Addressing MiFID’s Best Execution challenge 
By Jean-Baptiste Dezard, Marketing Director for Europe, ILOG.

Introduction

Part of the European Commission’s Financial Services Action Plan, the Markets in Financial Instruments Directive (MiFID)[1] is aimed at establishing comprehensive regulations for investment services and financial markets in the European Union. The goal is to create a single, pan-European financial market by establishing uniform rules that make it easier for companies authorized to operate in one member state’s market to operate in the other European countries as well. However it will initially make things harder for the companies to be ready for the implementation of this new regulation.

The commission is expecting MiFID will significantly lower capital costs for European companies, and at the same time, ensure strong investor protection by introducing an extensive set of new rules governing the relationship investment firms have with their clients.

MiFID is slated for implementation in November 2007 and will be adopted in different steps following the Lamfalussy process[2] (see “MiFID Current Status”), and sanctions for non-compliance will range from fines to suspension of trading rights. Even so, investment services haven’t been gearing up to apply MiFID’s rules, which will probably change often after their initial introduction.

MiFID has provisions for many areas, including conflict of interest, conduct of business, “best execution”, passporting rights, equity markets transparency, record keeping, client reporting and outsourcing. “Best execution” (see “Best Execution” definition – Article 21) is generally the area regarded to be very complex, as highlighted in a recent survey conducted by IBM showing that 75% of the respondents identified “Best execution” as the most challenging part of MiFID implementation.

Concrete Steps to Best execution implementation

Let’s examine the steps to implementation of a fictive investment bank EUFIB.

The chief compliance officer of EUFIB will have to ensure and to prove that “best execution” has been achieved. Proving “best execution” compliance requires proving compliance across a cycle of activities[6]. These can be laid out in the following clearly identified steps: prioritisation of factors, analysis and selection of execution venues, linkage to execution venues, creation of “best execution” policy, agreement of client to “best execution” policy, execution of orders, periodic review of factors and venues.

Firstly the EUFIB compliance officer must document the prioritisation factors per client/client group. Factors to prioritise include: price, cost, size of order, nature of order etc. The order of importance must take into account the needs of their clients for obtaining the best possible result. Where other factor may override apparent price and costs, the circumstance leading to this must be clear. 

Secondly the EUFIB compliance officer must document the analysis and selection process for execution venues. This should include what venues are available, like regulated markets, MTFs, Sis. For each venue he or she must ensure the performance of the venue against the factors defined for the client. This will include costs of execution and settlement for a venue as well as other considerations such as pricing quality (for example ensure a comparative pricing model for non-unique OTC derivative contracts, referencing market values of building blocks).

Thirdly EUFIB must document why a particular execution venues was not selected showing the consideration of connection costs and other reasons. EUFIB must also document the process of regular review of quality of execution and execution venues. The EFIB IT team must ensure that EFIB is linked to appropriate execution venues either directly or via an intermediary.

Fourthly EUFIB need to document the agreement of the “best execution” policy with each client. This needs to include prior agreement for off-market trades. The “best execution” policy needs to cover each class of instrument otherwise the execution of orders will be documented per trade. EUFIB IT need to be able to provide an audit trail that enables validation that the policy was applied. In addition, EUFIB must document any client instruction that overrides “best execution” policy.

Finally EUFIB need to document and implement the process for monitoring and review the “best execution” policy. This process must be at least annual, and every time a material change occurs that could affect the firm’s selection of execution venues. This will mean that rules governing that policy will potentially have to be changed very often and on a regularly basis.

Consequences in companies’ IS

The consequences for EUFIB’s IT are not trivial. It must ensure the following three key points are addressed to avoid the risk of regulatory breach.

1)	The coherence of the published policy and the implementation. This will be challenging because policy may need to be implemented across the range of EUFIB Order Management Systems and trade execution systems.

2)	The maintenance of the policy with the implementation. This will create more work for IT department to implement these changes and the process could quickly prove over-costly both in terms of times and human resources.

3)	The ability to demonstrate the “best execution”. This requires keeping pricing and policy for a given period of time and client group and demonstrating that the policy was executed for any given order.

A Business Rules Management System to manage Best Execution policy

Often business policies like “best execution” policy are unstructured content that guide business decisions to be made. Business Rule Management is a corporate best practice that controls the process by which corporate policies become implemented in the business applications on which the corporation depends for carrying out its day-to-day business. 

