Due Diligence is Stuck in the Stone Age (or at least the 1990s)
Updated: 1 May 2020
By: David Lauer
Many of us have been through the due diligence process in one form or another. Whether you’re selling technology to a larger firm, being onboarded as a new broker or under consideration by an asset owner for an investment, you’re likely familiar with the process. While there are exceptions, the majority of the time, you’ll receive a word doc, PDF or excel spreadsheet by email.
Up until recently, this has been the only approach known to most firms. Rarely does anyone use a standardized questionnaire or RFI document.
There are so many things wrong with this process, it’s hard to know where to start!
Just focusing on the narrow use case of buyside firms doing due diligence on their broker counterparties (whether when onboarding a new broker or upon meeting annual compliance and best execution responsibilities), we can highlight an extensive list of issues. The problems with this process are significant, and can pose material risks to firms, whether from a legal / compliance perspective or from a trading and best execution standpoint. At a high-level, these risks include:
Failure to ask the right questions;
Difficulty interpreting the answers, and knowing how to identify areas of risk;
Inability to analyze responses across multiple counterparties, or evaluate how individual counterparty responses are changing over time;
Confusion over document versions, with multiple iterations flying back and forth over email;
Difficulty retracing every message and maintaining auditable records; and
A lost history of one-off requests and attestations, disappeared down a black hole of old emails.
This doesn’t even begin to address the unreasonable array of resources that brokers are being forced to devote to this process. Nor does it account for the liability that buyside firms face when evidence suggests they might have been provided warning of counterparty actions destined to face future enforcement measures.
As someone who has been involved in this process for several years, I can tell you how difficult it is to formulate these questionnaires and ensure that all appropriate questions are included, let alone answered. Even getting a set of firms (both buyside and sellside) to agree on all the right questions, or the right way to ask them, can be a long and tedious process.
While I was leading efforts to distribute questionnaires to, and perform due diligence and risk assessment of, ATSs (in the days before ATS-N), I found it difficult to compile responses across 20 or 30 firms, compare them to one another, make sure I was using the most recent version of various response documents, and find the information in those responses that revealed risk. Managing all of those word docs, PDFs and excel spreadsheets meant that things inevitably fell through the cracks.
I had the good fortune of not working at a regulated entity, so I did not have to concern myself with a future audit or regulatory examination. I did not have a compliance department or internal / external audit to worry about, and I had no legal exposure if I missed something in those responses that led to losses for my clients. The same cannot be said for buyside firms, who face all of these risks, and more.
This is the challenge that led to the recent launch of Plia, a collaboration between Plato Partnership and Urvin.Compliance. Plia is a modern, secure web application providing buyside firms a set of standard questionnaires to ensure that they are asking all of the right questions.
For brokers, Plia offers the ability to answer questions one time and distribute to multiple clients, all while accommodating a standard approval hierarchy and workflow. Plia provides transparency into the questionnaire completion progress, and provides a simplified means of communication between counterparties, including discussion around individual due diligence questions and trading outliers.
Plia’s analytics make it easier to view responses over time, or compare responses across counterparties. The Plia application also combines custom category and question weighting with grading, providing quick visualization of risk areas by both counterparty and category. The application also simplifies integration of this data into a more comprehensive broker scorecarding system. The end-user can audit and track everything directly on the Plia platform.
Plia also leverages AI and professional services to help its clients make sense of questionnaire responses, quickly identify material differences, and reduce the amount of effort needed to review all of these responses. On the immediate horizon, Plia will soon have an entire suite of features, as well as the functionality, to support a robust best execution process, and automate many of the mundane operating and coordinating tasks traditionally delegated to best execution committees.
As we work collectively to bring due diligence into the modern era, Plia streamlines what has historically been a clunky and inconsistent process. By bringing due diligence up to speed with the current trading environment, Plia may go a long way toward helping firms achieve best execution, reduce their vulnerability to enforcement action, and improve client outcomes.
For more information on Plia, contact: firstname.lastname@example.org
The Art of Trading; The Science of Best Ex
Updated: 14 April 2020
By: Bill Stephenson
As a former global head of trading, achieving ‘best execution’ was something I always viewed as part art and part science. My trader colleagues understood the art of trading, but the hard part was actually the science; the quantitative measurement AND interpretation of trading outcomes. In the mid-1990’s, I became passionate about transaction cost analysis (TCA) and how we can improve our decision making and prove the execution value in the investment process.
We embraced measurement, the creation of unique benchmarks, and a mindset that aligned decision making with the long-term goals of the portfolios. Sounds easy, but it wasn’t. Traders are often measured trade-by-trade while portfolio managers and analysts are measured in months or years. It takes time to find balance, form a true meeting-of-the-minds, and ultimately create a benchmark aligning these three constituents--which I call the “Alpha Triangle.”
Though the process was not without its challenges, our firm was largely successful in training our focus on best execution within the context of the long-term investment strategy. Our process became well documented and scrutinized in regular reviews at our Global Best Execution Committee meetings.
The mid-2000’s saw a dramatic increase in electronic trading, growing reliance on algorithms and the overall proliferation of dark pools and exchanges. Trading had become increasingly complex; performance measurement increasingly difficult. Miscues by dark pools, broker-dealers, and exchanges only compounded this difficulty. Firms intent on maintaining high best execution standards felt the growing need for traders with a better understanding of market structure and the nuances of how various markets actually work. The game was changing quickly. Buyside traders faced a call for greater accountability. It was increasingly incumbent upon them to understand how their orders were handled, where they were being executed, and how these factors impacted trading costs.
For me, the tipping point came in late 2011, when one ‘dark pool’ settled charges with the SEC regarding false and misleading claims about trading with ‘natural liquidity.’ The good news from my firm’s perspective was that our executions in that venue, as we measured them, were adding value. It just wasn’t disclosed that they were principal transactions.
These events prompted us to ask an array of internal questions about the due diligence process when onboarding a new broker or new ATS. Even though the broker or venue provided value, were there reputational risks in trading with firms who don’t do what they say they do? Of course!
Besides our effort to collect the primarily private Form ATS filings from all the alternative trading systems, we began a deeper dive into evaluating all our counterparties; a huge undertaking. Collecting these filings proved to be just the beginning as we tried to unravel potential conflicts of interest among market participants and the overall complexities of the market.
By 2012, a buyside trader from another firm began to build a web-based system to engage broker-dealers as part of his firm’s due diligence and onboarding processes. That system was known as Plia and, in 2014, became a product for other asset managers. I viewed this as a much-needed system for central management of information that investment managers could acquire from their counterparties; brokers, trading systems, or even exchanges. Over the years, the system’s functionality and capabilities have improved, but the market structure and brokerage operations have only grown more complex.
For some, Plia was used to help avoid venues and brokers who could not or would not fully disclose their operations in a way that aligned with an investment manager’s best execution processes or values. It can add both a qualitative and quantitative aspect to best execution that will help any head trader or head compliance officer feel more comfortable about the risk management component of their remit.
As the complexities of trading increase across all asset classes, it is becoming more important that leaders in the asset management community develop standards with their counterparties such that all market participants will have accountability to each other in a constructive way. I believe that technology-enabled solutions developed by the industry and for the industry will mitigate risks in the investment and best execution processes, but it takes broad acceptance of such practices to truly make a difference for all.
For more information on Plia, contact: email@example.com