Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

V. Trading Performance Measurement

(2) MiFID best execution obligation This new rule is a crucial element of investor protection and must be viewed as the natural counterpart of a full liberalisation of the marketplace. This obligation is found in the now famous Article 21, which has been at the heart of the arguments put forward by many opponents of MiFID. After having summarised the main details of the provision, we will show that although MiFID puts the spotlight on best execution, it has not provided a clear definition or a measurable objective that would make it possible to determine whether trades have been executed in the best possible fashion. In the 2004 Directive, the best execution obligationhas beendefinedas anobligation of means whereby investment firms are required to have taken all reasonable steps to obtain the best possible result for the client. This obligation is therefore structured around three major principles: (i) an obligation of means to achieving the best possible result for the client, involving factors that determine whether or not this best possible result has been achieved; 31 (ii) documentation of an execution policy that includes the selected execution venues and documentation of the parameters that justify this selection; (iii) an obligation for investment firms to demonstrate, at the demand of the client, that execution has been carried out in accordance with the agreed execution policy and that the execution policy allows achievement of the best possible result on a consistent basis. MiFID considers best execution in the context of client categorisation and in a tiered manner. Accordingly, the assessment

throughout all phases of the investment cycle to ensure that the portfolio realizes its highest returns possible”. Even if the above definition is not yet widely recognised in the industry, we strongly believe that it is the right way to clear up most of the confusion surrounding best execution. Consistent with this definition, Kissell and Glantz (2003) claim that checking whether best execution is achieved results in analysing the entire transaction cost management process. This thorough check thus requires a complex post-trade procedure that should consist of the following steps: 1. Evaluate the implementation decision: Is the trading strategy optimal? Does it lie on the ETF? 2. Measure transaction costs actually incurred: Where and why did they occur? 3. Estimate transaction costs ex post : What are cost estimates with known market conditions? 4. Compare actual transaction costs with ex-post cost estimates: Is there over/ underperformance? 5. Measure execution performance: Has the intermediary executed at fair market prices? Did he add value? 6. Compare the cost difference with the value-added: Is over/underperformance related to superior/poor execution or to favourable/adverse price movement? 7. Record performance of intermediaries Although this procedure looks attractive and quite complete from a theoretical standpoint, it is rarely applied, as debate on the definition of best execution and/ or trading performance measurement is ongoing.

31 - Article 21 states, however, that whenever there is a specific instruction from the client the investment firm shall execute the order following the specific instruction.

65 An EDHEC Risk and Asset Management Research Centre Publication