When it comes to actually trading equities, the securities industry appears to agree that “best execution” means more than just getting the best price. There’s a wide divergence of opinion, however, when it comes to how regulators should deal with the challenge of ensuring that investors get good trades, and whether fund managers should use soft dollars.

The comment period for the Canadian Securities Administrators’ concept paper concerning best execution and the use of soft-dollar commissions closed at the start of May.

It’s clear from submitted comments that there’s consensus around a few major concepts, namely: that the definition of best execution incorporates a number of considerations beyond simply price; and that regulators should take a principles-based approach to directing firms to achieve best execution, rather than setting hard-and-fast rules that may prove counterproductive.

Nevertheless, beyond the two areas of consensus there’s a great deal of disagreement among those who filed comments on some of the more specific issues. Not surprisingly, many views tend to reflect a particular self-interest.

For example, TSX Markets stresses that regulators should act to ensure that trade-throughs are prevented on competing markets. Shorcan Brokers Ltd. argues, however, that trade-through rules restrict competition and lead to over-regulation that stifles innovation. Shorcan has traditionally been an inter-dealer broker in the bond market, but it notes that it’s looking at entering the equity market.

Similarly, the big dealers that internalize order flow in the “upstairs market” argue that internalization doesn’t impede best execution, because the liquidity that the practice adds outweighs the obvious conflicts of interest it also poses. They maintain that market enforcement will ensure that internalization doesn’t lead to inferior executions.

Soft dollars

Several fund managers defend the practice of using soft dollars, arguing that it’s all to the ultimate benefit of unitholders. The same goes for other practices, such as commission recapture and directed brokerage.

However, all the practices have their critics. The Canadian Security Traders Association Inc., for example, calls internalization “a grave impediment to best execution.” A few of the comments concede that soft dollars, commission recapture and directed brokerage can all be impediments to best execution as well, by swaying fund managers’ trading decisions. There’s also some support for abolishing the practices.

TD Asset Management Inc., for one, comes out in favour of eliminating soft dollars, saying that it would be “very supportive” of the CSA scrapping their use.

However, it says the ban should be phased in, with regulators first restricting the use of soft dollars to genuine research, along the same lines as the Britain’s Financial Services Authority has dictated.

Similarly, RBC Asset Management Inc. notes that it has stopped using soft dollars except to pay for research, but it insists soft dollars are essential to maintaining the availability of third-party, independent research.

“We strongly believe that as long as integrated dealers have access to commissions as payment for their research, so too should independent research providers,” it says.

Commission Direct Inc. proposes that regulators create a new registration category for “research dealers,” and the firms would be the only ones that could qualify for soft dollars.

The idea is to level the playing field between independent and integrated research providers. “This simple restructuring of the Canadian market would enhance disclosure, address best execution concerns, and place Canada in a leading role in setting a regulatory framework for its money management industry,” it suggests.

The only comment that arguably represents retail clients on the issues came from investor advocate Ken Kivenko. In his comment, he comes out in favour of an outright ban on soft-dollar commissions.
“Banning soft dollars reduces conflicts of interest, simplifies fund administration/governance and makes regulatory compliance monitoring easier,” he argues.

If the CSA isn’t willing to ban soft dollars, he says, it should sharply restrict the sorts of goods and services that they can be used to procure. He suggests that commissions and any related-party transactions should be disclosed in funds’ annual financial statements.

So far, there’s little consensus on best execution issues, other than the fact that they are complex, and regulators should tread lightly.

Firms’ claims that they don’t need rules to ensure they pursue best execution are slightly undermined by the fact that almost one-third of the 22 comment letters were submitted after the set deadline.
Nevertheless, the use of soft dollars looks like the most likely target for regulatory attention. IE