A qualitative approach to Best Execution

Buy-side firms are increasingly focused on finding qualitative ways of vetting their trading counterparties, with the advent of a new electronic order handling questionnaire marking a milestone in that journey. In this article, Mike O’Hara and Joel Clark of The Realization Group hear from Allan Goldstein of Trade Informatics, Paul Collins of Franklin Templeton Investments, Natan Tiefenbrun of Bank of America Merrill Lynch, Ross Barrett of the Investment Association and Mark Northwood of Bips Global. They all agree that collecting the right information is only the start of the process – it needs to be properly managed, updated and accessed, ideally using an electronic system.


Approach to due dilligence

Know Your Counterparty

Shrewd assessment of one’s counterpart is probably the most fundamental tenet of every business deal, as practitioners in any sector need to feel fully comfortable that the other party will be reliable, delivering exactly what is promised in a timely manner. Such due diligence might typically rely on a range of assessments, both qualitative and quantitative.

It’s a discipline the financial services industry is heavily focused on improving, as firms deal with new post-crisis regulations and a general business drive to vet counterparties more thoroughly and efficiently. Sell side firms have long undertaken extensive know-your-customer (KYC) exercises to protect themselves from a range of risks, but their buy-side clients are now ramping up their own know-your-counterparty routines.


Gone are the days when you could keep this information in a filing cabinet – if you want to be relevant then you need to make sure the data is fully up-to-date and accessible on an ongoing basis.
Paul Collins, Franklin Templeton Investments


“We have always done a pretty good job with KYC on the banks and counterparties we deal with, but I’m not sure the industry has historically focused enough on terms of business and access to counterparty data. Gone are the days when you could keep this information in a filing cabinet – if you want to be relevant then you need to make sure the data is fully up-to-date and accessible on an ongoing basis,” says Paul Collins, Head of Trading for Europe, the Middle East and Africa at Franklin Templeton Investments.

While some firms may be better than others at performing due diligence on their sell-side counterparties, it is widely recognised that there has been a lack of standardisation and consistency in the way in which information has been gathered, stored and updated in the past.



Formal compliance checks may be performed on counterparties on an annual or quarterly basis, for example, but individual traders are likely to carry out their own more idiosyncratic processes before striking a deal or during the course of a trade. Disparate but relevant information about particular counterparties would then be held in different places within firms, with no central repository to collate the data and no way of ensuring key information is retained when particular individuals leave or change functions.

“A variety of information may exist within an organization which could be considered documented evidence of due diligence on a counterparty, from emails and phone records to trading notes and other traditional documents like terms of business and questionnaires. So there is clearly a need for a central database to aggregate and democratize that information, to create a “corporate memory”. In many firms the information is spread among individuals and departments – compliance has some of it, legal has some of it and traders have some of it, so it’s very hard to look at it holistically and information is invariably lost,” says Allan Goldstein, Chief Operating Officer at Trade Informatics.


There is clearly a need for a central database to aggregate and democratize this information, to create a ‘corporate memory’. In many firms the information is spread among individuals and departments.
Allan Goldstein, Trade Informatics


It is not just within firms that disparate due diligence processes result in inefficiencies, but the lack of a standard methodology across the industry to assess counterparties can make things difficult for banks and brokers as well. Faced with a multitude of clients asking different questions about their processes, brokers will often expend significant time and resources in sourcing and approving information and then issuing the answers to their clients.


Best Execution

The sell side has broadly welcomed early moves towards greater standardisation in due diligence and some banks and brokers are already seeing clients looking to formalise their broker selection and monitoring processes. That is being driven in part by an industry-wide focus on best execution as participants prepare for the recast Markets in Financial Instruments Directive (MiFID II), set to be implemented in Europe in January 2018.

“There is heightened attention to best execution as buyside firms look to ensure they’re selecting execution counterparties for the benefit of their end investors.  But they want to be sure they are dealing with counterparties that won’t be a source of operational risk or conduct risk in the future,” says Natan Tiefenbrun, Managing Director for European Execution Services at Bank of America Merrill Lynch (BAML).

MiFID II covers a wide range of trading practices, but best execution will be central to its provisions, expanding on the requirements set out in the original MiFID text in 2007. Meanwhile the issue has been high on the agenda in the UK for several years, following the publication in mid-2014 of the Financial Conduct Authority’s (FCA) thematic review on best execution and payment for order flow.

Then in February 2015, the European Securities and Markets Authority (ESMA) published the findings of a peer review on how national regulators supervise and enforce MiFID provisions on best execution, concluding that the level of implementation and convergence of supervisory practices was relatively low.

