retail clients? 34. In principle, yes but it is important to add that some investment managers acting under discretionary mandates may undertake orders on behalf of retail and professional customers at the same time and allocate the deal across the respective funds. In such an order, factors other than cost and price may be relevant. The fund manager should be free to decide how to achieve the overall best result for his or her clients. Recital (67) of the latest Level 2 draft recognizes that other factors apart from price and cost may be given precedence in so far as they are instrumental in the delivery of the best possible result: Speed, likelihood of execution and settlement, the size and nature of the order, market impact and any other implicit transaction costs may be given precedence over the immediate price and cost consideration only insofar as they are instrumental in delivering the best possible result in terms of the total consideration to the retail client. Q2.5: What information will be appropriate in order to enable clients to be sufficiently informed about the execution arrangements of the firm and how will this differ as between retail and professional clients? 6

35. We do not believe that overly detailed disclosure will help clients make informed choices about the quality of execution arrangements. From the viewpoint of investor protection, it is hard to see how a plethora of information would be valuable. 36. Excessive information disclosure runs the risk of turning best execution into a trade-by-trade obligation something MiFID clearly states it is not. Our members believe that their clients are interested in the overall performance of the fund rather than trade-by-trade performance and that the costs of providing information should not outweigh the benefits. 37. Information disclosed to clients should therefore be a high-level summary of the firm s policy and describe a general approach the firm is taking to execution. Firms must be able to confirm that they have followed their policies. Competitive pressure between fund managers will also serve to ensure adequate disclosure to clients. Q2.6: Are there any best execution issues unique to UCITS management companies? 38. We are not aware of any issues unique to these companies. Q3.1: Do you agree that under MiFID there may be demand from retail and professional clients for best execution in relation to financial instruments typically available from dealers? If so, how significant is this likely to be? 39. The FSA is undoubtedly aware of the existing uncertainty around client classification. It arises because portfolio managers seek to match the classification of their underlying clients so they could be granted appropriate protection, while broker/dealers prefer to trade with them on market counterparty basis. ABI members clients are usually classified as professional. 40. In the case of very large firms, the request is frequently granted. For the rest, particularly for smaller firms, the classification status is often unclear: a firm may send a rebuttal letter to a broker/dealer, who may in turn respond with his terms of business, and the stand-off is allowed to continue even though trading takes place. 41. The feedback from our members suggests that many will continue to seek to opt down in this way under MiFID, irrespective of the venue chosen or the instruments traded. They will therefore expect to receive best 7

execution from both brokers and dealers in order to extend maximum protection to their clients. This is so that, when they pass orders for execution, portfolio managers can be certain that those aspects of the trade over which they have little or no control comply with Article 21(1) in a way that allows them to satisfy their wider obligations under Article 19. 42. Some of our members have informed us that they will trade as eligible counterparties in dealer markets. They will therefore have the full duty of best execution to their clients. 43. We are aware of arguments that best execution should never apply in OTC markets because the absence of agency obligation when a dealer deals on own account is presumed to mean there is also no customer order and therefore no execution. 44. We would argue that the need for client protection in financial markets arises irrespective of the function in which the firm has chosen to act. We therefore support the assertion FSA made in CP154 on Best Execution that the concept of best execution should refer to transactions executed as both principal and agent (p.36). There may, however, be circumstances where firms dealing on own account are not executing a customer order and we understand the FSA intends to clarify the scope of the obligation in its forthcoming paper on client classification. 45. MiFID is clear in applying the obligation to dealers. Level 2 Recital (69) explicitly states that: Dealing on own account with clients by an investment firm should be considered as the execution of client orders and therefore subject to requirements under Directive 2004/39/EC and, in particular, those obligations in relation to best execution. Also Level 2 recital (70) says: The obligation to deliver the best possible result when executing client orders applies in relation to all types of financial instruments. 46. Implicit in the same Recital is an assumption that even bespoke instruments are subject to best execution, even though the obligation may be framed differently: Best execution obligations should therefore be applied in a manner that takes into account the different circumstances associated with the execution of orders 8