Using BRMS, the issues described above are simplified. In BRMS, policy is expressed via rules in a business language, and managed in a controlled and secure environment. These rules are then deployed to rules engines that are integrated in one or more Order Management Systems or Trade Execution systems, where they are executed directly.

The advantage of the BRMS approach is that it addresses the issues above as follows:

1)	The use of a business language and its direct deployment to the operational systems guarantee a consistent implementation of “best execution” policy for their clients.

2)	BRMS reduces the IT burden for a firm to maintain “best execution” policy. BRMS enable non-IT experts to quickly and simply create the rules governing this “client policy” and as soon as the client expresses the desire to modify it, to quickly and easily do it.

3)	Finally a BRMS provides easy audit ability. So if a client or a regulator asks for proof, (potentially for transactions going as far back as five years) a firm using a BRMS could quickly determine, and prove, which rules have been applied to any given transaction.

Conclusion

MiFID will facilitate trading but business will get more complex having to deal with new regulations. The BRMS technology not only enables companies to easily implement MiFID and to manage “best execution” policy on a sustainable and flexible way, but also gives an opportunity to effectively manage policies across the entire organizations, while enhancing business agility and competitiveness.

-----------------------------------------“Hors Texte”------------------------------------------------

MiFID Current Status

MiFID is being adopted under a four-level regulatory approach called the Lamfalussy process.

Level 1 (i.e. the directive itself) – To be finalised for April 2004:
Adopted in 2004. Its objective is to reach agreement on framework principles and definition of implementing powers in Directive/Regulation. Directive is translated into national law where as regulation is applied directly from EU text.

Level 2 – Scheduled to be finalised for July 2006:
Current phase of MiFID. Level 2 drafts[3] were released in February 2006. They are close to the eventual final text and the basis for discussion with the European Securities Committee, who requests advice from the European Securities Regulators Committee on technical implementing measures.

Level 3 – Scheduled to be finalised for January 2007:
Committee of European Securities Regulators works on joint interpretation recommendations, consistent guidelines and common standards (in areas not covered by EU legislation), peer review, and compares regulatory practice to ensure consistent implementation and application. National regulators either have provided discussion paper on MiFID guidelines (eg. the English FSA[4]) or are planning to do so shortly (eg. the French AMF Plan to start discussion process in July 2006[5]).

Level 4 – Scheduled for November 2007:
Enforcement Commission checks Member State compliance with EU legislation.

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------------------“Encadré technique”---------------------------------------------------------

Article 21 defines “Best execution” as the obligation for firms to obtain the “best possible result for their clients” when executing orders in the absence of specific instructions from the client. In seeking to deliver “best execution” a firm should take a wide-range of factors into account, such as price, costs, speed, likelihood of execution and settlement, size, and the nature of the order and other relevant considerations. The obligation on firms requires them to establish a policy to achieve “best execution”. It is not an order-by-order requirement to ensure (and prove) that “best execution” has been achieved in relation to any given order to which the overall obligation applies.

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Notes and references

[1] See “The European Commission on MiFID”:
http://europa.eu.int/comm/internal_market/securities/isd/mifid2_en.htm.

[2] See “The application of the Lamfalussy process to EU securities markets legislation”:
http://ec.europa.eu/internal_market/securities/docs/lamfalussy/sec-2004-1459_en.pdf.

[3] See “Mifid Level 2 - Draft Implementing Directive”:
http://ec.europa.eu/internal_market/securities/docs/isd/dir-2004-39-implement/dir-6-2-06-final_en.pdf.

[4] FSA: Financial Services Authority (for Great Britain). See “DP06/3: Implementing MiFID's best execution requirements”: http://www.fsa.gov.uk/pubs/discussion/dp06_03.pdf.

[5] AMF : Autorité des Marchés Financiers (for France). See “La directive sur les marchés d'instruments financiers : enjeux et conséquences pour la régulation française”:
http://www.amf-france.org/documents/general/6905_1.pdf

[6] See “Background Note: Draft Commission Regulation implementing the Markets in Financial Instruments Directive 2004/39/EC (‘MiFID’)”: 
http://ec.europa.eu/internal_market/securities/docs/isd/dir-2004-39-implement/dir-backgroundnote_en.pdf

[7] Note that there is on obligation to include a venue if cost of connection is disproportionate.