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Benefits and Pensions Monitor April 2007

‘Best Execution:’ Will It Work?

By: Robert Smythe

What is ʻBest Execution?ʼ

It is often considered to be ʻBest Price,ʼ but this is not the case. ʻBest Executionʼ factors include price, timing, certainty, anonymity, and execution costs. When optimally managed, these factors can improve portfolio performance.

What has changed in the Canadian securities marketplace that requires any action on the part of pension plans, investment managers and plan sponsors? There are two things: the emphasis on ʻBest Execution ʼ in Canada and globally, and the multiple trading venues that will be available in Canada in 2007.

Why ‘Best Execution?’

Under regulatory rules, broker/dealers are obligated to achieve ʻBest Execution.ʼ Since there is no universal definition of ʻBest Execution,ʼ regulators have advised broker/dealers to establish agreements with their clients as to what constitutes ʻBest Execution.ʼ

best execution

While pension plan and investment managers look at Alternative Trading Systems (ATS), Electronic Crossing Networks (ECN), and Direct Market Assess (DMA) to execute trades, they also need to understand how they can impact ʻBest Execution.ʼ

Since the new trading paradigm coming to Canada will change the way markets function, broker/dealers, pension plans, and investment managers need to prepare for this change now.

The New Trading Environment

The advent of multiple and competing marketplaces has resulted from a regulatory desire to create a framework for the competitive operation of traditional exchanges and alternative trading systems. Rule changes and alternative marketplaces began to appear in 2006.

The resulting equity marketplaces in Canada include:

Other trading venues scheduled to emerge in 2007 include TriAct and Instinet.

In addition to equities, trading approaches for fixed income, options, derivatives, and other alternative investments involving trading venues such as the Montreal Exchange (MX), CanDeal/TradeWeb, and CBID must be managed. The upstairs trading capabilities of the major broker/dealers should also be factored in.

Prior to making an informed decision with regard to which marketplace will provide ʻBest Execution,ʼ the trading characteristics of these venues need be understood.

An investment manager can no longer simply toss an order to a trader and assume all is well. With the multiple options now available, wrong choices may have a noticeable impact on portfolio performance. Modern investment managers must now work even more closely with their traders to ensure that their trading strategies achieve ʻBest Execution.ʼ

The Canadian Regulatory Structure

New securities marketplaces in Canada are the result of action taken by the Canadian Securities Regulators (CSA) starting back in 2001.

In Canada, there are multiple regulators overseeing financial services. This is illustrated in Figure 1. The regulators moving ʻBest Executionʼ forward include the Canadian Securities Administrators (CSA), provincial security regulators, and the IDA-RS.

Regulators have been concerned about the efficiency of the Canadian financial industry. Similarly, the Canadian financial industry has been concerned about the efficacy of regulatory processes. These concerns were well summarized in a December 11, 2006, speech by David Dodge, governor of the Bank of Canada, on ʻImproving Financial System Effiiciency: The Need for Action.ʼ

best execution

ʻBest Execution,ʼ in its broadest definition, can become the focal point for the many initiatives that are needed to improve the efficiency of the Canadian financial industry.

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