Financial Industry Regulatory Authority, Inc. (FINRA) and the Municipal Securities Rulemaking Board (MSRB) recently issued notices regarding the duty of best execution.1 FINRA’s stated objectives are to remind firms of their obligations to provide best execution, to reiterate best execution principles particularly relevant in automated markets, and to provide guidance on conducting regular and rigorous reviews. The FINRA Notice also specifically addresses best execution obligations in the context of directed orders and fixed income markets. The MSRB Notice provides implementation guidance with respect to its new Rule G-18 governing best execution in the municipal securities markets.
While the FINRA Notice provides an excellent dissertation of the legal contours of best execution it does not specifically provide practical guidance on how to achieve regulatory compliance. The MSRB Notice states that it is substantively consistent with FINRA’s approach to best execution.
Background on the Duty of Best Execution
The duty of best execution requires broker-dealers to seek to execute customers’ trades at the most favorable terms reasonably available under the circumstances (i.e., at the best reasonably available price).2 FINRA and the U.S. Securities and Exchange Commission (SEC) have long recognized that the scope of the duty of best execution may evolve as changes occur in the market and new technologies develop.
FINRA Rule 5310 provides “[i]n any transaction for or with a customer or a customer of another broker-dealer, a member and persons associated with a member shall use reasonable diligence to ascertain the best market for the subject security and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions.” The factors that determine “reasonable diligence” include: (i) the character of the market for the security (e.g., price, volatility, relative liquidity and pressure on available communications), (ii) the size and type of transaction, (iii) the number of markets checked, (iv) accessibility of the quotation, and (v) the terms and conditions of the order that result in the transaction as communicated to the member and persons associated with the member. In addition, Supplementary Material .09 to FINRA Rule 5310 provides that a firm should consider transaction costs as well as the existence of internalization or payment for order flow arrangements.
Regular and Rigorous Review for Best Execution
In its Notice, FINRA expressed that “given developments in order routing technology, order-by-order review of execution quality is increasingly possible for a range of orders in all equity securities and standardized options.”3 Firms that do not conduct an order-by-order review for some orders must have procedures in place to ensure that they periodically conduct a regular and rigorous review of execution quality4 for those orders, which must be conducted on a security-by-security, type-of-order basis (e.g., for equity securities, limit order, market order and market-on-open order). While FINRA does not state a position for requiring order-by-order review for execution quality whenever it is available, it does espouse for the first time that orders that are internalized should be subject to an order-by-order analysis of execution quality. A regular and rigorous review resulting in internalization will only justify the initial determination to internalize, but it would not, on its own, satisfy supervisory obligations regarding best execution; rather, FINRA expressed that a regular and rigorous review of internalized orders must also be subject to an order-by-order analysis of execution quality.
The FINRA Notice largely reiterates guidance provided over the past 15 years. Some of the key guidance reiterated with respect to conducting a regular and rigorous review of best execution advises that a firm:
- determine whether any material differences in execution quality exist among the markets trading the security
- consider which policies and procedures a firm would use in conducting a review of best execution for its own accounts
- review the execution quality on various trading centers to which it may route including with respect to latency, potential information leakage and fill rates
- consider other competing markets to which it does not currently route
- with respect to the use of filters (i.e., tools that limit trading to specific counterparties or specific securities), ensure they are used only for a legitimate purpose and have policies and procedures in place to assess their use
- may rely, as an introducing firm, on the regular and rigorous review by the executing firm, so long as the executing firm fully discloses the statistical results and rationale of its review to the introducing firm, and the introducing firm reviews both the methodology and the results of that review
Payment for Order Flow
FINRA provided no additional guidance with respect to best execution where there is a payment for order flow arrangement.5 FINRA merely reiterated that an order routing inducement, such as receipt of payment for order flow, must not interfere with a broker-dealer’s duty of best execution.
FINRA notes that payment for order flow arrangements are specifically addressed in its Rule 5310, Supplementary Material .09, which provides that a firm should consider the existence of internalization or payment for order flow arrangements when conducting its regular and rigorous review of execution quality.
With respect to directed orders (i.e., unsolicited orders for which the customer has provided specific instruction to route the order to a particular market), FINRA notes that it provides specific guidance on the modified duty of best execution in Supplementary Material .08 to its Rule 5310, which provides that a firm is not required to undertake a best execution determination regarding the market of execution beyond the customer’s specific instruction. The FINRA Notice emphasizes that firms still must handle directed orders promptly and in accordance with the terms of the order. Although FINRA does not provide guidance on what constitutes “promptly,” that will not deter FINRA staff from investigating firms’ compliance with the requirement, similar to its Market Order Timeliness reviews.
Where a firm is unable to route the order to the specific market in accordance with the customer’s instructions, the customer must be informed of that fact and have been provided the opportunity to revise or cancel the order. Firms also should be mindful that they have the ability to refuse to permit the use of directed orders.
In this context, FINRA reminds firms that as part of their regular and rigorous review, they have an obligation to assess whether it should establish connectivity to trading centers for routing customer orders. FINRA advises that such consideration and decisions made regarding other trading centers should be well documented.
