2.1.2.2 Execution of orders

44. 1) Introduction - The investment service of execution of orders on behalf of clients encompasses “acting to conclude agreements to buy or sell one or more financial instruments on behalf of clients”1 and thereby exposes the investment firm to more prudential risks than an investment firm only transmitting the orders. The definition of execution of orders has been amended in MiFID II to also include “the conclusion of agreements to sell financial instruments issued by the investment firm itself”.2

45. When executing orders, the investment firm places itself between buyers and sellers of financial instruments and acts as the broker between them by concluding the transaction.3 From a prudential supervision point of view, the investment firm assumes responsibility for concluding the transaction and therefore the responsibility of the investment firm for the sound functioning of the financial markets increases as compared to an investment firm that solely transmits these orders to another broker.

46. 2) Relevant risks - Since investment firms performing this investment service are an essential link in the transactions in financial instruments, prudential regulation should enforce a certain amount of time during which the investment firm can “survive” financial distress and thus be able to perform its function within the financial markets. If the investment firm were to fail, the agreements to buy or sell financial instruments which have not yet been executed or settled will remain open. After the investment firm fails, its clients will not know whether and when their transactions will be executed. If the investment does not follow the delivery-versus-payment model (in which the delivery of the financial instrument occurs at the same time as the payment for that financial instrument), the client of the investment firm may face a situation in which he has already transferred the funds for the transaction but will not receive the financial instrument. This can create distrust in the financial markets, which can spread to other firms active in the financial markets besides the failed investment firm. To prevent these forms of stress (or periods of distrust between the various actors) in the financial markets it is essential to have a minimum capital requirement that gives supervisory institutions the ability to wind down in an orderly manner a firm with minimum disruption for the clients of the firm. It should be noted that this risk for clients is dependent on the market in which the transaction is concluded. The risks will be increased if the investment firm concludes its transactions OTC or on an imperfect market. Albeit that, with the introduction of European Market Infrastructure Regulation4 (EMIR), all “standardised OTC derivative contracts should be cleared through a CCP”.5 By requiring all standardised OTC contracts to be centrally cleared, the specific risks of OTC contracts are transferred to the central clearing system and will thus resemble the risks of other transactions in financial instruments that are centrally cleared. For those OTC transactions that are not required to be centrally cleared, the European legislator acknowledges that these pose additional risks to the participants in the transactions as “OTC derivative contracts that are not considered suitable for CCP clearing entail counterparty credit and operational risk”.6

47. An OTC transaction means that the conclusion of the transaction is a bilateral agreement between the executing broker and the counterparty. If something were to happen during the settlement of this, non-centrally cleared, bilateral agreement, either with the counterparty or the investment firm, the settlement of the transaction might not occur, thus leaving the investment firm’s client without the purchased financial instrument and possibly also without the funds used to purchase it. However, if the investment firm concludes the transaction through an exchange for a financial instrument that is subject to central clearing or an OTC derivative contract that is required to be centrally cleared, the risks of errors in the settlement are significantly reduced. In these cases, the settlement of the transaction will usually take place through a clearing member which assumes responsibility for the clearing and settlement of the transaction. Through this central clearing mechanism, the risk of a counterparty not being able to deliver its part of the transaction is fully mitigated by the clearing and settlement framework which will ensure the settlement takes place even if one of the parties involved in the transaction is unable to deliver its part.

48. Other legislative frameworks provide additional assurance, in addition to the regulation of the OTC derivatives markets.7 The European legislator, for instance, stated that “it is necessary to ensure that transfer orders cannot be revoked after a moment defined by the rules of the system”.8 However, the European legislator stated that, in the context of settlement finality in payment and securities settlement systems, that “while [this] Directive [...] reduced the disruption to a securities settlement system caused by insolvency proceedings against a participant in that system, it is necessary to address other risks that securities settlement systems are facing, as well as the risk of insolvency or disruption in the functioning of the [Central Securities Depositories] that operate securities settlement systems”.9 The CSD Regulation10 was introduced more recently because, according to the European legislator, “Central securities depositories (CSDs), together with central counterparties (CCPs) contribute to a large degree in maintaining post-trade infrastructures that safeguard financial markets and give market participants confidence that securities transactions are executed properly and in a timely manner, including during periods of extreme stress”.11 With the CSD Regulation, the European legislator intended to “prevent and address settlement fails”.12

49. The European legislator has, therefore, acted to ensure that financial markets function adequately and that participants in those financial markets can rely on the effectiveness of financial markets and finality of transactions entered into on those financial markets. Although all these legislative efforts by the European legislators will reduce the risks of an investment firm executing client orders, the risk will not be nil and should therefore lead to a regulatory response addressing the operational risk for an investment firm executing orders.13

50. 3) Framework for assessing risks - The risk incurred by performing the investment service of execution of orders therefore falls within the agency costs as defined by Moloney. “Where a firm executes an order on behalf of a client […], the conduct rules which govern the provision of investment services generally, and which include the anchor fair treatment obligation (the obligation to act honestly, fairly, and professionally in accordance with the best interests of clients) and disclosure and record-keeping requirements apply, as do the conflict-of-interest requirements”.14 These requirements are in place as the information asymmetry between clients and the investment firm can be significant. These conduct requirements do not preclude the need for prudential requirements, however, as the firm might still be liable for certain errors made either intentionally (through fraud) or unintentionally (through errors or incompetence).

51. In the framework proposed in Section 2.1.4 of this study, an investment firm providing execution of order services will be subject to prudential requirements addressing operational risks. Other financial risks will not be applicable, as the service of executing orders will not result in direct implications for the investment firm’s balance sheet or have direct economic consequences that would warrant a regulatory response to mitigate a financial risk.