TM fines expose ‘best execution’ issues

Institutions in Asia should take note of recent fines imposed on ConvergEx and State Street for charging unwarranted price mark-ups and hidden spreads, argue market participants.

The UK’s Financial Conduct Authority (FCA) last month followed these penalties with a review of TM providers that is likely to be referenced by other regulators, including in Asia, says Graham Dixon, director at London-based consulting firm Inalytics.

The FCA found that 13 managers transitioned £165 billion ($276 billion) of UK portfolio assets during 2010 to 2012. The top five managers accounted for 68% of those deals and nearly 80% of the volume of assets traded. (Custody executives in Asia declined to speculate on equivalent statistics for this region.)

The report also cited seven areas where transition management mandates were “particularly vulnerable to conflicts of interest”, four of which are related to execution.

ConvergEx Global Markets, the agency broker arm of BNY Mellon, had been fined $43.8 million by the US regulator in criminal penalties and restitutions in December, after pleading guilty to defrauding their clients. Some of these trades were related to ConvergEx’s TM division. The firm was found to have charged fees through fabricating transaction reports to incur mark-ups and spreads on trades that went against clients’ instructions, and their best interests.

Meanwhile, in the UK, State Street was in January fined £22.9 million for overcharging six clients a total of $20.17 million. The institutions included Kuwait Investment Authority, the Royal Mail and Sainsbury pension funds and the National Pensions Reserve Fund.

Such cases indicate that, despite Europe and the US having best execution policies in place – under the Markets in Financial Instruments Directive (Mifid) and the Regulation National Market System, respectively – they are no guarantee that clients will get the best outcome in terms of pricing.

Moreover, the rules differ in scope. For example, the Mifid best execution rules affect investment managers and brokers, while in other markets – such as the US – only brokers are caught.

In Japan, best execution is a requirement under the Financial Instruments and Exchange Act, but is said to be loosely defined and mainly imposed on equity brokers.

There is room for best execution policies to be more broadly employed globally, says John Moore, managing director of Asia-Pacific investment services at Russell Investments, which offers TM on an agency basis (rather than as a broker-dealer).

In many markets, including in Asia, best execution principles are often not applied to FX and fixed income trades, which are often done by transition managers on behalf of their clients, says Moore.

One reason for this is that equities largely trade in more orderly and transparent venues, says Hiroshi Matsubara, marketing director at technology firm Fidessa in Japan. By contrast, fixed income trading is largely done over-the-counter, meaning it’s harder to measure execution outcome.

“Many buy-side institutions still are not familiar with how to apply the ‘best execution’ concept to fixed income instruments, as it is still very difficult to define what benchmark should be used for measuring these OTC trades,” he says.  

Aside from the potential issues of overcharging, agency TM providers such as Moore argue that using a single broker-dealer significantly limits potential sources of liquidity.

Nevertheless, several of the main TM providers in Australia are investment banks, including Citi, Goldman Sachs and UBS. (That said, it was reported last week that JP Morgan was winding down its Australian TM business.) State Street is also a major player, although some expect its Australian business to come under pressure given the recent news.

One executive in Sydney says the broker-dealer TM model has remained robust in Australia as TM business have to be independently audited there. Any organisations that provide services to the country’s superannuation funds must comply with this requirement.

However, TM audits done on investment managers are performed as part of a broader audit of their entire portfolio management business, he says.