From the desk of John Arnesen
Consulting lead, Pierpoint Financial Consulting
Once the dust had settled on MiFID I back in 2007 it was clear that agency securities lending was largely immune from its provisions and the market collectively determined that best execution was not applicable. After all, given the huge number of variables that must be accounted for in a loan transaction, it would be virtually impossible to capture all that information in a reportable format and for anyone to make sense of it. Right?
Fast forward a number of years and the market began preparing for MiFID II but during an early round of Q&A it became clear that MiFID I Article 21 did not “ exclude any types of orders or financial instruments from the scope of its application” and “ Securities financing transactions (SFTs) should therefore fall under the obligation of best execution whenever a client of an investment firm issues an order and expects the investment firm to act on her behalf” So despite the majority of the lending market believing they were exempt under MiFID I , it wasn’t the case.
Under MiFID II, the debate centered around Article 27 (RTS 27) which in summary requires the reporting requirement for trading venues, market makers and liquidity providers to evidence they have taken “all sufficient steps to obtain the best possible result for client when executing orders…”. During 2017, ICMA were very vocal about the practicalities of the requirements and worked tirelessly to explain the limitations of reporting under the provisions. In its January 2017 paper, ICMA concluded with “A lot of work and expense to produce a lot of meaningless data”. I’m sure I have heard this said of another piece of regulation recently!
Notwithstanding this, under MiFID II, best execution does apply to agency lending activity and the requirement is not only to provide best execution but full disclosure of the activity to underlying clients and its associated risks. This is understandable given the entire regulation is driven to deliver greater investor protection and transparency, a positive pursuit with which few would disagree. However, given its Over -the-Counter (OTC) nature how does a firm really go about demonstrating that that it is treating a client fairly and striving to act in its best interests at all times?
From an agency lending perspective, best execution is not new. While MiFID II may have formalised the requirement, the principle of fairly allocating loans has been an inherent feature of most, if not all vendor-based lending systems for many years. Based on a points system which is calculated by multiplying the loan value with the fee or rebate, the points are allocated to each client in a queuing system. The greater the points a client has, the higher in the queue they are placed. The agent will then do one of two things; either assign the loan to the first eligible client in the “queue” or allocate on a proportionate basis from all clients that could participate.
Typically, both agent lender and borrower will want to reduce the number of movements in the settlement process and assign a loan from the client in the queue that can satisfy the request in one settlement instruction. This is reasonable given that the agent absorbs all settlement costs which, in certain markets can be expensive. Those clients that “missed out” are, as a result better positioned for the next loan opportunity.
This is a practical way to ensure that regardless of a client’s size of assets when joining a lending programme they have every opportunity to take part in a loan. Agent lenders have dozens if not hundreds of clients all looking to achieve the same result; maximise their revenue potential under their individual permitted risk profile.
This is where it becomes challenging.
Despite the fact that clients are pooled in a lending system and in many instances, they will hold the same assets, the reality is that is it rare that any two clients have the same risk profile governing their lending programme.
Counterparty approvals and limits, collateral acceptability, regulatory restrictions on term lending applicable to UCITS, borrower approval of the client and a host of other considerations essentially make each client unique. It was commented at a post-trade conference in 2016 by one participant that “clients are in a pool of one…”What can happen is that the client eligible for the next loan opportunity cannot participate because, for example they do not accept equity collateral which this particular borrower wants to post or perhaps the borrower is not approved by the client or vice versa. If agents have contemplated and solved for this, they will have built an “override code” with a drop-down menu that can assign a reason why the loan opportunity was overridden. This becomes important under MiFID II to demonstrate to the relevant National Competent Authority (NCA) that steps have been taken to record occasions when the queue is overridden but equally, it gives the agent a set of data that can be discussed with clients should the occurrences of overrides become too frequent.
However, best execution mandates that firms act in the clients’ best interest at all times and to seek the best possible outcome. That in itself is a thorny issue, not to be compliant necessarily but to demonstrate it in any meaningful, measured way. For example, the best fee may not be the best outcome for a client. Through experience a trader may turn down a borrower offering the highest fee as they know that particular borrower to have a tendency and history of returning loans quickly. What if another borrower was offering a lower fee but in contrast had a history of keeping loans for a long duration? The latter scenario is a better outcome for the client which is why, using a benchmarking service, fees cannot be used in isolation as a measure of best execution. A number of elements have to be considered in approaching this subject which has made providers think more holistically about their clients’ performance. This led to the creation of Best Execution Policies for agency lending, many of which can be found on-line. An easily found and good example of one is from Brown Brothers Harriman (BBH) which clearly sets out the considerations they take into account when executing loans.
Pierpoint Financial consulting is committed to improved methods for development and application of Best Execution, in line with regulatory requirements. Talk to us about why we think that sometimes “Best execution is not the best outcome for investors”. Whether you are a client wrestling with how to measure Best Execution or an agent lender concerned that you are delivering it well, contact us for more detailed information.