related to particular types of financial instruments. For example, transactions involving a customised OTC financial instrument that involve a unique contractual relationship tailored to the circumstances of the client and the investment firm may not be comparable for best execution purposes with transactions involving shares traded on centralised execution venues. 47. The Recital confirms that the contractual relationship between the dealer and the portfolio manager triggers the obligation. 48. Although Recital (69) in Level 2 states that a quote may constitute a specific client instruction which would take precedence over the best execution obligation according to Article 21(1) - it also says that the quote would have to meet the investment firm s obligations under Article 21(1) if the firm executed that quote at the time the quote was provided. This clearly brings it back to having to take all reasonable steps to obtain the best possible result for a client. 49. However, although brokers and dealers are both subject to best execution, we believe their obligations are not identical. This is because both the capacity in which they act and the markets in which they operate are different. (Please see our answer to Question 3.2. for further comments on this issue.) Q3.2: Do you consider that the benchmark execution model may provide a useful additional approach by which dealers may be able to satisfy the best execution requirements? If so, in what markets will it be of most use? 50. We recognise that the benchmarking model outlined in the DP is an attempt to resolve some of the inherent problems of providing best execution in dealer markets and we welcome the opportunity to comment. 51. Our members do not believe the model would work in practice and they therefore do not think it could provide an additional approach by which dealers might be able to satisfy their best execution requirements. 52. There are several reasons for their opposition. They do not think the benchmarking model is practicable for the reasons set out below, nor do they believe it would provide the level of protection envisaged. The results it would produce risk being irrelevant at best and misleading at worst. Because of this, the overall costs of developing, implementing and reviewing the model, and the likely market disruption it would cause, would significantly outweigh its benefits. 9

53. It is also not clear how the FSA proposals would apply when dealers are located in third-country jurisdictions or even within the EU should member states choose to adopt different approaches to implementation. Absence of market failure 54. Benchmarking is based on an assumption that best execution in dealer markets cannot be achieved or demonstrated without some kind of price comparison. This in turn implies that financial instruments are currently traded at suboptimal prices and that there is therefore a market failure. 55. The FSA s own Feedback statement on DP05/5 (Trading Transparency in the UK Secondary Bond Markets) and the research published in May by the Centre for Economic Policy Research on behalf of a number of trade associations (including the ABI) both confirm that there is no market failure. They conclude that the market is functioning well and that spreads are tight. 56. Both also warn that increasing transparency may damage liquidity. The FSA says in the Feedback Statement that transparency is not an end it itself as the ultimate aim should be to have markets that are fair, orderly and clean (p. 3). 57. Although price comparison may be an important aspect of investor protection, there is no evidence in either paper that it would improve the functioning of dealer markets. In any case, the nature of investor protection ought to be proportionate to the largely wholesale nature of these markets. 58. Our members strongly believe that there is no market failure. Because dealer markets are relatively illiquid and decentralised, with limited preand post-trade transparency, the process of price discovery is constrained by their structure. It is not the same as for very liquid equities: unlike brokers, dealers are not in a position to search the market in order to prove that the price quoted is the best possible result for the client. In addition, some instruments traded over the counter are so bespoke that price comparison can be meaningless. Absence of information asymmetry 10

59. The FSA claims in Chapter 3 of the DP that there is information asymmetry between dealers and their clients, which weakens the position of the latter and restricts their ability to receive best execution. 60. Our members do not believe this is the case with a caveat that access to information will always to some extent depend on the firm s size and the accompanying market power. 61. Dealers may have access to IDBs and the advantage of knowing their own book but portfolio managers may have a better overall view of the market and the ability to compare quotes from several dealers. The growth of trading platforms such as Tradeweb has also increased the amount of pricing information available to portfolio managers. New solutions are evolving all the time. 62. CEPR research on European Bond Markets concludes: the main dealers say they have no need for greater transparency they have access to MTS data, and their inter-dealer market is in any case an institutional markets, with large information flows. Big investors, too, have a lot of market information. The large buy-side institutions will have many dealers contacting them directly. Conversely, they value their relationships with dealers in the OTC setting. If they have a big position to switch, they normally don t parcel it out but give it all to a single dealer to work the order. They find no problem with best execution. P.56 Cost 63. The overall costs of benchmarking accumulated along the execution chain are likely to be prohibitive. The costs to dealers of developing and implementing the model would be passed on to buy-side investors. In addition to these external costs, portfolio managers would have to bear the cost of analysing individual dealer s benchmarks. This process would absorb time and resources, particularly when benchmarks are derived from complex internal pricing models or established by extrapolating from indirectly referable prices. The resulting delay may in turn reduce the number of trades portfolio managers are able to do. Ultimately, this would hinder their ability to implement their investment strategies successfully. 64. There are also costs to the market as a whole if dealers choose to withdraw liquidity altogether. There is a risk that this may happen if the 11

