Can ESG trading and best execution coexist?

Buy-side trading heads have good reason to be wary of proposals to trade only with counterparties that meet certain environmental, social and governance (ESG) standards. After all, they serve as fiduciaries to clients, not to the environment or to a set of social ideals.

But with those same clients asking what the buy side can do to support ESG initiatives, eyes have turned towards the trading desk. Besides adjusting their own operations – like assessing energy usage or expanding diversity and inclusion practices – the natural next step is for desks to examine their counterparties and ensure they’re trading with ESG-friendly dealers.

The potential conflicts with best execution requirements immediately spring to mind. How can desks justify decisions to limit trading with ESG-unfriendly banks that could also obstruct their access to less-liquid markets? If volatility spikes, would the desk come crawling back to those dealers with whom it may now need to trade?

In Europe, the second Markets in Financial Instruments Directive (Mifid II) makes best execution the law, with managers required to “take all sufficient steps to obtain, when executing orders, the best possible result for clients” after accounting for conditions such as price, order size and speed of execution.

Traders describe best execution as a process that depends on individual circumstances and the ability to compare to tradeable market mid-prices, a challenge in and of itself. Sometimes going to a single dealer to execute a large, illiquid trade makes sense. Other times, chopping up the order and spreading it among several counterparties achieves the best outcome.

The question is, if there’s a trade-off between regular and ESG-based execution owing to fewer counterparty options – or if a client’s order becomes odd-lot-sized and harder to execute when it’s separated from ESG-agnostic client orders – what will underlying investors be willing to accept?

The restriction of counterparties for governance issues is an easier argument to make since a counterparty’s mismanagement could inhibit its ability to meet financial obligations. Adjusting trading based on environmental factors is a tougher sell, though, especially when managers already use their investment arms to address environmentally conscious clients’ needs.

Nevertheless, Ulf Erlandsson, founder and chief executive of the Anthropocene Fixed Income Institute, argues that funds should leverage the lucrative revenue their trading generates by putting relationships with the worst fossil fuel funding banks on ice.

When it comes to meeting best execution responsibilities, Erlandsson suggests starting with smaller, less-relevant counterparties. The larger ones will take note, and best execution will escape unscathed.

In other words, small actions from ESG-friendly trading desks can have outsized impacts. With enough pressure, the buy side could help generate real change by directly increasing the cost for banks to work with the worst polluters.

Asset managers are looking at similar initiatives, but it’s early days for the industry. Some corporates are also understood to have put some ESG-unfriendly dealer counterparties on the ‘naughty step’. While corporates don’t face the same best execution restrictions as asset managers, their relatively smaller trading volume means this lever is only really available for the biggest firms in the market.

Dealers already face reputational risks for their involvement in high-polluting industries, as BNY Mellon’s decision to scrap a potential financing deal of a controversial Australian coal project illustrates. Even indirect pressure from trading partners would help increase these risks.

Sceptics argue that the buy side is better off changing ESG-unfriendly practices by engaging with the companies in which they invest. There’s certainly evidence to support the effectiveness of such an approach, and a myriad of ESG-related problems will likely require nuanced corporate engagement.

But when it comes to the environmental challenge of climate change, there may not be enough time to rely solely on engagement. With countries needing to roughly halve global emissions within the decade, no other issue demands such urgent action – and, perhaps, such uncomfortable solutions.