Delivering best execution

4 April 2018

best execution

The SFC published a circular and a report on the Thematic Review of Best Execution early 2018 which set out guidance on the standards of conduct and internal controls the SFC expects of licensed corporations (LCs) in delivering best execution.

The circular and report list out some of the good industry practices that LCs should take into consideration, where they need to ensure the systems and controls that are implemented are effective and adequate in order to comply with the SFC’s Code of Conduct.

A number of compliance deficiencies were identified by the SFC during the thematic review of selected LCs in respect of some operational areas, which will be further elaborated below together with some suggested good practices, and LCs are reminded to have in place robust controls and monitoring programs to ensure that client orders are executed in the best available terms. LCs should also carry out regular or periodic review and testing of these controls and programs to ensure best execution is achieved consistently, and that each of the procedures is duly supervised by the senior management.

  1. Governance and management supervision

Some LCs have designated people that are responsible for best execution, but not all investment products and asset classes are covered within their ambit, while some LCs have set up committees on best execution which did not meet regularly, and senior management was not actively supervising the relevant procedures nor reviewing the policies on best execution regularly.

Suggested good practices:

  • Review and revise best execution policies and procedures regularly
  • Implement policies that require staff to escalate best execution-related matters to senior management
  • Set up a designated committee that is made up of representatives from different departments to discuss issues such as delays in executions and deviations in execution outcomes
  • Produce pre-trade reports that contain multiple quotes and/or validation on a specific quote
  • Produce post-trade execution reports that compare the execution outcomes with benchmarks such as volume weighted average price (VWAP).
  1. Best execution factors

An LC that placed sizeable orders for illiquid stocks only adopted the price as the best execution factor, other factors such as the likelihood of execution and likelihood of settlement were not considered. Some LCs with simple business models which only relay client orders to the Stock Exchange for execution did not consider any best execution factors.

Suggested good practices:

  • Have in place policies that prioritise best execution factors across different types of clients, asset classes and trading scenarios
  • Take all relevant best execution factors into account such as price, cost, speed of execution, likelihood of execution, speed of settlement, likelihood of settlement and size and nature of the order to ensure that best available terms are obtained when executing client orders.
  1. Applicability of best execution

Some LCs carved out all OTC products without any proper assessment when considering best execution, while others believe they did not owe best execution duties to clients as they only engage in principal trading and not agency trading.

Suggested good practices:

  • When engaging in agency trading, the obligation to deliver best execution remains with LCs as they are required to protect their clients’ interests in order execution
  • When engaging in principal trading, LCs should carry out proper assessments to determine whether they owe the best execution obligation to clients before applying any carve outs.
  1. Responsibilities of execution staff

The execution staff of an LC often split clients’ orders for illiquid stocks in order to reduce market impact, where the original order quantity is recorded on paper upon receiving the client’s instructions, and the staff manually crossed out the executed quantity. This manual crossing-out process is prone to human error, there are instances where the staff did not execute some of the client orders correctly and because they were not properly recorded this lead to them being neglected.

Another LC that has high daily execution turnover did not have appropriate procedures or systems in place to ensure execution quality, and checks performed on all executions were done manually.

Suggested good practices:

  • Obtain multiple quotes from different counterparties for execution
  • Input the trading price and the next best available quotes obtained in the trading system
  • Perform post-trade checks to compare quotes and execution prices, and determine if client orders were executed at the best prevailing prices.
  1. Controls and monitoring

The controls and monitoring systems to assess execution quality for OTC products of a number of LCs were generally not as robust as those used for exchange-traded products, best execution is not considered as an important area for some of the LCs where their compliance functions do not have established controls or systems to monitor or review the best execution policies and procedures. In some LCs, this area is either not covered by its compliance/internal audit functions, or only a few of the many different kinds of controls and monitoring are required to be done.

Suggested good practices:

  • Determine appropriate metrics and benchmarks to assess execution quality based on the characteristics of different financial instruments, as well as the complexity and scale of the LC’s operations
  • Review execution reports on a daily basis
  • Require execution staff to document any deviations or implementation shortfall
  • Ensure every control or monitoring that are established are properly assigned to the responsible function/department for implementation.
  1. Arrangements with affiliates, connected parties and third parties

Due Diligence was not properly conducted on the affiliates, connected parties and third parties that are engaged in client order executions for a number of LCs, where ongoing monitoring or assessment of the execution quality was not conducted as well. There are also insufficient controls and monitoring of client orders that are placed with these affiliates or third parties, where for instance, an LC was unaware that the orders placed might be executed in ‘dark pools’.

Suggested good practices:

  • Have in place systematic processes to review third party execution
  • Evaluate the performance of third parties by assigning them scores
  • Establish a committee to oversee the selection, appointment and ongoing monitoring of all third parties appointed for execution.

We Can Help

As the financial instruments that LCs provide are becoming more and more sophisticated and cover multiple asset classes, it is essential that robust monitoring processes are in place to ensure best execution, and that clients’ interests are properly and sufficiently protected.

We can help you to review and revise your best execution policies and procedures, and identify any compliance gaps or deficiencies in your systems and controls in order to carry out remedial measures to strengthen your compliance framework, with the aim of ensuring that you are in full compliance with the SFC’s rules and regulations.

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