costs of running a dealing function turn out to be so high that the banks capital may be more profitably employed elsewhere. Although it is more likely that dealers would choose to deal with eligible counterparties only, a situation where some dealers can afford to offer regulatory best execution and others cannot may make some of the latter exit the market. 65. These multiple costs will ultimately be passed on to end-beneficiaries. Whether they would be offset by keener pricing is contestable - FSA s Feedback Statement on bond market transparency concluded that spreads are already tight and the market is functioning well. Again, the absence of market failure means the gains from regulatory action would be limited. Timing 66. Our members are concerned about the time it would take to implement the benchmarking model and the effect any delay would have on firms ability to implement MiFID before November 2007. 67. The delay would be particularly acute for portfolio managers. As second in the chain of execution in the majority of cases, they would have to wait for broker/dealers to decide on their business models and establish suitable execution arrangements before they can fully implement their own. In particular, the shape of portfolio managers execution arrangements would depend on whether broker/dealers decide to adopt a model where they do not offer best execution but deal on eligible counterparty party basis only. 68. Our members have indicated that they would prefer to have their MiFIDcompliant execution policies in place by the end of 2006 if those are to be given time to bed down before the final implementation deadline. Any delay would make this impossible. Super-equivalence 69. We believe that the benchmarking proposal goes beyond the MiFID requirements and it is therefore super-equivalent to the Directive. Considering the limitations imposed on member states wishing to introduce additional requirements created by Level 2 Article 4 (1), we would question the rationale behind and need for a complex model not required by the Directive and not in the interest of UK markets. 12

70. If a wider policy change is intended by the DP such as making the market more suitable for retail investors or increasing transparency then this ought to be done over a longer timescale, in consultation with industry and after extensive cost-benefit and market failure analyses. Alternative approaches and copy-out 71. FSA claims in the DP that benchmarking is only one option for providing best execution in dealer markets. It goes on to highlight the alternatives in 3.13. 72. We would argue that they are not really alternatives as such, as they assume either no best execution provision at all or the creation of an interposing broker. Both would alter the market by adding another link in the chain of execution (in the case of former, they would effectively block off direct access to dealers by retail and professional clients). 73. Neither of the two options suggested is particularly attractive to portfolio managers, as both imply additional costs and possible market disruption. Our members would either have to provide best execution themselves or they pay commission to an interposing broker. 74. Instead, we believe that the best way to implement MiFID provisions is by copy-out. This would preserve the current market structure, while imposing additional checks and balances which would fulfil FSA s policy objectives of investor protection and market efficiency as stated on page 21 of the DP. 75. The template for such an approach is already sketched out in Chapter 2 of the DP through the concept of an execution chain. Our answer to Question 2.1 outlines our understanding of the chain and the division of responsibility. Both the portfolio manager and the broker will play some part in providing best execution and the sum total should add up to the best possible result for the client even if the extent of respective obligations differs. 76. In dealer markers, as elsewhere, the emphasis should be on process. This would mean that dealers like brokers or portfolio managers would have to have execution policies and arrangements in place. 77. The fact that they are dealing on own account means their scope for assessing various factors under Article 21(1) is limited. We agree with IMA s response which states that this in reality means that dealers 13

