Complying with “best execution” requirements is nothing new for fund managers, but some could easily end up failing to meet their fiduciary obligations this year due to circumstances beyond their control — the unprecedented market volatility and remote working generated by the COVID-19 pandemic.
About a dozen operations managers at US fund management firms who spoke with FinOps Report over the past week acknowledged they were concerned about whether their firms would be able to fulfill their best execution obligations, but none was willing to explain how their firms would address any potential issues. Instead, they claim there is only so much they could do to ensure some of the intertwined key components of best execution such as price discovery, execution quality and cost reduction given the reduced liquidity and intraday price swings over the past few weeks. Market volatility is far higher than that experienced during 1987’s Black Monday, the 2008 global financial crisis, and even the end of the Great Depression. The heightened market data traffic has also generated gaps in data necessary to analyze execution quality, acknowledge market data experts.
The US Securities and Exchange Commission, the U.K.’s Financial Conduct Authority and other regulators require registered investment advisers to demonstrate that they evaluated trade execution options and picked the one that would be most beneficial to the fund and therefore its investors. In 2019, the SEC issued an interpretation of registered investment advisers’ fiduciary obligations under the Advisers Act to include best execution by evaluating the full range and quality of services. The second incarnation of Europe’s Markets in Financial Instruments Directive (MiFID II), effective in 2018, says that fund managers and other financial firms must go beyond taking “reasonable steps” to taking “sufficient steps” to ensure best execution and publish detailed information on trade execution and quality.
Although US unregistered alternative fund managers may not be under the same strict legal obligation as registered investment advisers to meet best execution they still do for practical reasons. “It comes down to meeting their obligations to investors as the limited partners in the fund,” says Ankur Laroia, managing director of digital transformation services for global financial services consultancy BDO US in New York. “They are simply more active traders than mutual fund managers, use more complex trading strategies which rely on derivatives, and more often execute their own transactions.”
At the heart of complying with best execution requirements is setting up a written policy for how it should be implemented and following it. “The fund manager needs to show consistency in how it executes the best execution strategy,” says Laroia who has led technology implementation projects at hedge fund management shops. The largest fund management firms typically have best execution committees comprised of chief compliance officers, trading desk directors and operations directors determine how to best execute the investment strategy of a separate investment committee — when to buy and sell assets, which brokers to use, and the criteria by which to judge brokers. The buck stops with the chief compliance officer who will hopefully have past experience on a trading desk or rely on subordinates who have worked at trading desks and are embedded in their firm’s trading operations for several weeks at a time.
The essential framework of a best execution policy includes documenting price discovery, broker and venue selection, execution analysis, testing, and reporting. Buy side firms then need to evaluate the effectiveness of their best execution policies on at least a quarterly basis if not more quickly. “There is no single barometer for best execution,” says Jacob Rappaport, managing director and head of equities trading for broker-dealer INTL FCStone in New York. The criteria that fund managers must use to judge their brokers or themselves executing orders include the price of the transaction, the speed of execution, the cost, the value of research, the responsiveness of the broker, and the efficiency of trade settlement. Fund managers give each factor a different weighting depending on the asset class and investment strategy involved.
Working from the comforts of home might sound even more effective than working from the office, but it has turned into an anathema for traders who must depend on their firms to set them up with the right equipment to transmit orders. “Some fund sales traders told us they had trouble working orders with their brokers due to a lack of the right technology from their out-of-office remote locations,” says Frank Grampone, executive vice president at BXS, a New York-based best execution data analytics firm. “Their only solution to maintaining a dialogue with brokers is to use the phone for order instructions, fills, and the like.” However, legal experts caution that the practical alternative could put fund managers at risk for breaching best execution requirements if the call was not recorded because it was conducted over a personal cell phone rather than a company-issued device. Problems with connectivity are expected to decline as more wirehouse traders return to their physical offices in June and July.
Even if fund managers can successfully communicate with their broker-dealers, their efforts to ensure the correct price discovery and execution quality have been hampered by the recent market volatility as top of the book depth is diminished and fleeting. Orders often can’t be completed at their arrival prices. “On-screen prices have become unreliable,” says Rappaport. The reasons are multi-fold: prices are moving far too quickly, the bid and ask spreads have less depth and lack real liquidity. The London-based trade group International Capital Markets Association recently said that electronic trading in European corporate bonds effectively shut down during the height of the pandemic in March as the prices on trading platforms were not executable and electronic requests for quotes did not return quotes. As a result, traders were forced to revert to voice trading. Rappaport says that his firm is gaining market share in principal trading as clients increasingly rely on it to commit capital to supplement liquidity in less liquid situations or otherwise access markets inaccessible through electronic trading.
Market volatility will also likely impact the accuracy of transaction cost analysis (TCA) reports which measure explicit costs such as fees, and implicit costs such as market impact. “Fund managers use TCA to evaluate the quality of their own and their brokers’ execution performance based on their barometer for acceptable performance,” explains Jim Toes, president of the Security Traders Association, the New York-based trade group representing traders at fund management firms and broker-dealers. “Brokers will differ in performance and the fund managers can find any outliers who fall outside the range.” Fund managers, says Toes, do understand that transaction costs are likely to have increased during the pandemic and will be comparing the execution quality of the broker before and during the COVID-19 pandemic. Broker-dealers who deviate too far from expectations could find their relationships terminated.
