Note from IMP

Dear Clients, Friends and Colleagues:

We at IMP took a hiatus from our previous compliance newsletter to get a better sense of what is important and useful to our constituents.  Based on feedback, we have revamped our newsletter to present a single topic in greater depth each quarter, and to present it from different perspectives.  In particular, since IMP has extensive experience with trading compliance, we will seek to frame compliance surveillance requirements in terms of what is actually happening on the buy side trading desks.

We hope that this new format is useful to you, and we welcome your comments.

Kind regards,
Jane Stabile

This Quarter’s Topic: Best Execution

In this issue, we will look at the topic of Best Execution, or “Best Ex.” There has been a lot of discussion in the US and Europe regarding Best Ex. The MiFID II regime has had an impact on the information Eurozone firms must capture and be prepared to report, but the SEC’s OCIE has issued documentation on it as well.


What to Know

What is Best Ex?   It is more than getting the lowest price for a security purchased or the highest price for a security sold.  In fact, equity traders have long been judged by their ability to obtain the best price, lowest fees, appropriately timed execution relative to the market, and several other data points.  Other asset classes are more complex.  For example, while there is only one security representing a given firm’s class A shares, there may be hundreds of bonds from the same issuer at any given time, and thousands of bonds issued by other entities that will be very similar.  However, the pool of appropriate investments is likely much smaller, and it is up to the investment professionals to determine the best instrument to buy or sell to achieve the client’s goals. 

Regulatory Implications

How can a CCO ensure that her firm is adhering to Best Ex guidance?  The OCIE issued a risk alert in July of  2018 with the following list of the “Most Frequent Bests Execution Issues Cited in Adviser Exams:

  • Not performing best execution review;

  • Not considering relevant factors during best execution review;

  • Not seeking comparisons from other brokers;

  • Disclosure issues;

  • Soft dollar issues and;

  • Weak policies and procedures.


Weak Policies and Procedures:  Based on the above, it seems that the first step is crafting an effective policy for Best Ex along with the procedures to be able to conduct a meaningful review. 

Not Considering Relevant Factors During Best Execution Review:  The policy and procedures should specify what constitutes the Best Ex review, and it will need to be relevant to the asset class you are examining.  Much of this is done already on the equity side.  Since the equity market is generally more transparent, vendors offer products that collect market data, compare it to executed trades, and provide asset managers with Total Cost Analysis (TCA) reports that allow them to assess a trader’s performance.   Meeting with the equity trading desk and becoming familiar with the report and its results may help you “tick the box” for that asset class.

Not seeking comparisons from other brokers: Fixed income asset classes, as noted above, will need to be relevant to the instrument the desk is trading.  For example, municipal bonds are very different from corporate bonds, and the factors considered are necessarily different as well. The best way to understand what needs to be reported is to meet with the group trading the asset class and discuss any data they are currently capturing.  For example, many corporate debt desks will capture multiple bids (Comparisons from Other Brokers) for each trade in the order management system (OMS) they are using, and that data can be cited during your review.

Disclosure & Soft Dollar: Many firms have eliminated their soft-dollar programs altogether, but if your firm is still using soft-dollars to pay for research, you will want to ensure that they comply with (Section28(e)) safe harbor requirements.  In any case, they should be disclosed to investors, along with any other relevant factors—such as broker targets-- that could impact which broker the firm uses for a given trade.  We should note that trading that is impacted by MiFID II/MIFIR is no longer eligible for soft-dollaring, so CCOs for global firms will need to ensure that Best Ex policies are appropriate for the markets where their firms are doing business.  

Not Performing a Best Execution Review:  This seems the most obvious requirement, but keeping on top of the multitude of reports, filings and reviews required makes it easy for a review to either slip through the cracks or be continually delayed.   Make sure your staff is prepared and check out our CLEAR page to see how IMP can ensure you never miss a review.


Enforcement Actions

  1. In 2018, the SEC charged Merrill Lynch with misleading customers about how it handled their orders. According to the SEC’s order, Merrill Lynch falsely informed customers that it had executed millions of orders internally when it had routed them for execution at other broker-dealers, including proprietary trading firms and wholesale market makers. Merrill Lynch agreed to settle the charges, admit wrongdoing, and pay a $42 million penalty.

  2. In 2018, the SEC entered an order finding that a former portfolio manager (PM) for Putnam Investment Management, LLC, prearranged trades with brokerage firms in violation of the rules governing cross-trades. The SEC order also found that Putnam’s training and monitoring procedures related to cross-trading were inadequate, and that it failed reasonably to supervise the PM. Putnam agreed to reimburse approximately $1,095,000 to its harmed clients and to pay a $1 million penalty, and the PM agreed to pay a $50,000 penalty and to a nine-month suspension from the securities industry.

  3. In 2013, the SEC found discrepancies between Goelzer Investment Management (“GIM”) statements regarding its best execution policies and its actual practices. GIM stated that it “conducted comparative brokerage firm commission rate analysis” in its Form ADV but could not provide any evidence that the analysis occurred. GIM paid a $500,000 fine as part of the settlement.

  4. In 2013, the SEC announced an enforcement action relating to best execution against A.R. Schmeidler & Co. (“ARS”). ARS had an agreement with a clearing firm to split a flat-rate commission fee.  After a renegotiation, ARS began receiving a greater share of the commission and did not notify its clients of the change or conduct an analysis to ensure it was providing best execution.  ARS agreed to settle the case for more than $1 million in disgorgement and penalties.

Mechanics of Trading

How can Compliance provide surveillance of best execution practices?   Twenty years ago, most fixed income trading took place over the phone.  Traders would wrangle with brokers to figure out whether they could execute their trades with the best price, while getting the trading done quickly before the market moved against them.  In cases where PMs and Traders are trying to buy or sell a security that does not have a great deal of liquidity, some orders are still done that way.  Traders or PMs will contact a short list of brokers whom they know will typically trade or have inventory in their desired investment, and negotiate a transaction via phone, on Bloomberg or other types of communication vehicles.

However, most of the trading is now done electronically.  Workflows can vary, but PM/traders will typically search liquidity sites for bonds matching their criteria and execution details will be captured in the OMS.   The differences in execution are often differences in overall workflow and can be driven by several factors, including:

  1. Strategy

  2. Instrument (security) type

  3. Constraints (regulatory, client and market)

For example, a PM may be trying to beat the yield offered by a specific index by mimicking the weights of the industry sectors but holding only some of the bonds in the index and/or by holding bonds she thinks will provide an enhanced yield over those in the index. 

In this example, let’s assume the fund a PM is reviewing shows a significant, negative difference between the fund and the benchmark in the healthcare sector:

Fund Healthcare Sector:   3.5%                                 Benchmark Healthcare Sector:  5%

Let’s also assume that the PM has available cash to buy more bonds in the healthcare sector, and she has the additional, following criteria:

USD based                                     AAA rated                             Duration of 4.5-5 years

The PM also has the following constraint:  Not more than 10% in any single issuer.  The workflow might look something like this:


Compliance Responsibility:  What should Compliance do to monitor Best Ex, other than running a report and getting sign-off from investment managers?   As a compliance professional, spending time understanding the workflows of your organization will not only help you better assess the risk, it will also help you in designing the type of surveillance that can be an early-warning system of potential trouble.

Need help performing your Best Execution review? Contact IMP.