A formal written trade policy is a cornerstone of responsible asset management, balancing regulatory compliance with effective trading practices. This policy outlines the approach to executing trades, ensuring transparency, fairness, and optimal outcomes for clients. It typically focuses on four key areas:
1. Meaning of Best Execution
Best execution refers to the obligation of asset managers to achieve the best possible result for clients when executing trades. While often misunderstood as simply achieving the best price, best execution is a multifaceted concept involving:
- Execution Price: Achieving favorable prices relative to the market.
- Trading Costs: Minimizing both explicit costs (e.g., commissions) and implicit costs (e.g., market impact).
- Speed and Likelihood of Execution and Settlement: Completing trades efficiently and ensuring settlement reliability.
- Order Size and Liquidity: Considering the size of the order relative to market liquidity.
- Nature of the Trade: Factoring in urgency, market conditions, and potential risks such as information leakage.
Example: An asset manager holding a large position in a company nearing bankruptcy might opt to sell the stake to a trusted dealer at a discounted price. This avoids the execution risks and information leakage that could arise from selling piecemeal in lit markets. Although the price may appear suboptimal at first glance, this approach can better serve the client’s interests, exemplifying best execution.
2. Determining the Optimal Execution Approach
The trade policy should articulate the factors guiding the selection of the execution strategy. These include:
- Urgency and Order Size: Trades with high urgency or large volumes may require aggressive execution strategies.
- Security Liquidity and Nature: High liquidity favors algorithmic trading, while low liquidity may necessitate high-touch approaches.
- Execution Venues: Assessing the characteristics and reliability of available venues.
- Investment Objectives: Aligning the trade execution with the long-term or short-term goals of the strategy.
- Reason for the Trade: Differentiating between risk rebalancing, profit-seeking, or client-driven trades.
Regulatory Considerations:
- MiFID II (Europe): Prohibits soft-dollar arrangements to ensure client commissions are used solely in the client’s interest.
- Trade Methods by Asset Class:
- Equities: Often traded via algorithms or DMA.
- Fixed-Income Products: Typically require high-touch principal or agency approaches.
3. Approved Brokers and Execution Venues
An integral part of trade policy is maintaining a curated list of approved brokers and venues, developed through due diligence and periodic reviews.
Approval Criteria:
- Execution Quality: Consistently competitive pricing and capacity to handle large or complex trades.
- Financial Stability: Ensuring counterparty risk is minimized.
- Ethical Standards: A strong reputation for compliance and integrity.
- Settlement Capabilities: Reliable clearing and settlement infrastructure.
- Cost-Effectiveness: Reasonable commissions and other explicit costs.
- Capital Commitment: Willingness to commit resources for principal trades in illiquid markets.
Best Practice: A Best Execution Monitoring Committee (BEMC), comprising portfolio execution, compliance, and risk personnel, should oversee the broker list. This committee conducts regular assessments and updates, ensuring that brokers meet the required standards.
4. Monitoring and Oversight of Execution Arrangements
Ongoing monitoring ensures execution quality and adherence to best practices. The process involves:
- Broker Oversight: Continuously evaluating brokers for financial health, error rates, regulatory compliance, and reputational risks.
- Execution Quality Analysis:
- Benchmarking against metrics such as arrival price, VWAP, or TWAP.
- Regularly reviewing trading records to identify patterns or issues.
- Addressing Issues: Prompt removal of brokers failing to meet standards and resolution of client or regulator concerns.
- Regulatory Compliance: Maintaining transparent records for audits and inquiries.
Key Takeaways
- Best Execution is Multifaceted: It encompasses price, cost, speed, and risk considerations rather than merely securing the best price.
- Execution Strategies Must Be Flexible: Tailored to the nature of the trade, asset class, and market conditions.
- Robust Broker Selection: Approved brokers and venues should meet stringent criteria for reliability and performance.
- Continuous Monitoring: Ensures brokers and execution strategies remain aligned with client interests and regulatory requirements.
A well-documented and diligently implemented trade policy not only enhances the asset manager’s operational effectiveness but also builds trust with clients and regulators by demonstrating a commitment to transparency and client-centric execution practices.