The combined effect of MiFID II, the FCA’s thematic review and the ESMA peer review has been to push best execution higher up the industry agenda, accentuating the business case for taking greater control over counterparty selection. Mark Northwood, Principal at trade execution consultancy Bips Global, believes these recent developments have helped to crystallise the accepted definitions of best execution for investment firms.

“The FCA review really clarified the fact that best execution is about effective process, insightful monitoring and ongoing management attention on getting the best outcome for investors. The regulators are explicit that anyone handling client orders needs to have clear order handling policies and good governance in place, which requires a combination of qualitative and quantitative techniques,” Northwood explains.


Buy-Side firms want to be sure they are dealing with counterparties that won’t be a source of operational risk or conduct risk in the future.
Natan Tiefenbrun, Bank of America Merrill Lynch



The level of attention to the detail of counterparty due diligence may vary from one buy-side firm to the next, but among the most constructive industry developments over the past year has been the Equities Electronic Order Handling Questionnaire, developed by members of the Investment Association (IA) and the Association for Financial Markets in Europe (AFME).

The initiative aims to establish a common framework for buy-side firms to request information from electronic trading providers in the European equity markets. Split into seven sections, the questionnaire covers best execution, trading venue selection, algorithmic trading, non-displayed liquidity, transaction cost analysis, client confidentiality and risks and controls.

On algorithmic trading, for example, sell side firms would be asked to answer a comprehensive set of questions about their algo offering, explaining how the various strategies work, whether they can be customised, and how they will react to different market conditions. As algorithmic trading has grown, market participants have developed a need for a more effective way of exchanging this kind of information, says Ross Barrett, Capital Markets Specialist at the IA.


The regulators are explicit that anyone handling client orders needs to have clear order handling policies and good governance in place, which requires a combination of qualitative and quantitative techniques.
Mark Northwood, Bips Global


“There is more and more algo trading happening in the market and banks are naturally fielding a lot of questions from their clients, but there was a general sense that the process of sending questions and answers back and forth by email wasn’t really working. The questions were often repetitive or open-ended, and the answers tended to be either too detailed or too high-level,” Barrett explains.

Dealing with disparate questions from clients may be difficult for banks and brokers, but for buy-side firms, it would be even tougher to reconcile answers from multiple counterparties and make effective execution decisions on that basis. It is hoped that having a common, detailed set of questions will make life easier for both sides and also lead to more informed and effective decision-making and risk management in the future.


Standard framework

Beyond algorithmic trading, the questionnaire requires sell side firms to summarise their best execution policies, explain how trading venues will be selected, detail what post-trade analysis will be provided and explain how client confidentiality will be protected. In total, the document runs to well over 70 questions and requires significant detail to be provided by the sell side, but having a standard set of questions has the potential to significantly ease the burden of supporting buy-side due diligence. The sell side now has an opportunity to maintain a “golden copy” combined with a distribution platform to efficiently manage distribution and modifications.

“This is now a much less significant overhead for us, because we maintain our most current set of answers to the questionnaire so that we can respond to client requests in a matter of minutes. We still get bespoke questions coming in as well, and that takes more time because we may not have the answer immediately available and may need input from compliance and legal before we can respond,” says BAML’s Tiefenbrun.

The questionnaire is still a relatively new initiative, having been launched in March 2016, but it is steadily gaining traction as market participants recognise the benefits of having a standard framework. As it is a non-binding document drawn up by practitioners rather than regulators, there is no obligation for firms to use it, or to stick entirely to the agreed text, but its architects at the IA and AFME are confident it will become the basis of buy-side due diligence for electronic orders in the future.


here was a general sense that the process of sending questions and answers back and forth by email wasn’t really working. The questions were often repetitive or open-ended, and the answers tended to be either too detailed or too high-level.
Ross Barrett, The Investment Association


“Our members have been very pleased with the questionnaire, and I believe there has already been widespread adoption. We hear from the brokers that they are seeing more of them coming through, so it is already improving the flow of information between buy side and sell side, and also has the potential to reduce costs,” says Barrett.


Central information platform

While the formation of the questionnaire may be considered an effective solution to the challenges that have been encountered by both sell side and buy side in carrying out effective due diligence, it is really only the start of the process. The issues entailed in the questionnaire are extensive and the drafting deliberately stopped short of standardising answers, which means buy-side firms still need to collect and make sense of a fairly large volume of qualitative information.

“The questionnaire is a very positive development, but when you think about all the things traders have to agree and communicate with counterparties across asset classes and derivatives, it goes well beyond electronic trading protocols. These accepted practices and broader terms of engagement now need to be systematically agreed, captured and retained for future reference as well,” says Northwood of Bips Global.

