SFC ISSUES GUIDANCE ON BEST EXECUTION FOLLOWING THEMATIC REVIEW

On 30 January 2018, the Securities and Futures Commission (SFC) issued a circular to set out its guidance on the standards expected of licensed corporations on best execution (Circular). The SFC also provided further detailed guidance in its Report on the Thematic Review of Best Execution (Report).

This follows the SFC’s thematic review of 21 licensed corporations (LCs) announced in November 2016, which assessed the effectiveness and adequacy of the LCs’ arrangements for delivering best execution. On 9 February 2018, the HKMA issued a circular to draw the attention of registered institutions to the SFC’s guidance.

Under paragraph 3.2 of the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission and paragraph 3.2 of the Fund Manager Code of Conduct, licensed or registered persons are required to execute client orders on the best available terms to deliver best execution. They are expected to have in place arrangements, including controls, monitoring and management supervision, to obtain the best available terms. Such arrangements must be periodically reviewed to ensure that best execution is achieved consistently.

In the Report, the SFC sets out its observations, expected standards and good practices in relation to the following areas:

1. Governance and management supervision
2. Best execution factors
3. Applicability of best execution
4. Responsibilities of execution staff
5. Controls and monitoring
6. Arrangements with affiliates, connected parties and third parties

The SFC has indicated that it will continue to monitor local and global market and regulatory developments and may propose further measures. We highlight the key aspects of the SFC’s guidance below.

1. Governance and management supervision

The SFC expects the management of LCs to have sufficient oversight on matters relating to best execution. Trade exceptions and other relevant matters should be brought to the management’s attention on a timely basis.

LCs should also establish and regularly update best execution policies and procedures. Such policies and procedures should cover all types of financial products handled by them. The SFC noted that some LCs under its thematic review did not cover all types of products in sufficient detail, focusing mainly on equities but not other asset classes.

The SFC advises that best execution policies and procedures should address the following at a minimum:

• factors to be considered in delivering best execution;
• applicability of best execution and carve outs;
• monitoring and control mechanisms to review execution quality of trades; and
• respective roles of the operational and control functions in ensuring best execution.

If applicable, these policies and procedures should also address the following:

• how to handle clients’ orders where multiple quotes exist, or where pricing information is insufficient; and
• disclosure to clients of best execution arrangements, including carve outs and the exclusive use of affiliates, connected parties and third parties.

In addition, LCs should provide staff with periodic training, including when policies and procedures have been updated.

Good practices identified by the SFC include (among others):

• post-trade execution reports to compare execution outcomes of client orders with benchmarks such as the Volume Weighted Average Price (such reports to be made available to clients upon request);
• policies and procedures which reference regional regulations and provide practical guidance to staff on how to adhere to these.

2. Best execution factors

The SFC expects LCs to take sufficient steps to obtain the best available terms when executing client orders, after taking into account relevant factors, such as price, cost, speed of execution/settlement, likelihood of execution/settlement, and size and nature of the order. The relative importance of each factor may vary from case to case.

The SFC emphasises that specific instructions from a client on one part of an order should not be treated as releasing an LC from its best execution obligations in relation to other parts of the order.

The Report gives an example of good practice by an LC, which had policies outlining the specific best execution factors relevant to its business, and prioritised factors across different types of clients, asset classes and trading scenarios.

3. Applicability of best execution

The SFC’s expectations are that:

• when LCs enter into agency or back-to-back principal transactions with clients, the best execution obligation remains with the LCs where clients rely on them to protect their interests;

• when LCs enter into principal transactions with clients (other than those which are back-to-back in nature), the LCs should make their own assessment to determine whether clients are relying on them to protect the clients’ interests, and whether the best execution obligation is owed.

The Report provides an example of good practice by an LC where a systematic method was used to assess whether the best execution obligation applied. The LC used the following assessment criteria (to be considered collectively):

• Does the client initiate the transaction?
• Is it a market convention for clients to “shop around”?
• Is it a relatively transparent market?
• Is disclosure made to the client that no best execution is provided?

4. Responsibilities of execution staff

The SFC stresses that execution staff and their supervisors form the first line of defence in the trade execution process. They should demonstrate reasonable diligence in:

• handling client instructions;
• monitoring execution outcomes;
• obtaining multiple quotes where applicable (in the absence of multiple quotes, sufficient pricing information should be obtained on a best-effort basis to validate quotes provided to clients).

The Report provides an example of good practice in relation to obtaining quotes, where an LC required its execution staff to record the traded price as well as the next best available quotes obtained. Compliance staff would then check the completeness and accuracy of the information recorded, and perform post-trade checking to determine whether the orders were executed at the prevailing best prices.

5. Controls and monitoring

The SFC expects controls and monitoring to be in place to review the quality of the execution and to detect and address anomalies. This should be carried out by the second and third lines of defence, such as compliance and internal audit functions. Appropriate metrics and reference benchmarks should be used depending on the characteristics of the financial instruments and the complexity and the scale of the LC’s operations. The Report provides various examples of good practices by LCs.

6. Arrangements with affiliates, connected parties and third parties

The SFC stresses that regardless of whether orders are executed via affiliates, connected parties or third parties, the obligation to deliver best execution remains with the LCs. LCs should therefore:

• carry out due diligence on affiliates, connected parties or third parties engaged for execution; and
• implement a systematic process to monitor execution outcomes on a continuous basis (examples of good practices by LCs are provided in the Report).

In addition, the SFC highlighted that soft dollars, rebates and other inducement arrangements with affiliates, connected parties or third parties should be clearly disclosed to clients according to the regulatory requirements. Further, the selection of execution parties by an LC should not be based primarily on the existence of inducement arrangements, without further assessment of the performance of such parties.

CONCLUSION

The increased speed of trading (the execution of which is largely electronic or automated) and the increased complexity and variety of financial products make it all the more important to have comprehensive best execution policies and procedures in place.

In light of the SFC’s focus on investor protection and conflict of interests, licensed and registered firms should review their systems and controls as early as possible to ensure that they meet the SFC’s expectations set out in the Circular and the Report. Although the good practices provided by the SFC are examples and are not intended to be exhaustive, they contain useful tips to firms who are looking for ways to enhance their systems and procedures.