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Risk - June 14, 2004

Impact of the updated European Investment Services Directive with regards to Best Execution

A survey conducted by Edhec-Risk Advisory

Best Execution - A challenging issue, a promising debate, a regulatory challenge

With the objective of conducting a European survey on Best Execution, Edhec-Risk Advisory has approached more than 150 institutions, including the largest European investment managers.

The final results of this initiative were presented on Wednesday 9th June at the Hôtel Crillon in Paris. The presentation provided 50 representatives of the largest investment firms, as well as the main brokerage houses, with the opportunity to discuss the difficult challenge of implementing best execution controls, as can now be expected following the agreement on the revised European Investment Services Directive.

The survey enabled the current positioning of European Fund Managers vis-à-vis their new obligation of achieving transaction best execution, where the elaboration of execution strategy is not fully outsourced to the broker-dealer, to be assessed.

The survey, which was conducted over a period of 4 months (from January to April 2004), consisted of the following steps:
  • Collection of written responses to a detailed questionnaire
  • Series of formal interviews based on the same detailed questionnaire
  • Series of qualitative interviews in order to refine specific questions
The results encompass responses from 68 institutions, providing a fair representation of the European industry, despite a small size bias due to the fact that most of the respondents represent mid-size or large institutions. Assets managed by the sample respondents amount to more than €4,000bn.

A changing landscape

The survey has revealed a major change in the relationship between Asset Managers and their intermediaries. If Direct Market Access, or DMA (direct access to the exchange through connectivity provided by the broker) has already convinced more than 60% of respondents, volume traded through such a facility only represents 7.5% of the total volumes. If DMA is still considered to be marginal, it is interesting to note that more than 66% of respondents intend to increase their DMA volume over the coming years, with 22% foreseeing DMA to represent up to 50% of their trading volume. The growing success of DMA may be explained by the fact that algorithmic trading is currently used for less than 5% of volumes by 41% of respondents, while 58% process up to 50% of their trading volumes through algorithmic trading programmes (internally or through brokerage services).

However, even more important for broker-dealers is the increasing need for transparency and control over the execution process. The survey reveals that an increase in transparency is a key element for 40% of the survey respondents, while up to 50% of respondents are willing to implement more stringent controls over trade execution. 10% of respondents are satisfied with the current status of the relationship.

Is regulation arriving too late?

Investment managers clearly think that best execution is an important issue to be dealt with. For 65% of respondents, the handling of best execution is a very important question, with 26% considering it to be an important issue – a total of 91% – while only 9% of respondents believe it can not be considered to be an important issue. However, this importance is mainly justified today by internal policy considerations. Only 3% of respondents have highlighted regulation as being a driver for implementing best execution, while the two most important criteria put forward are transparency (47%) and efficiency (75%).

Sadly for the investor, while operational efficiency and transparency are the most frequently cited benefits of controlling execution costs, it is surprising to note that the benefit of reducing transaction costs, which is an important question for investors, is ranked well behind (only 21% of respondents).

Implementing Best Execution: a difficult challenge

46% of respondents have already implemented an infrastructure for controlling best execution, with 28% intending to do so in 2004-2005. This apparently favourable situation should not camouflage the fact that most of the respondents have probably only implemented these procedures for equities, leaving less liquid markets, such as fixed income, open to potential large swings due to the trading activity, resulting in high implicit execution costs.

Moreover, if the monitoring of execution delays and the quality of prices is a primary objective of the infrastructure developed internally, it is surprising to see that direct costs, such as brokerage fees, are not monitored by nearly 30% of respondents, despite the fiduciary duty of the investment manager. Moreover, opportunity costs arising from delays are not controlled by half of the respondents.

What controls are you focusing on?

This situation is exacerbated by the fact that with less than 45% of institutions having implemented a proper order management system, the requirement of time-stamping orders from front to back appears to be a difficult challenge to by-pass. For those institutions who have implemented time-stamping, the investment decision is the most challenging event to track, even though it is necessary for determining the implementation shortfall, which represents the most accurate absolute measure of execution costs.


It now seems evident that the industry has reached a clear maturity point with regards to the understanding that best execution is an important objective to achieve in order to better align organisations with the most successful houses. However, the ultimate interest of the investors would appear not to be the most important reason for this. The implementation of best execution infrastructure will prove to be an important challenge as it may require substantial investment in technology, especially for small investment firms who have not yet felt the need to implement advanced order management systems. Moreover, the reach of investments both in terms of geographic location, but also in terms of instrument types, results in complex conceptual challenges to be dealt with.

With more execution venues available to European managers, it would appear that the European regulation is coming at a good time. However, the very nature of the regulatory requirements should be more clearly defined in order to avoid the industry having to come up with the means for implementation yet again which might result in investments that are not always perfectly appropriate, and possibly inconsistent, across competing organisations.

For further information on this survey, please contact Jean-René Giraud: jrg@edhec-risk.com.