ESMA consults on firms’ order execution policies under MiFID II

RegCORE – Client Alert | Capital Markets Union

QuickTake

On 16 July 2024, the European Securities and Markets Authority (ESMA) published a consultation paper (CP) and draft regulatory technical standards (RTS) specifying the criteria for establishing and assessing the effectiveness of investment firms order execution policies (OEPs).The CP and draft RTS are available here.Show Footnote Detailed rules on OEPs are set out in the EU’s Markets in Financial Instruments Regulation (MiFIR)Regulation (EU) No 600/2014, available here.Show Footnote and the Markets in Financial Instruments Directive II (MiFID II)Directive 2014/65/EU, available here.Show Footnote (as amended, including in the MiFIR/MiFID II Review)See analysis here and/or the primary rulemaking instruments in respect of the:
• MiFIR Review please see: Regulation (EU) 2024/791 of the European Parliament and of the Council of 28 February 2024 amending Regulation (EU) No 600/2014 as regards enhancing data transparency, removing obstacles to the emergence of consolidated tapes, optimising the trading obligations and prohibiting receiving payment for order flow (Regulation (EU) 2024/791), available here.
• MiFID II Review please see: Directive (EU) 2024/790 of the European Parliament and of the Council of 28 February 2024 amending Directive 2014/65/EU on markets in financial instruments (Directive (EU) 024/790), available here.Show Footnote, as supplemented by related rulemaking instruments.

The consultation runs until 16 October 2024 and seeks stakeholder input on all matters in the CP as well as specifically the questions summarised in Annex 1 to the CP. The CP focuses on the following themes:

1. The establishment of a firm’s OEP, including the classification of financial instruments in which firms execute client orders and the initial selection of venues for the OEP;
2. Procedures of firms to monitor and regularly assess the effectiveness of order execution arrangements and the OEP;
3. Firm’s execution of client orders through own account dealing; and on
4. How firms should deal with client instructions.

Based on the responses received to the CP, ESMA will prepare a final report for subsequent submission of the final draft RTS to the European Commission ahead of these being published in the EU’s Official Journal.

The draft RTS are mandated by Article 27(10) of the MiFID II Review Directive, which was published in the EU’s Official Journal on 8 March 2024, taking effect on 28 March 2024 with a transposition deadline of 29 September 2025. The draft RTS aims to enhance investor protection and foster a consistent application of the best execution requirements across the EU’s Single Market. The focus in the RTS in specifying the criteria for establishing and assessing the effectiveness of investment firms’ OEPs, accounting for whether the orders are executed on behalf of retail or professional clients, preserves the flexibility in how standards detailed in OEPs are applied to differing client categorisation types. It should be noted that the EU is also in the process of amending (and thus lowering the threshold) as to when a client may be categorised as a professional client. That change is being advanced as part of the EU’s Retail Investor Strategy (see separate coverage on that topic from our EU RegCORE).

This CP and draft RTS serve to complement ESMA’s efforts in finalising the aims and outcomes of the MiFIR/MiFID II Review as well as to contribute to improve and further harmonise the EU’s Capital Markets Union (CMU) – see standalone coverage from our EU RegCORE on CMU in 2024 and beyond reflecting key announcements made by EU and ESMA policymakers on and after 22 May 2024.

Key takeaways from the CP and draft RTS on OEPs

The best execution requirements under Article 27 of MiFID II oblige investment firms to take all sufficient steps to obtain, when executing client orders, the best possible result for their clients, taking into account various factors such as price, costs, speed, likelihood of execution and settlement, size, nature, or any other relevant consideration. The best execution requirements apply to both retail and professional clients, but with different implications depending on the category of the client. For retail clients, the best possible result is determined in terms of the total consideration, which represents the price of the financial instrument and the costs related to execution. For professional clients, the best possible result may be determined by reference to other factors, depending on the specific circumstances of the order and the client.

Investment firms are required to establish and implement effective arrangements for complying with the best execution obligation, including an OEP that explains how orders will be executed for the client and that includes information on the different venues where the firm executes its client orders and the factors affecting the choice of execution venue. Investment firms are also required to monitor the effectiveness of their order execution arrangements and policy and to review them regularly or whenever a material change occurs that affects their ability to obtain the best possible result for the client. Furthermore, investment firms are required to provide appropriate information to their clients on their OEP and to obtain their prior consent to it, as well as to demonstrate to their clients and to the competent authorities, upon request, that they have executed their orders in accordance with their OEP and the best execution obligation.

