In the parable “the blind men and the elephant” an elephant is surrounded by several blind men, all of whom use their sense of touch to describe what the elephant is like. In the story, each of them examines a specific part of the elephant, and, therefore, describes the creature quite differently. In most versions, the men end up in an argument over what the elephant looks like, as they all have a different view based on what part they were touching.
The lesson, of course, is that each of the observers had a unique perspective, and only by combining all of them, would they collectively be able to accurately describe the elephant. The quest to evaluate trading quality is remarkably similar; combining several key perspectives of the process is the only true way to gain an accurate picture, particularly for institutional investors.
From the time a portfolio manager makes a decision to purchase or sell stock, many steps take place. Their order traverses their trading desk, a routing broker dealer and, quite often, multiple market centers consisting of exchanges, alternative trading systems and market makers. It is important to measure the performance of each of these participants in the proper context in order to gain an accurate understanding of the full process. In the case of retail investors, the SEC set up a framework in 2001 (Rule 605) that has done a credible job of spurring improved execution quality, but there are two caveats to keep in mind.
First, it took many years before the full benefit of the disclosures helped retail investors, since the brokers who routed those orders were not covered by the rule. (Rule 605 only applies to the market centers which actually execute these orders – not to the retail brokerage houses that route their client orders to those market centers). Over the ensuing decade, however, the best execution policies of the large retail brokers changed to measure execution quality of the orders they route, using Rule 605 as a starting point for the analysis.
David Weisberger is Managing Director, Trading Services at Markit