New Era of Best Execution Ushered in by MiFID

Best execution is a core principle of MiFID and is fundamental for investor protection. When providing investment services to their clients, investment firms are obliged to act honestly, fairly and professionally in accordance with the best interests of their clients. This fiduciary duty an investment firm owes its client is further developed in the best execution obligations contained in Article 21.

Best execution means that, when firms execute client orders, they must take all reasonable steps to deliver the best possible result for their clients, taking into account a variety of factors, such as the price of the financial instrument, speed of execution of the order and cost. For retail clients, best possible means the most favorable result in terms of the price of the instrument and the costs associated with the execution.

This area is singled out because of the information asymmetry arising between the service provider and the client. Under normal circumstances, clients have very little opportunity to monitor whether the investment firm that executes orders on their behalf has indeed acted in their best interest since they are unlikely to have the access to the relevant information that would help them assess the quality of the service.

There is thus a danger that some investment firms could take advantage of this information asymmetry by giving unfair treatment to their clients without necessarily suffering the usual reputational consequences in a competitive market. This is why MiFID established a clear obligation for the execution of client orders.

MiFID establishes a regime where multiple trading venues will be able to compete for client order flow. Competition between trading venues should lower the cost of transacting financial instruments and thus contribute to the greater efficiency of European capital markets. However, it is well known that liquidity pools are extremely sticky, which means it is extremely hard for new trading centers to attract new business even if they can provide better services than their competitors.

As trades are driven to those venues that can consistently provide the highest quality results, the best execution obligation will help ensure that firms are not able to ignore such venues. Apart from promoting competition, best execution obligations should thus also contribute to greater market integration.

Best execution is not limited to shares but applies to all financial instruments. However, investment firms, though always subject to best execution obligations, are not expected to meet these obligations in the same way for each type of instrument.

When assessing a particular firm's compliance with MiFID, regulators will decide whether the firm's policy is adequate and whether the firm adheres to its policy in practice. The policy will also have to be dynamic. Investment firms must monitor its effectiveness in order to identify and, where appropriate, correct any deficiencies.

In particular, firms must regularly assess whether the execution venues included in the policy are actually delivering best execution and make appropriate changes when necessary. For example, the policy may have to be amended to take account of the emergence of new venues.
In most cases, in order to have a reasonable chance of securing the best possible result for their clients, firms should assess a choice of venues. This will allow them to determine which venue is offering the best conditions and to route the order to that venue.

The European Commission has noted that it is possible that a firm using a single venue for the execution of its client orders could comply with the best execution rules, depending on specific circumstances such as type of clients and financial instruments. But the Commission expects that the greatest competition among execution venues will be in the area of share trading. As more venues attract liquidity and compete, reasoned the Commission, it will become harder for investment firms to execute orders at only one venue and still meet the best execution obligations. CESR has published detailed guidance on this subject at www.cesr.eu.