policies would have a relatively narrow focus, covering, for example, speed of execution, size of order and nature of instruments. 78. In an illiquid and decentralised market with little pre- or post-trade transparency, meaningful price comparisons are limited. MiFID talks about taking all reasonable steps to obtain the best possible result for the client. We believe the structure of OTC markets means it is not always reasonable for dealers to search for other prices. Price may therefore feature in their policies only for some types of instruments in certain circumstances. 79. For example, where instruments traded are relatively liquid, dealers may be in a position to describe the process used to inform price formation. That could include checking prices posted on electronic networks and inter-dealer broker screens. But the extent to which this can be done will be contingent on what is being traded and how, so the same process will not be applicable in all circumstances. 80. Price may feature more prominently in portfolio managers policies but would be based on limited pricing information, again depending on the venue and the instrument traded as well as size of the order and other factors. This is because the price references a portfolio manager has are the alternative prices obtained from competing dealers and other pieces of information such as bond yield data or indicative prices from trading platforms. Where there are lots of dealers and a reasonable amount of liquidity, this is practicable. For example, Tradeweb allows portfolio managers to compare several dealers quotes in real time and preserve an audit trail of execution. It is increasingly being used for small trades. 81. However, this is often not possible. For example, in emerging markets stock, a portfolio manager may build up a trade with one dealer over several conversations. If he did this with several dealers but then did not buy, his ability to trade with them in future would be jeopardized. In other cases, he might get the first call from a dealer and accept on the spot. It would be up to him to judge whether the price constituted the best possible result for the client. 82. In cases such as these, where the opportunities to shop around are limited (other examples include where there is only one dealer in a particular instrument or the instrument is entirely bespoke), a portfolio manager would have to explain in his policy the process he goes through in order to fulfill his obligation of best execution. Very often, the focus would be on ability to trade at all and on speed and efficiency with which it can be done. Price might be third or fourth in the level of importance. 14

83. Rather than being an absolute guarantee of best execution, dealers execution policy would basically be a series of checks and balances designed to align the interests of dealers and their clients. This, together with the more general duty on all investment firms under Article 19, the conflicts of interest provisions and the competitive pressure all dealers face in a dynamic marketplace, all serve to minimize risk and enhance investor protection. Q3.3: What would be the likely costs of this approach? Please see our answer to Question 3.2. Q3.4: What particular characteristics of reference prices make them suitable benchmarks for particular instruments or in particular circumstances? Please see our answer to Question 3.2. Q3.5: Do you agree that a dealer could construct prices by extrapolating from indirectly referable benchmark prices and thereby satisfy MiFID s best execution? Please give examples for specific financial instruments. Please see our answer to Question 3.2. Q3.6: In what circumstances could financial or economic indicators or indices be relevant benchmarks? Please see our answer to Question 3.2. Q3.7: Would dealers consider charging clients an additional fee or commission for providing best execution? 84. We cannot comment on sell-side dealers intentions and ultimately this will be a commercial decision for them. From the portfolio managers point of view, a fee would further increase costs that would have to be passed on to clients. 15

85. Also, although a fee may allow both parties to consider the costs and benefits of execution in a more explicit manner, we believe that best execution should be an integral part of the overall service provided. Q3.8: Are there any circumstances in which an execution model which uses internal benchmarks could be sufficiently robust to satisfy the best execution requirements? If so, what? Please see our answer to Question 3.2. Q3.9: What are your views on the possible benchmarks identified in paragraph 3.43? Please see our answer to Question 3.2. Q3.10: Would trade associations be willing to develop such benchmarks for the purposes of best execution? If so for what products / instruments? 86. As a trade association representing portfolio managers, we do not believe it would be appropriate for us to develop benchmarks in this area. If the development of benchmarks is indeed the role of trade associations and we would question the whether it is - then it ought to be left to those representing broker/dealers. Q3.11: Do you agree that the benchmark execution model can work for financial spread bets and CFDs? Please see our answer to Question 3.2. Q4.1: Do you agree with our analysis of the requirements to review and monitor? 87. We acknowledge the need to review and monitor best execution arrangements and policies if portfolio managers are going to be able to demonstrate that the right processes are in place. But these have to be carefully calibrated to ensure they are supported by cost-benefit analysis. 16

