I was chatting with a few work colleagues last Friday about best execution and derivatives. They confidently asserted that without real fungibility (i.e. the ability to trade the same instrument on different venues), price comparison is not possible and so any notion of best-ex was pretty meaningless.
By coincidence, I was later looking at the wording in the best-ex policy of my own broker (and yes, it was a slow afternoon). Interestingly though, it reminded me that best-ex is a much broader concept than just price comparison – it needs to take into account the liquidity, tradability and reputation of any venue, together with an assessment of my own sophistication/naivety.
So imagine how the concept of best-ex could extend into the rapidly converging OTC and exchange traded markets. Agreed futures, swap futures, CMFs and other OTC products are not strictly fungible, but they are certainly economically equivalent. If that’s the case then maybe my broker needs to explain why they traded a future rather than a swap future or OTC contract in order to hedge my risk. Also, any decision would need to include their obligation to make best use of my scarce capital by minimising my margin requirement.
So maybe the idea of best-ex does have a real place in derivatives markets – if so, then expect a whole range of tools to come out to help the derivatives industry achieve and measure it.
Interesting topic! Indeed with the vertical silo in place in Europe and therefor no fungibility there is no meaning to the term best execution. In the Netherlands TOM created a virtual fungibility tool. I’ll explain: The first step is to look for the best price. Then the contract will be converted (by a consortium of market makers, organized by TOM) to the open interest pool at choice. Currently 90% of the trades go to TOM because the price is better and 10% first go to Euronext following the best price and will be converted to a TOM contract. Therefor the brokers will have the open interest always in one silo and benefit from the best price of two exchanges. This tools breaks down the barrier of the vertical silo and makes real best execution in option possible! So far TOM gained 33% marketshare in options in the Netherlands and next year we will have more than 50% marketshare.
CEO, TOM (The Order machine)