The fact that the questionnaire is being largely distributed and answered by email at this stage also makes it difficult to quickly and efficiently compare answers as they come in and may deter firms from keeping their counterparty information updated on a regular basis. But if due diligence is only carried out annually, there is clearly a risk that important counterparty information may not be collected.

The need for some kind of central information sharing platform to host the questionnaire and manage the flow of questions and answers has been recognised from the outset. AFME and the IA published an extensive set of specifications to help their members identify software providers that could deliver an electronic trading information platform, and a vendor presentation day was held in June 2016 at the IA in London.

Among the solutions that successfully completed the associations’ review process was Plia, a counterparty management technology offered by Trade Informatics, a financial technology firm based in the US. The review process continues and it remains to be seen whether the industry will coalesce around a single platform to manage the exchange of counterparty information, but Trade Informatics’ Goldstein believes Plia is well-placed to meet the needs of market participants.


Peer comparison

“The Plia system gives firms a single repository where they can hold all of the annual due diligence information and questionnaires and also log all of the counterparty information that is collected on a day-to-day basis by traders and front-office staff. So when staff go into a broker due diligence/best-execution meeting or engage with a regulator for an audit, they can clearly evidence their due diligence and pull all of the relevant information very easily,” says Goldstein.

Significant as the questionnaire and other such information gathering exercises may be, it is the ability to combine that formal intelligence with ad hoc information that is gathered during the normal course of business that is likely to engender the most effective due diligence in the future. Managing the process electronically should also lead to more proactive use of the information than if it is stored on disparate emails and spreadsheets.

“In many cases the questionnaires are still just a tick-box exercise for many firms and little is done with them beyond a cursory glance. The concept of an electronic database is the first step towards being able to do something measurable with the qualitative information and exercising proper peer comparison,” says Goldstein.

Effective peer comparison should not necessarily seek to align scores to particular responses and make what should be a qualitative review more quantitative in nature, Goldstein adds. Using the questionnaire and any supplementary points of inquiry, firms should dig as far as possible into the mechanics of a broker’s offering and then set the responses against those of other providers to determine the true profile of each counterparty.

Buy-side firms may still have some way to go before they are in a position to exercise sophisticated qualitative peer comparison, but it is one part of the unwavering focus on best execution that is driven not only by MiFID II, but also by a general business drive to take greater control over trade execution and counterparty selection.


Consistent communication

Franklin Templeton’s Collins sees best execution as a two-part process comprising that which is outsourced to the sell side through smart order routers and algorithms, and that which is encompassed in internal decision-making at the trading desk level. The use of questionnaires and systems and controls is central to the due diligence process, but firms also rely on their counterparties to ensure best execution when handling orders.

“Preparing for MiFID II is a great opportunity to re-evaluate all of our processes and policies to make sure we are pursuing best execution in the optimal way. We realise that the more tools we have to enhance that process the better, and the more we can blend the qualitative and quantitative approach to yield better results,” says Collins.

Banks and brokers must also play their part in the increasing sophistication of the buy side’s due diligence, and that goes well beyond simply answering questionnaires and responding to requests for additional information as and when they are made. It is also incumbent upon brokers to communicate any material changes in their order handling processes to their clients in a clear and timely manner.

Such changes to sell-side processes may not be consistently communicated across the industry today, and here again any communication is likely to take place over a range of email, instant messaging or phone calls, which does not always lend itself to effective record-keeping, adding further to the need for a central counterparty management system.

“If we add a new venue, change the logic by which we choose which venue orders are posted to, or change the behaviour of one of our algorithms, we have a governance process that determines when such changes have a material impact on execution and should therefore be proactively communicated to clients. We are now seeing some clients looking for a solution to standardise how they receive, acknowledge and store such communications,” says Tiefenbrun.



Going forward, there is little doubt that industry processes for achieving and evidencing best execution will continue to evolve. As the implementation of MiFID II edges closer and the order handling questionnaire becomes more deeply embedded in the due diligence process, buy-side traders should find that they are better equipped to make more informed choices about their counterparties.

But despite the tangible progress that has already been made, it is unlikely to be plain sailing. The importance of adopting a qualitative approach to best execution may be more widely recognised than it was in the past, but putting it into practice will require firms to overcome cultural as well as technological challenges.

“Although the actual matching of orders is mostly electronic, those orders are often handled by a process combining programmed and human decision-making. Human traders introduce a degree of discretion into the process, typically in response to complex order instructions and market conditions – dealing with that variability will be the big challenge in the years to come,” says Northwood.

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