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Since the beginning of the MiFID II regime, firms have been watching the FCA for signs of supervisory and enforcement activity. For wealth managers and brokers, the recent Dear CEO letter sends a clear signal. The FCA supervision apparatus is about to focus on their compliance with the regime’s best execution rules. Indeed, anyone in the dealing sphere should take notice – the policing of best execution is underway in earnest. Now would be a good time to make sure your best ex arrangements are up to scratch
The letter sets out the following three expectations of firms, which should necessarily guide us as we prepare for FCA scrutiny:
- Effective day-to-day execution processes
- Contingent arrangements for periods of market distress
- Clear, comprehensive and effective oversight and monitoring arrangements.
For further detail on the FCA’s expectations, the letter points us to the Investment Platforms Market Study. And although this study deals specifically with platforms, we can nonetheless apply its observations to dealing by brokers and managers.
Effective day-to-day execution processes
A central concern in the platforms study was that FCA testing found that only 80% of retail customers in their sample achieved a price as good as the best available. And because the FCA followed this observation with the advice, “firms also need to consider the overall cost of trading including clearing and settlement”, we should be on notice that FCA supervision of best execution for retail customers will focus on the price achieved and the cost charged. In other words, although a variety of factors can and should be considered, the FCA’s prime concern is that customers get value for money.
Contingent arrangements
In addition to an expectation of good prices and fair costs, the FCA also put firms on notice that they expect arrangements to be in place such that customers can continue to trade in times of market distress. The expectation is that platforms do not rely solely on an RSP system (where each order results in RFQs being sent to market makers) because such systems can be unreliable in times of market distress when market makers cease to provide quotes. Relying on a small number of third-party dealers or venues is not just a problem for firms using an RSP system. The fewer the brokers available to any firm, the more likely they are to experience market liquidity problems. Indeed, firms should also consider having more than one means of executing or transmitting orders – an ability to move from electronic to voice broking, for example, might be sensible for certain instruments.
Oversight and monitoring
The absence of robust monitoring at most platforms was also a cause for FCA concern. They found that some firms were using third-party systems for monitoring dealing but that these arrangements could be undermined by inadequate sample sizes or wide price variation tolerances that only pick up major anomalies. It is important to note that robust monitoring is central to the FCA’s view of what it takes to meet the bar of “all sufficient steps”. Any firm that has designed their dealing process without thought to how the results can be validated needs to take swift action. Indeed, if the FCA visit you, the absence of robust monitoring will be a problem even if they find you have been achieving best execution in practice.
Reacting to the Dear CEO letter
There are three areas all wealth managers and brokers can give attention in order to better ready themselves for this heightened regulatory scrutiny.
- Annual best execution review
You need to review your policy and produce an RTS 28 report annually. Do not treat these activities as administrative formalities. The platforms review demonstrates that the FCA are most concerned about price, cost and depressed-market liquidity. It is impossible to divorce broker and venue selection from your efforts to get the results in these areas. Your policy and RTS 28 reviews should therefore mean that your list of brokers receives serious scrutiny on an annual basis. Have any brokers failed to get you the best price on more than just the odd occasion? Have you had trouble filling orders? If the answer to either is yes, it’s time for a serious discussion about a changing of the guard.
- Ongoing monitoring: The data you feed into your annual review should also be crunched on an ongoing basis. The FCA expect problems to be remedied throughout the year. If a particular broker has been flagged on multiple occasions, dealers should be proactively considering the need to divert order flow elsewhere. And while it will likely be your trading volumes that dictate whether or not this monitoring is automated or manual, with either approach, make sure your sample sizes and variation tolerances are appropriate. Exceptions in your monitoring should prompt a reassessment of your dealing approach in the first instance – do not just increase the variation so that the exceptions go away. Ensure also that any discussions and decisions following such monitoring are documented – you want to be able to demonstrate your good governance.
- Audit trail: A record that documents the rationale for the approach taken to each trade is particularly important in instances where you gravitate away from the approach of seeking the best price. Although it can be necessary to move the focus away from price in order to achieve best execution, such instances will nonetheless stick out as anomalies in your monitoring as well as in any checks carried out by third parties like the FCA (if they choose to visit). And because the importance of other factors, such as a need for speed, will not be immediately obvious to an individual crunching the data, it is best to have a documented explanation. How you choose to maintain your audit trail will likely depend on the size and complexity of your operation. But whether it is a “dropdown” list or a more detailed free-text explanation, you should have a means of justifying the approach taken.
Start with your best execution policy
Any FCA supervision of your firm’s best execution capabilities will begin with a look at your policy. A common error when drafting best execution policies is the tendency to merely replicate the rules. Do not draft a policy that merely says there are a variety of factors (price, cost, speed, etc.) that must be considered when placing trades. Outline and explain the importance you place on each factor for each instrument. Ultimately, your policy is the prime means of justifying your approach to the FCA – make it count.
Check your RTS 28 report
It is not unreasonable to think that the FCA will look at RTS 28 reports when considering who to visit. Remember that the RTS 28 report is not like an FCA submission – you retain control of it after the required date of publication. So, while you should have had it ready to go in April, if you have any lingering doubts about its content, take the time now to get it up to scratch.
We can help
We helped numerous firms prepare for MIFID II and have a team of specialists in best execution. Get in touch to talk through what the Dear CEO letter might mean for you.
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