When the European Markets in Financial Services Directive was adopted three years ago, fund managers appeared content. After all, more competition in markets would mean their broker-dealers would get a "better deal" for their firms and their clients.

Well, it didn't exactly work out that way.

Fund managers are finding that fragmentation of liquidity among a surge of lit, semi-lit and dark pools means that broker-dealers have not always acted in their best interest even if they wanted to. Reporting of trades has not been standardized.

Now, a potential overhaul, known as MiFID II, could result in clarifications on reporting transparency and how trading venues are categorized. That might help improve the accuracy and timeliness of data to fund managers. But transparency alone is not enough, experts say.

"When MiFID first went live, most fund managers didn't think through what they should be asking of their broker in terms of best execution," said Niki Beattie, managing director at The Market Structure Practice, a London consultancy. "However, now that they have experience of the market, they are being more discerning in their discussions with broker-dealers."

The existence of a best execution contract is no guarantee a broker-dealer is meeting its obligations. If anything, it offers a false sense of relief, said Gary Wright, director of research at B.I.S.S. Research, London.

All broker-dealers are obligated to do is take "all reasonable steps" to obtain the best possible result for the client based on a very broadly worded best execution policy. That policy can include price, speed, liquidity and clearance and settlement costs," Wright said. All of these can differ depending on whether the customer is classified as a retail, professional or eligible counterparty.

So how should a fund manager protect itself? The best defense appears to be mounting an offense. Fund managers should know just how many trading venues are executing the orders; what routing logic does the smart order-routing system use to determine where and how to apportion trades to venues, how is latency measured and what percentage of trades fall within which types of algorithms-be they liquidity seeking, benchmarking or tactical strategies.

"The buy side is getting better at asking the right questions. But it still needs to understand the broker-dealer's business model. Even if the broker-dealer can access multiple venues, the fund manager needs to know the reasons the decisions were made and how the trades were executed," said Alexandra Foster, head of European sales for agency brokerage Instinet in London.

That means finding out what percentage were executed through an external dark pool or the broker-dealer's internal crossing system and why. That is because if a broker-dealer is internalizing order flow, the buy-side firm may have incurred an opportunity cost by not going directly to external destinations.

In the case of dark pools, says Foster, clients should understand the broad percentages of the different types of liquidity that interact with internal broker-dealer and external dark pools. Dark pool liquidity can be impacted by: cash orders, direct market access orders, and portfolio trading orders, how long orders reside in the dark pool and how the orders are protected against being potentially gamed by other market players.

But even asking for more detailed information from broker-dealers may not be enough to compare results among multiple service providers. "It's difficult to find a single, neutral source of post-trade data against which to measure execution performance," said Steve Grob, director of group strategy for Fidessa, a global order management system provider headquartered in London.

The problem of accommodating multiple trading platforms is made even worse by the fact that every venue can act as a trade reporting destination for any other venue or broker.

Different lit and dark venues, Grob explained, can also take advantage of different trade reporting rules under MiFID.

The European Commission's failure to mandate a single post-trade data feed-aka a real-time consolidated tape-may be corrected under MiFID II, but in the meantime, buy-side desks face plenty of uncertainty on where to place orders.

"Brokers have stepped up offering smart order routers and proprietary transaction-cost analysis tools yet without better pricing data they are often ineffective,'' said one operations executive at a UK investment firm.

Exchanges counter that the consolidated tape is not a panacea for ensuring fund managers can meet best execution requirements. "Fund managers are placing too much emphasis on the so-called consolidated tape and not enough on their own due diligence in verifying that the broker-dealer is protecting their interests," said Christian Katz, chief executive of SIX Swiss Exchange in Zurich.

Among the ways to do due diligence: Thomson Reuters, Bloomberg, ITG and Fidessa all offer their own versions of pre and post-trade consolidated tape. Fidessa also provides a Fragmentation Index, a single number which tracks the rate of fragmentation of any stock or index over time. A separate Fragulator takes this a step further and shows a view of the trading pattern for any stock or index over any time period across all lit and dark venues. The goal: to help the buy side select the appropriate destinations for its order flow.

Longer term, buy-side firms might want to move trade execution in-house. "Self-directed trading has increased in line with the widening range of execution options available, which will make best execution agreements irrelevant,'' Beattie said.

"A strong buy-side trader has the opportunity to define best execution for himself and shape how well the broker-dealers are doing," Beattie continued.

But such an endeavor won't be easy to achieve, fund managers say. Costs of buying the right smart order-routing, pre-trade analytic and transaction cost analysis systems aside, the trading desk also will need to convince the portfolio manager and chief investment officer its strategies can either improve investment returns or reduce transaction costs. Or both. 

What Discerning Fund Managers Should Ask:

1. Which trading venues are accessed and why?

2. How does the broker's order-routing system work?

3. What percentage of trades were executed through which algorithms and why?

4. What percentage of trades were executed in internal and external dark pools and why?

5. How do you protect trades in dark pools?

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