Fixed Income Markets
The fixed income markets have evolved significantly over recent years as the use of electronic trading systems, including alternative trading systems, to facilitate trades continues to grow. Nevertheless, the amount of pretrade price transparency is still relatively limited when compared with the equities and options markets. In addition, the market for a particular fixed income security can vary significantly depending on the specific product. Both FINRA and the MSRB describe the duty of best execution as requiring that a firm “use reasonable diligence to ascertain the best market for the security and to buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions.”
FINRA and the MSRB further advise that the best execution rule is a “facts and circumstances” analysis and that the key factor in determining whether a firm has met this reasonable diligence standard is the character of the market for the security itself, which includes an analysis of price, volatility and relative liquidity. In reality, and as firms are aware through the examination process, the staff almost exclusively relies on price as the determining factor. Indeed, the comparison of prices in the first instance is the means by which regulators generate their alerts. We expect that as transparency in the fixed income markets continues to progress, the best execution requirements will continue to evolve and will more closely resemble what is required of equity securities.
FINRA provided additional guidance on the duty of best execution. Some key points:
- Given significant differences between the fixed income markets and the equities markets, firms may determine that their review of execution quality for fixed income securities may be less frequent than that of equity securities or options.
- Firms need to routinely analyze and determine whether pricing information available from electronic trading platforms should be incorporated into their best execution policies and procedures. (FINRA incorporates such pricing information in its best execution reviews, so firms should also.)6
- FINRA notes, however, that prices of a fixed income security displayed on an electronic trading platform may not be the presumptive best price of that security for best execution purposes.
- Firms are required to evaluate the execution quality of the venues that they have access to and, to the extent information is reasonably available, regularly assess whether other venues to which a firm is not connected may provide the opportunity for best execution.
- Firms should also have policies and procedures in place for determining when they will access platforms or engage in further conduct in seeking to execute a customer order (e.g., when they will post a bid-wanted on a platform or reach out to other dealers).
- Firms must compare the quality of the executions they are obtaining for customers via current order routing and execution arrangements (including executing against orders as principal) to the quality of the executions that they could obtain from competing markets. (Note that it is unclear how this is to be accomplished in the absence of an identical, actual execution.)
- In some instances, obtaining quotations from multiple sources could adversely affect execution quality due to delays in execution or other factors. Consequently, firms’ procedures should include relevant factors in assessing when obtaining quotations or other pricing information from outside sources may and may not be appropriate.
The MSRB notes in its guidance that MSRB Rule G-18 governing best execution is generally substantively consistent with FINRA Rule 5310, with specific tailoring to the municipal securities market. Further, the MSRB states that steps taken by a dealer that meet the reasonable diligence standard under FINRA Rule 5310 generally will be considered to meet the reasonable diligence standard under MSRB Rule G-18 in circumstances that are substantially the same.
Extreme Market Conditions
Interestingly, and perhaps in anticipation of market reaction to an eventual interest rate hike, both FINRA and the MSRB addressed firms’ and dealers’ conduct during extreme market conditions. In the event of extreme market conditions affecting the trading of fixed income securities (e.g., a shortage of liquidity and divergent prices during periods of significant ratings changes or interest rate movements), firms should consider establishing and implementing procedures designed to preserve the continued execution of customers’ orders in a manner consistent with their best execution obligations while recognizing and limiting firms’ exposure to extraordinary market risk. It is expected that procedures for extreme market conditions rarely will be used, and firms must document the basis for activation.
While an order-by-order, facts and circumstances analysis and review of each transaction may be the appropriate and correct “legal” guidance, these principles are of little practical utility for FINRA, the MSRB or broker-dealers for the vast majority of executed orders. Instead firms should mirror the objective parameters established by FINRA examinations, sweeps and other reviews for best execution. As a practical matter, FINRA cannot review the facts and circumstances of each transaction any more readily than a firm can. For that reason, FINRA has developed highly objective protocols to review for best execution. Firms should consider the following:
Regular and Rigorous Review for Execution Quality
Firms should establish, maintain and enforce robust supervisory procedures and policies regarding regular and rigorous reviews for execution quality. Thus, firms should well-document the conduct of such reviews, the data and other information considered, order routing decisions and the rationale used. This is important not only to allow firms to make appropriate routing decisions but also so that a regulator will understand what information was considered and why. More important, it will help regulators understand the absence of relevant information for certain factors and what factors firms consider relevant (e.g., the FINRA Notice explains that certain factors may be relevant to particular order types but not as to others, given the absence of available information). It is our experience that the primary factors considered are price and, in some circumstances, speed.
FINRA Reviews for Best Execution
Reviews for best execution should be conducted in the same manner as FINRA performs its sweeps and examinations. FINRA does not conduct a facts and circumstances review of each transaction. It would be impossible for a firm or a regulator to do so. Instead, FINRA, based on statistical market analysis, establishes parameters for comparison to other transactions in the same security. If the transaction is a certain variance from other transactions in the security executed away from the firm, the execution will be presumed to violate best execution. Other facts and circumstances may be argued to justify the price, but if it is in excess of the variance, FINRA more often than not will consider it a violation. The industry is left to glean the regulatory parameters from examinations and discussions with the FINRA staff in response to sweep findings.
Several key provisions of both the FINRA Notice and the MSRB Notice require firms to document policies and procedures and to further document adherence to those policies and procedures. The result appears to be to assist the regulators in the conduct of their reviews. Along with the practical guidance provided herein, firms should ensure that their policies, procedures and determinations regarding best execution are well documented.