Trade Governance

All asset managers should have a trade policy document that clearly and comprehensively articulates the firm's trading policies and escalation procedures. The curriculum can be quite wordy in this section. The heart of the message is simply this:

“Firms need to have a written document that outlines how to handle all aspects of trading”

An asset manager’s trade policy ensures that its execution and order handling procedures align with the duty of best execution it owes clients. The following items should be covered by the policy:

• Meaning of best execution.
• Factors determining the optimal order execution approach.
• Listing of eligible brokers and execution venues.
• Process to monitor execution arrangements.

Meaning of Best Execution

While achieving the best trade price for the client is essential, it’s a bit too simplistic. We must also factor in the trade’s nature. Is it urgent? Is there a risk of information leaking? What are the overall trading costs?

Clients should not be disadvantaged, but different service levels can be offered as long as they are paid for and disclosed to all clients. This might involve using different approaches based on the trade’s size and characteristics.

Optimal Order Execution Approach

The curriculum emphasizes the importance of firms having a written set of factors to consider when making order execution decisions. These factors go beyond just getting the best price; they guide how trading is managed.

The 2020 CFA Level III Program curriculum outlines the following factors:

• Urgency of an order: Does the order need to be executed aggressively at an accelerated pace, or can it be traded over a longer period of time? What is the size of the order relative to the security's normal liquidity?
• Characteristics of the securities traded: How liquid are the securities to be traded (e.g., the average daily volume)? Are the securities standardized or highly customized?
• Characteristics of the execution venues used: Which type of trading mechanism or venue is used? Are both lit (on-exchange) markets and dark markets available to trade a security?
• Investment strategy objectives: Is the investment strategy short-term or long-term in nature?
• Rationale for a trade: Is a trade intended to capture an investment manager's expected return views? Or is it a risk trade or a liquidity trade? Underlying trade objectives may have important implications for the optimal trade approach.

Listing of Eligible Brokers and Execution Venues

Once again, the curriculum states that firms should have a written policy in place about who they use to transact their trades. The curriculum outlines the important considerations in choosing a broker. Perhaps a firm should just use these very criteria?

• Quality of service: Does a broker provide competitive execution compared with an execution benchmark, such as submission price or VWAP?
• Financial stability: Will the broker or execution venue be able to fulfill obligations in all market environments? When such brokers as Lehman Brothers and MF Global went bankrupt, it caused substantial disruption to their clients' activities.
• Reputation: Does the broker or execution venue uphold high ethical standards and treat clients fairly?
  Settlement capabilities: Are the operations supporting the broker/execution venue robust? Can trades be settled in a reliable and efficient manner?
• Speed of execution: Can urgent trades be implemented with minimal delay and at the best price possible? What is the maximum volume that can be traded with minimal delay?
• Cost competitiveness: Are the explicit costs (such as commissions or exchange fees) competitive?
• Willingness to commit capital: Is the broker willing to act as a dealer to facilitate trading for a client? This can be particularly important for less liquid securities that need to be traded in a timely manner.

Process to Monitor Execution Arrangements

Trading firms are advised to regularly assess their brokers. They should have systems for monitoring and assessing trade execution efficiency, like using benchmarks such as VWAP. The curriculum suggests establishing a committee to stay informed about current and potential brokers and keeping approved broker lists updated with new information.

Additionally, firms should retain trade records for several years, and the curriculum highlights key aspects to consider in trade records.

• Address client concerns: For example, trading records can be used as evidence by an investment manager to show clients that their accounts have been treated fairly. This is particularly relevant if an investment manager runs similar strategies that might frequently trade in the same direction. For instance, there may be a need to demonstrate fair trade allocation or that particular strategies are not being favored at the expense of others.
• Address regulator concerns: A regulator may be interested in assessing how the investment manager has met the best execution standards. In addition, regulators need to monitor market integrity and detect criminal behavior, such as “fake volumes,” “quote stuffing,” and “spoofing,” which are illegal activities in most markets.
• Assist in improving execution quality: A database of past transactions may be used to analyze and refine the execution process to control and improve trading costs.
• Monitor the parties involved in trading/order execution: Trading records can be used to evaluate how performance by brokers and execution venues may compare in execution quality. This helps inform which services should be retained in the future.

Question

In terms of choosing an optimal broker, willingness to commit capital and act as a dealer to facilitate trading for a client is particularly important for which of the following trade types:

1. Less liquid; more urgent.
2. More liquid; more urgent.
3. More liquid; less urgent.

Solution

The correct answer is A.

When dealing with less liquid assets (which are harder to buy or sell without impacting the price) and more urgent trade situations (where quick execution is necessary), the involvement of a broker who is willing to commit capital and act as a dealer becomes particularly important. This is because in such scenarios, a broker’s ability to hold inventory and facilitate the trade is crucial to prevent substantial market impact and achieve a favorable execution.

B is incorrect. In more liquid markets, there is generally less need for a broker to commit capital and act as a dealer because liquidity makes it easier to execute trades without the need for a dealer’s intervention. More liquid markets often allow for efficient execution without a dealer’s assistance, even in urgent situations.

C is incorrect. In situations where trading is both more liquid and less urgent, the need for a broker to commit capital and act as a dealer is further reduced. In these cases, the client may have more time to execute the trade without resorting to a dealer’s services.

Reading 11: Trade Strategy and Execution

Los 11 (i) Evaluate a firm's trading procedures, including processes, disclosures, and record-keeping with respect to good governance.