This is why we welcome the DP s emphasis on flexible and proportionate implementation, in line with firm s arrangements and its position in the chain of execution. We particularly support the point made in 4.23 of the DP that portfolio managers are not in a position to and should not be expected to monitor all the steps undertaken by broker/dealers on their behalf. 88. Few of our member firms currently have formal best execution policies in place but most have various procedures for monitoring and reviewing their execution arrangements. Some of the controls currently used do not stem directly from but contribute to the monitoring and reviewing obligations. 89. For example, it is standard practice to have in place a clear segregation of duties between account managers and in-house dealers. Any anomalies in prices or other factors which contribute to providing the best possible result for clients are thus more likely to be detected. Most firms also conduct counterparty polling at least annually, where brokers are assessed both from a fund manager s and trading desk s perspective (i.e. on the basis of execution quality, advice, research ideas and so on). 90. There are also controls designed specifically with best execution in mind. Most firms, for example, use compliance monitoring to evaluate transactions against firm s internal arrangements and policies. Most use sampling as a way of checking for discrepancies. There are also occasional annual reviews of end-to-end arrangements and policies and their ongoing delivery of best possible result for the client. 91. Member feedback suggests that they believe these arrangements to be sufficient to ensure the quality of execution for their clients. A more prescriptive approach risks turning what should be a commercially driven practice into a tick-box exercise where the costs would undoubtedly outweigh the benefits. 92. The quality of execution attained by our members is ultimately reflected in the performance of funds they manage. That competitive pressure is enough of a motive to monitor performance. The variety of controls in place, coupled with the experience, skill and judgment of portfolio managers and their dealing desks, preclude the need for heavy regulation. They also ensure that losses from individual trades are likely to be small so there is little incentive to monitor extensively. The costs of data collection and analysis alone are likely to exceed the savings made. Q4.2: On monitoring: do you agree with the comparisons suggested in paragraph 4.11? If not, how would you assess the effectiveness of your 17

arrangements? Will firms monitor their trading on a daily, weekly or monthly basis? 93. In principle, we agree with the comparisons outlined in 4.11. However, we would like to register some concern about the tone of both the question and the monitoring section in the DP. They both seem to imply that assessments could be conducted on a trade-by-trade basis. Not only would trade-by-trade assessments provide little discernible benefit but in some cases they would not possible at all. The execution a firm gets cannot be measured against an absolute standard it is not what the Directive requires anyway but should be seen in the context of that firm s execution policy. Q4.3: On reviewing: do you conduct qualitative or quantitative reviews of brokers, regulated markets or MTFs now? If so, how frequently? 94. As a trade association, we are not in the position to answer this question. However, we believe most of our members have a system in place where both fixed income and equities counterparties are reviewed by fund managers and dealing desks. Some firms also periodically review trading volumes and compare them to counterparty review results. Q4.4: Please estimate and explain any incremental costs that you will incur to comply with these requirements. 95. If the requirements are implemented in a principles-based way, then the costs should not prove to be onerous for firms. Q4.5: Do you agree with our analysis of how the requirements to review and monitor might apply in dealer markets? In particular, will dealers be able to compare and evaluate benchmarks? 96. Our answer to Q3.2 explains we do not believe that benchmarking is a suitable way of demonstrating best execution. Q4.6: Have you considered what data you will need to review and monitor? 97. A post-trade review of execution quality will be relatively straightforward for liquid securities. However, in OTC markets where there is no posttrade transparency, the processes of reviewing and monitoring will be 18

constrained by the lack of available data. The emphasis will instead be on pre-trade controls (such as obtaining competitive quotes) to ensure the best possible result for the client. Q4.7: Have you considered any changes that may be needed to order management systems to capture data for monitoring? 98. There is still uncertainty about the structure of the market post-mifid implementation so we believe it may be too early to consider these changes. Q4.8: Will execution venues provide data to firms to demonstrate their execution quality and compete for order flow? 99. We cannot comment on firms intentions but we may in any case have to wait for markets to take shape once the regulatory requirements are clear. Q4.9: What other approaches do you suggest to demonstrate that client orders have been executed in accordance with a firm s policy? 100. We believe the process-driven approach described in our answer to 4.1 should be sufficient to demonstrate that orders have been executed in accordance with firm s policy. Q4.10: Is there a role for an industry-led initiative to address these issues? 101. Depending on the final shape of the proposals, there may be room for some industry guidance. 19