However, ESMA has observed that the implementation of the best execution requirements under MiFID II has shown shortcomings and areas for improvement in several EU jurisdictions, based on its own work and the feedback from national competent authorities (NCAs) and stakeholders. Some of the issues identified by ESMA include the lack of sufficient documentation and analysis to justify the choice of execution venues, the failure to demonstrate that client orders were executed in accordance with the OEP and the disclosure of only generic and insufficient information about the OEP and the steps taken to obtain the best possible result for the client. Moreover, ESMA has noted that the best execution requirements could benefit from further clarification and harmonisation, especially in light of the high fragmentation and complexity of the EU securities market. As ESMA states in its CP such high fragmentation “…results in a broad choice of venues where a firm can send an order to buy or sell a financial instrument.”

Accordingly, ESMA has developed the draft RTS to specify the criteria to be taken into account in establishing and assessing the effectiveness of the OEP, as required by Article 27(10) of the MiFID II Review Directive. The draft RTS covers the following aspects: the categorisation of classes of financial instruments for the purpose of the OEP; the selection of execution venues and the criteria for identifying the venue to which the order will be routed; the monitoring and assessment of the order execution arrangements and policy and the correction of any deficiencies; the treatment of client instructions and the impact on the best execution obligation; and the dealing on own account when executing client orders and the related conflicts of interest and fair price considerations.

The draft RTS proposes that the classes of financial instruments for the OEP should be based on the instrument groups of the ISO Standard 10962, which provides a classification of financial instruments (CFI) code. However, the draft RTS also allows investment firms to cluster several classes of instruments into a single class, if this does not impair the ability to obtain the best possible result for the client. Alternatively, the draft RTS suggests that a fixed list of classes of financial instruments could be used, based on the classification of financial instruments set out by the MiFID II RTSs 1 and 2, which specify the transparency requirements for trading venues and investment firms in respect of different types of financial instruments.

The second section of the draft RTS details the requirements for investment firms to select execution venues for their OEP per class of financial instruments, per category of retail and/or professional clients and by accounting for certain further factors, such as the order frequency and value, whether the executed financial instruments are EU- or non-EU instruments and the availability of certain order types. The draft RTS also requires investment firms to include in their OEP at least those venues that enable them to obtain on a consistent basis the best possible result for the execution of client orders and to maintain and update a list of the selected venues with certain information, such as the date and person or body of approval, the classes of financial instruments and types of transactions for which the venue may be used and the type of access to the venue. The draft RTS also asks respondents to provide their views on the proposed factor of “order sizes” respectively for retail and professional clients, to be considered in investment firms’ selection of eligible execution venues in their OEPs and internal execution arrangements.

The draft RTS obliges investment firms to specify in their OEP the criteria that they apply to identify the venue to which they will route the order for execution, where a specific client order can be executed on several venues. These criteria must include the obligatory and discretionary factors that the firm accounts for when making the order routing decision, such as the price, costs, speed and likelihood of execution, the real-time and historical market data and the size and nature of the order. The draft RTS also requires investment firms to provide a comparison of the results for the client that would be achieved by executing the order on each of the execution venues listed in the OEP, taking into account the firm’s own commissions and costs for executing the order on each of the eligible venues.

The third section of the draft RTS sets out the requirements for the monitoring and assessment of the order execution arrangements and policy by investment firms, as well as the correction of any deficiencies. The draft RTS requires investment firms to monitor the effectiveness of their order execution arrangements and policy on a continuous or periodic basis (at least annually), using certain thresholds to measure the performance per class of financial instruments and to trigger a review of the selected venues when the overall performance of the monitored transactions breaches a minimum percentage of traded volume. The draft RTS also requires investment firms to assess their order execution arrangements and policy at least annually or whenever a material change occurs, using a reference dataset based on consolidated tape data or alternative data sources and to update their order execution arrangements and policy and correct any deficiencies within a reasonable period (but no later than three months after conclusion of a review). The draft RTS allows investment firms to rely on monitoring and assessments performed by third parties, such as independent data providers, as long as they review the external processes thoroughly and ensure that they are representative for their client base of the investment firm with regard to the financial instruments and order sizes assessed.

The fourth section of the draft RTS clarifies the concept and the implications of a specific client instruction, which is defined as either a choice of one option out of multiple options offered by the investment firm related to a part or aspect of the order, or an instruction to the investment firm to handle the order in a different way than foreseen by the OEP. The draft RTS requires investment firms to set out in their OEP the arrangements for dealing appropriately with specific instructions from clients and to specify the impact of instructions on the criteria of the venues selected for the order execution and the ability to obtain the best possible result for the instructing client. The draft RTS also requires investment firms to include certain safeguards in their OEP to prevent inducing a client to choose a specific execution venue and to warn the client of the consequences of such a choice. The draft RTS also stipulates that where an investment firm receives a specific instruction, it should only treat the part or aspect of the order specified by the client as a specific client instruction and for all other parts and aspects of the order, it should process them in the same way as orders without specific instructions.

