IA opens best ex debate

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by Dan Barnes.

The risks of pushing for quantitative execution analysis, when too little data exists to support it, have been revealed in a whitepaper published by the Investment Association (IA).

Produced in association with industry magazine The DESK, and monthly show Trader TV, it is designed to help investors, regulators and compliance teams better understand the execution reports provided by trading desks.

Traders are under pressure to explain their decision-making processes since MiFID II simultaneously split execution costs from research payments, and created a framework for best execution reporting for buy-side desks. The wide range of instruments that sit under the fixed income umbrella, an absence of post-trade data for trading and over-the-counter (OTC) trading for bonds create many possible execution outcomes.

The potential exists for these outcomes to be misunderstood, and the IA has published the paper to enhance transparency around the best execution process, and the many factors that need to be assessed. Asset managers have been keen to open up how their processes work, and to unpick any complexity.

JanusHenderson_Andy Munro“We have a layered analysis,” says Andy Munro, global head of fixed income trading at Janus Henderson, speaking in the latest issue of The DESK. “We assess whether we followed our processes via a decision tree, and if we did, then was the price we obtained good, in respect of the size of the order and market liquidity. Then post trade, we ask if we made the correct decisions.”

Following the publication of transaction costs for individual funds, under the packaged retail investment products (PRIIPs) rules in January 2018, some were able to report ‘negative’ transactions costs. While market commentators have welcomed greater transparency, these negative costs imply that long-only funds generated more money than they spent via the trading process potentially misleading investors.

To avoid confusion about the way traders manage risk and costs, the paper makes the case for only using IA quantitative analysis of execution where there is sufficient market data to benchmark factors such as price, but also to take into account the importance of factors such as speed and opportunity cost where failure to execute may prevent an order being filled in its entirety.

It discusses the complexity of best execution analysis (BEA) by highlighting the effect of different factors such as liquidity, order priorities, venue access and market conditions upon the optimal execution outcome.

Use of transaction cost analysis (TCA), which is common in the equity markets, can be used to support BEA in liquid fixed income markets, the paper argues, but is limited to orders where price is the key execution objective.

The paper calls for the development of a consolidated post-trade tape in Europe, along the lines of the Trade Reporting and Compliance Engine (TRACE) in the US, a limited reduction in dealer capital restrictions to better support market liquidity, and regulatory pressure on excessive market data costs in order to better support execution analysis. n

Contact dan.barnes@fi-desk.com for a copy of the paper.

©TheDESK 2018
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