The Friday List: 10 Best Execution Best Practices
Today, we offer our “Friday List,” an occasional feature summarizing a topic significant to investment management professionals interested in regulatory issues. Our Friday Lists are an expanded “Our Take” on a particular subject, offering our unique (and sometimes controversial) perspective on an industry topic.
In the wake of the Robinhood GameStop trading fiasco, the Justice Department, the SEC and Congress have launched investigations into market manipulation and trading practices. Investment advisers, fiduciaries to their clients, wonder how this type of scandal could negatively affect them or their clients. We think that advisers should focus on their best execution practices to ensure that their clients are not somehow disadvantaged by the adviser’s trading venue choices. The SEC has stated that advisers have an obligation to seek best execution of a client’s transactions where the adviser has responsibility to select broker-dealers to execute client trades. As many advisers have a limited understanding of their best execution obligations, we offer 10 best execution best practices.
10 Best Execution Best Practices
- Qualitative Execution Factors. An adviser must maximize client value, which includes cost, but should also consider qualitative factors such as speed, price improvement, market access, reliability, financial stability, service, and research.
- Policies and Procedures. An adviser should adopt policies and procedures that address broker selection, execution factors, conflicts of interest, trade aggregation and allocation, trade errors, cross-trading, and disclosure.
- Best Execution Reviews. An adviser should conduct annual best execution reviews that compare commission rates against what was/is otherwise available. Although the adviser should get data from its clearing broker, it should also obtain some third party verification from a competing broker, a peer universe comparison, or a consultant.
- Best Execution Committee. An adviser should create an internally independent committee to assess best execution without a personal conflict of interest. Larger firms create a separate best execution committee, while smaller firms include best execution as an agenda item for a management committee or an investment committee.
- Benchmarks. The best execution review should assess commissions against one or more benchmarks such as VWAP (Volume Weighted Average Price); average value of price improvement per trade; total value of price improvement; average basis points price improvement; percentage of trades at best price, within spread, and outside of spread; and average basis points from trade high, low, mid-price high and mid-price low.
- Clearing Broker. If the adviser only recommends one clearing broker to its clients, the adviser should obtain specific direction from the client in writing, periodically remind the client of the direction, disclose all commission rates, and provide robust Form ADV disclosure.
- Dark Pools. If the adviser uses dark pools or algo trading venues, it should make sure that the venue does not favor certain types of clients or trades and that the adviser’s clients obtain the best possible rates.
- Soft Dollars. If the adviser receives soft dollars (e.g. research), it should engage in heightened best execution reviews because of the inherent conflict of interest. The SEC is much more likely to attack best execution when the adviser receives soft dollars in return for directed trading.
- Conflicts of Interest. Adviser should also assess other conflict of interest red flags including brokers who offer special product distribution arrangements, preferential IPO access, step-outs to affiliates, sequencing preferences, and direct payments to individuals.
- Disclosure. An adviser should fully disclose its trading practices including its best execution review processes, trade aggregation and allocation practices, and soft dollar arrangements.