The draft RTS also sets out the conditions and requirements for investment firms to invite a client to select an execution venue, which is considered as a specific client instruction, in accordance with Article 27(4) of MiFID II. The draft RTS requires investment firms to specify in their OEP the arrangements to ensure that they only invite a client to select an execution venue when all the execution venues out of which the client could choose for the specific class of financial instruments are consistent with the OEP of the investment firm and thus allow them to obtain the best possible result. The draft RTS also requires investment firms to include in their OEP certain details, such as an explanation of how the policy prevents inducing a client to choose a specific execution venue and a warning to the client immediately prior to placing an order that the client’s selection of an execution venue may prevent the firm from obtaining the best possible result for the execution of the order.

The fourth section of the draft RTS also addresses the situation where investment firms deal on own account when executing client orders, such as with matched principal trading, dealing against the firm’s own proprietary position, or executing in response to a request for quote. The draft RTS requires investment firms to specify in their OEP the arrangements to ensure that they only deal on own account when executing client orders where certain conditions are met, such as the express provision and consent for this option in the OEP, the compliance with the best execution obligation and the disclosure of the relevant information to the client. The draft RTS also requires investment firms to set out in their OEP the ways to identify, prevent and manage the conflicts of interest related to dealing on own account when executing client orders and to ensure the fairness of the price proposed to the client when dealing on own account in OTC products, in accordance with the existing rules under MiFID II.

Key considerations and challenges for firms

While the draft RTS impose clarifications to existing concepts, it does also include new requirements for firms. While there may be some further changes between the draft RTS and the final RTS, there is unlikely to be much divergence from core supervisory principles and expectations. Accordingly, some firms may want to review and assess corresponding changes to their OEPs and counterparty-, execution venue- and client facing documentation to facilitate compliance. In addition to documentation, firms will need to ensure that they have adequate systems and resources for monitoring and assessing the execution quality of their OEPs and arrangements and that they use reliable and representative data sources for their analyses.

Firms should also define clear and measurable thresholds and indicators for monitoring and assessing the execution quality and establish appropriate frequencies and methodologies for their reviews. In keeping with existing requirements and respective supervisory scrutiny by NCAs, firms are reminded that they must also notify their clients of any material changes to their OEPs and arrangements and update them within a reasonable period based on the seriousness of the deficiencies.

A further key compliance consideration for firms arising out of the draft RTS is the handling of specific client instructions and the supervisory scrutiny that NCAs may direct to how firms deliver on meeting those requirements and expectations. Firms should ensure that they have clear and transparent procedures and arrangements for dealing with specific client instructions and that they inform their clients of the consequences and risks of such instructions.

Firms should also ensure that they follow the specific client instructions only in respect of the part or aspect of the order specified by the client and that they process the rest of the order in accordance with their OEPs. Firms may also want to ensure that they do not use any dark patterns or other techniques that may influence or distort the client’s decision to provide a specific instruction.

Given the clarifications that the draft RTS offer in terms of the conditions and arrangements under which firms may deal on own account when executing client orders, such as matched principal trading, dealing against the investment firm’s own proprietary position or executing in response to a request for quote, firms should ensure that they have adequate policies and procedures for dealing on own account when executing client orders and that they only do so when it provides the best possible result for their clients.

Firms should also ensure that they have effective systems and controls for checking the fairness of the price proposed to the client and for preventing and managing any conflicts of interest that may arise from dealing on own account. Firms should also ensure that they inform their clients of the possibility and implications of dealing on own account and that they obtain their prior express consent before proceeding to execute their orders in this way.

Outlook and next steps

ESMA has aimed to develop the draft RTS with due regard to the principle of proportionality and the possible costs and benefits for the market participants. That being said, ESMA invites respondents to highlight in their response the benefits of the proposals and any specific concerns they could raise for them in terms of their associated costs.

Despite that approach, the requirements set out in the draft RTS and/or any (what we anticipate to be minor) changes that flow into the final RTS (which will be covered in further standalone analysis from PwC Legal’s RegCORE) may mean that some firms might want to already conduct a review of their existing OEP and respective documentation, systems and controls as to how it meets the regulatory requirements and supervisory expectations.

Firms’ efforts in complying with the aims and outcomes of the RTS and their OEPs should also consider how this may factor into the wider range of MiFIR/MiFID II Review driven reforms along with the EU’s revised CMU priorities (both of which are covered in separate Client Alerts from PwC Legal RegCore).

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