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Marshall E. Blume |
Questions have been raised in the USA regarding the operability of best execution in major marketplaces. The effectiveness of Regulation NMS (National Market System), the US’s equivalent of the "best execution" portion of Europe’s MiFID (Markets in Financial Instruments Directive), is being questioned in a paper from the highly respected Center for Financial Research at Wharton University.
In his paper, "Competition and Fragmentation in the Equity Markets: The Effect of Regulation NMS", Wharton finance professor Marshall E. Blume, warns that best execution as a concept could backfire and could stifle market innovation. He says that the principle – "all buyers see the prices asked by all sellers and all sellers see the prices offered by all buyers - and little guys are treated the same as big ones" – is fine in theory but naïve in practice and could increase costs for the institutional investors that serve individual investors.
Blume has a number of concerns regarding Regulation NMS. One argument is that it is not the best possible price for every trade that is important but the overall average price obtained in buying or selling a bucket of instruments. When a trader has to acquire or dispose of a large number of shares, the trade will be broken into many individual trades. In these circumstances, the trader is looking for speed in completing the overall deal before the market starts to move in an adverse direction. That every trade is executed at a best possible price is irrelevant to the importance of completing the trades quickly.
Blume gives another simple example of where best execution may fail. A trader may wish to buy 200 shares in one company. One exchange may offer a top of the book price to sell 100 shares at, say, $20. The next price available at that same exchange could be another 100 at $20.01. However this price is invisible to the trader. If the next "best price" open to the market is a second exchange selling 100 shares at $20.02, the trader will have to go for that price, whereas he would have been better getting all the shares at the first exchange. Blume concludes by saying that it is a fallacy that all market participants want best execution - "some investors place a high premium on speed of execution; some investors with large orders focus on market impact; and some investors prefer a non-anonymous trading market."
Regulation NMS is due to be implemented in the USA in October of this year, a month before MiFID takes effect. Its best execution requirements are simpler than those of MiFID but it is still causing concern. The US markets are very similar to those of Europe. Where does that leave the far more complex best execution requirements of MiFID?
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