However, judging broker dealers or themselves through TCAs won’t be easy for fund managers. “As a rule of thumb, the greater the market volatility the lower the accuracy of the TCA,” cautions BXS’ Grampone. The reason; one of the key metrics used for implicit costs– a comparison of the price of execution to the value weighted average price (VWAP) might be skewed if the broker-dealer or fund manager cannot retrieve precise market data, such as tic data, to make the analysis or the data is stale. Grampone says that BXS audits quote data by monitoring for erroneous quotes, erroneously wide quotes and crossed/locked markets to compare trends and detect outliers. Case in point: if BXS detects a single quote with a 20 cent spread in a security which has an average quote spread of only two cents, BXS would remove the quote from its analysis for being an outlier.
“The fund manager needs to have all of the right market data at the time the trade is executed and historic data on how it previously executed an order in the same equity,” says Patrick Flannery, chief executive of MayStreet, a New York-based market data management platform provider. The right data includes full-depth order book data immediately before and after trade execution as well as trade data. The data can be sourced either directly from exchanges via their proprietary data fees, in a consolidated manner via the SIP or in a consolidated manner via third party vendors, such as MayStreet, Refinitiv or Bloomberg. Because SIP data only includes top-of-book data many brokers and their fund manager clients don’t use it to determine execution quality. “With the amount of market data traffic essentially doubling overnight beginning in late February, market data systems run by fund managers and brokers have become strained resulting in gaps in data that managers need to perform their analysis of execution quality,” says Flannery. “It can be very challenging to get pristine data, meaning no data loss of any kind and to also have it GPS time-stamped at the nanosecond level.”
Several operations managers at US fund management firms tell FinOps Report that during the past two months they had trouble accessing market data providers either because their logins didn’t work or because they could not download their data feeds. Flannery recommends that fund managers experiencing market data gaps have some serious talks with their market data vendors and internal teams about their technology architectures to pinpoint the causes of the glitches for fixing. Given that fixing data gaps isn’t easy, particularly during periods of high market data traffic, more firms are turning to specialist market data management firms to reduce systems strains and to provide complete data, he says.
When judging brokers or themselves, evaluating fixed-income transactions appears to be more problematic than equities either because fund managers are not receiving TCAs for those financial instruments or because the reports alone can’t fulfill best execution requirements. Some fund managers insist that the same methodology is often incorrectly used for fixed-income assets as for equities, making TCA reports for fixed-income securities ineffective. “Meeting best execution for fixed-income instruments is always far challenging than for equities because of the different inputs involved some of which are subjective,” says Jane Stabile, president of IMP Consulting, a Boston-based consultancy specializing in helping asset managers optimize their use of trading and compliance systems. “The fund management firm needs to store information on the yield, maturity, and spreads based on a benchmark. It also needs to explain the purchase or sale based on overall trading strategy and its effect on the rest of the portfolio.” Not all fund managers do so.
Stabile recommends that portfolio managers keep competitive bids and record explanations in their front-office systems as evidence of their thought processes on the trade to ensure coverage for client or regulatory purposes. Leading order-execution management systems (OEMS) are designed to accommodate this need and provide connectivity to electronic trading venues and liquidity providers, says Stabile. The most popular ones are from Charles River, now owned by State Street Corp., Fidessa now owned by ION Group, Eze Castle Software, now part of SS&C Technologies and BlackRock. Boston-based Athena Systems offers a combined order management, electronic trading and position recordkeeping platform it says is winning interest from hedge fund and institutional fund managers.
For fund managers worried about how they will meet best execution requirements under the new market volatility, reduced liquidity, and tighter budgets outsourcing the trading desk is an option. Over two dozen firms now offer outsourced trading services as either part of larger organizations or standalone boutiques; they include Jefferies Group, Cowen, Jones Trading, custodians Northern Trust and State Street, and INTL FC Stone which entered the business through is 2019 acquisition of Fillmore Advisors.
Service providers can achieve economies of scale, upgrade technology, buy more data fields and access a larger pool of liquidity than many smaller asset managers. Fund managers can also rely on the outsourced traders as backup for when their own traders fall ill, can’t access markets or can’t work overnight. The outsourced services go a step beyond simply executing trades by providing compliance services and market color. Paris-headquartered global research firm Opimas estimates that asset managers with less than US$1.5 billion in assets under management could shave off several basis points per trade using outsourced trading desks with one in five asset managers with over US$50 billion in assets outsourcing part or all of their trading desks by 2022. However, outsourcing trading has its limitations. The cost differential with in-house trading decreases as the value of assets under management increases. Some fund management firms also worry that the intangible loss of market insights and customer relationships outweigh the cost savings.
In a July 2018 Risk Alert summarizing its findings from examining 1,500 registered investment advisers, the SEC’s Office of Compliance Inspections and Exams warned that some registered investment advisers didn’t compare brokers for best execution requirements or only used one broker. Some also didn’t follow their own best execution procedures. Whether fund managers will fare better two years later under far more arduous circumstances is becoming increasingly more doubtful. So far it appears that they can only make a best effort and hope for the best.
Gwen Williamson, a partner in the law firm of Perkins Coie in Washington DC, recommends that fund managers review their Form ADVs and other other disclosures to ensure they reflect the actual and potential impacts of the pandemic. Those include any sustained obstacles to achieving best execution and any changes to trading and best execution practices. “To the extent that a fund manager adjusts its trading or best execution practices during the pandemic, the practices and procedures should be revised accordingly which requires the fund board’s approval,” says Williamson. “Depending on its strategies and market conditions, in a worse case scenario, the fund manager will have to disclose it cannot meet its best execution requirements.”