Best Execution and Competition Between Trading Venues - MiFID's Likely Impact

Abstract

Directive 2004/39/EC of the European Parliament and of the Council on markets in financial instruments (`MiFID') enhances investor protection in Europe by harmonizing the rules of conduct applicable to investment services providers, including best execution requirements. Under MiFID, Member States must allow internalization of orders and, therefore, eliminate the `concentration' provisions requiring transactions in equity securities to be executed by intermediaries on a regulated market. This article argues that MiFID's best execution provisions may represent a compromise between those Member States that, on one hand, having concentration rules in place, intended to protect the incumbent exchanges from the consequences of their repeal and those, on the other, that intended to fully exploit the opportunities of financial liberalization in Europe.

After examining MiFID's broad definition of best execution, the article considers several provisions that limit the Directive's flexibility. These provisions tend to favour incumbent exchanges, which offer the best prices for the securities listed on them. Indeed, MiFID requires firms to include similar venues in their execution policy and also subordinates off-exchange trades to clients' prior consent. Moreover, Commission Directive 2006/73/EC implementing MiFID foresees a `total consideration' requirement which, though not contemplated at level 1, was advocated throughout the level 2 consultation process by some continental exchanges. This requirement will have an impact on competition between trading venues, to the extent that reference to the traded instruments' price will put established and more liquid markets at a competitive advantage. The article further considers the applicability of best execution duties to dealers. Depending on the scope assigned to the relevant rules, dealers will be able to compete with other trading venues under either greater or smaller constraints. The controversy amongst CESR members in this respect is particularly significant for quote-driven markets and may reflect the different weight of these markets on the two sides of the Channel. The article concludes that the possible impact of the new best execution provisions on competition amongst trading venues could see the stock exchanges as winners, contrary to MiFID's original purposes.

Keywords: Best execution, trading venues, execution venues, MiFID, financial instruments, investor protection, internalisation

JEL Classification: K22, G14, G15, G28