What Best Execution In Equity Trading Really Means - Part 1

Arthur Levitt, Chairman emeritus of the SEC, said at an SIA conference in Boca Raton in November 1999: Best execution encompasses a number of factors starting with the price of the execution and the opportunity for price improvement. Other factors include speed and likelihood of execution. For institutional investors, anonymity and liquidity might be overriding concerns. In any case, the quality of execution must always be viewed from the customer's perspective, not the firm's.

This paper discusses the concept of best execution in that light, the regulatory environment in which it is defined, and examines a number of approaches for the investor to obtain the best execution possible.

Best Execution

Best execution means different things to different people. To some it means attaining the inside price of the best quoted bid or offer for an order. To others, notably institutional investors or traders, it means working a large order without moving the market in an adverse manner.

Traditionally, one would assume that achieving the best execution is the same as finding the best price for a trade at the time the trade needs to be made. This seems reasonable at first glance, but upon closer inspection, one might find that the time horizon considered here is too short, particularly for institutional investors and large orders. Considering that large orders are often worked over multiple days, and the value of the definition dwindles. Additionally, consider market volatility in context with daily VWAP (volume weighted average price, a price point few institutional traders want to exceed in trading); today's worst price can be much better than tomorrow's best price. Therefore, the definition mentioned earlier lacks validity in today's environment.

Due to the sheer number of variables present in any market it is difficult, if not impossible, to show that the best possible execution is actually achieved. Many firms quote best execution as a marketing tool to sell their products and services; however no firm will guarantee that best execution is ever achieved.

The number of firms who advertise best execution has grown significantly over the past few years, primarily as the number of participants within the capital markets arena has grown. As trading volume has increased so has the number of execution venues (in conjunction with a loosening of financial regulations). The increase in competition and number of execution venues has lead to increasingly fragmented pools of liquidity and the necessity for development of algorithms to discern ways of achieving optimal execution within this environment.