Proposed Rule2022-27644
Regulation Best Execution
Primary source
Metadata and text below are from the Federal Register, a public-domain U.S. government work. Always verify the official published version before relying on it for any legal matter.
Published
January 27, 2023
Issuing agencies
Securities and Exchange Commission
Abstract
The Securities and Exchange Commission ("Commission") is proposing new rules under the Securities Exchange Act of 1934 ("Exchange Act") relating to a broker-dealer's duty of best execution. Proposed Regulation Best Execution would enhance the existing regulatory framework concerning the duty of best execution by requiring detailed policies and procedures for all broker-dealers and more robust policies and procedures for broker-dealers engaging in certain conflicted transactions with retail customers, as well as related review and documentation requirements.
Full Text
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[Federal Register Volume 88, Number 18 (Friday, January 27, 2023)]
[Proposed Rules]
[Pages 5440-5556]
From the Federal Register Online via the Government Publishing Office [<a href="http://www.gpo.gov">www.gpo.gov</a>]
[FR Doc No: 2022-27644]
[[Page 5439]]
Vol. 88
Friday,
No. 18
January 27, 2023
Part II
Securities and Exchange Commission
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17 CFR Parts 240 and 242
Regulation Best Execution; Proposed Rule
Federal Register / Vol. 88 , No. 18 / Friday, January 27, 2023 /
Proposed Rules
[[Page 5440]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 240 and 242
[Release No. 34-96496; File No. S7-32-22]
RIN 3235-AN24
Regulation Best Execution
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule.
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SUMMARY: The Securities and Exchange Commission (``Commission'') is
proposing new rules under the Securities Exchange Act of 1934
(``Exchange Act'') relating to a broker-dealer's duty of best
execution. Proposed Regulation Best Execution would enhance the
existing regulatory framework concerning the duty of best execution by
requiring detailed policies and procedures for all broker-dealers and
more robust policies and procedures for broker-dealers engaging in
certain conflicted transactions with retail customers, as well as
related review and documentation requirements.
DATES: Comments should be received on or before March 31, 2023.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
<bullet> Use the Commission's internet comment form (<a href="https://www.sec.gov/regulatory-actions/how-to-submit-comments">https://www.sec.gov/regulatory-actions/how-to-submit-comments</a>); or
<bullet> Send an email to <a href="/cdn-cgi/l/email-protection#84f6f1e8e1a9e7ebe9e9e1eaf0f7c4b8e5a4ecf6e1e2b9" http: sec.gov">sec.gov</a>">rule-comments@<a href="http://sec.gov">sec.gov</a></a>. Please include
File Number S7-32-22 on the subject line.
Paper Comments
<bullet> Send paper comments to Secretary, Securities and Exchange
Commission, 100 F Street NE, Washington, DC 20549-1090.
All submissions should refer to File Number S7-32-22. This file number
should be included on the subject line if email is used. To help the
Commission process and review your comments more efficiently, please
use only one method of submission. The Commission will post all
comments on the Commission's website (<a href="https://www.sec.gov/rules/proposed.shtml">https://www.sec.gov/rules/proposed.shtml</a>). Comments are also available for website viewing and
printing in the Commission's Public Reference Room, 100 F Street NE,
Washington, DC 20549, on official business days between the hours of 10
a.m. and 3 p.m. Operating conditions may limit access to the
Commission's Public Reference Room. All comments received will be
posted without change. Persons submitting comments are cautioned that
the Commission does not redact or edit personal identifying information
from comment submissions. You should submit only information that you
wish to make available publicly.
Studies, memoranda, or other substantive items may be added by the
Commission or staff to the comment file during this rulemaking. A
notification of the inclusion in the comment file of any materials will
be made available on the Commission's website. To ensure direct
electronic receipt of such notifications, sign up through the ``Stay
Connected'' option at <a href="http://www.sec.gov">www.sec.gov</a> to receive notifications by email.
FOR FURTHER INFORMATION CONTACT: David Dimitrious, Senior Special
Counsel and Arisa Tinaves Kettig, Special Counsel at (202) 551-5500,
Office of Market Supervision, Division of Trading and Markets,
Securities and Exchange Commission, 100 F Street NE, Washington, DC
20549.
SUPPLEMENTARY INFORMATION: The Commission is proposing to add the
following new rules under the Exchange Act: (1) 17 CFR 242.1100 (Rule
1100 of Regulation Best Execution); (2) 17 CFR 242.1101 (Rule 1101 of
Regulation Best Execution); and (3) 17 CFR 242.1102 (Rule 1102 of
Regulation Best Execution). The Commission is also proposing to amend
17 CFR 240.17a-4 (Rule 17a-4 under the Exchange Act).
Table of Contents
I. Introduction
II. Duty of Best Execution
A. Current Regulatory Framework
B. Prior Commission Statements
C. FINRA and MSRB Best Execution Rules
III. Existing Order Handling Practices and Overview of Proposed
Regulation Best Execution
A. Existing Order Handling Practices
1. General Broker-Dealer Practices
2. Order Handling Conflicts of Interest
3. Crypto Asset Securities
B. Overview of Proposed Regulation Best Execution
IV. Discussion of Proposed Regulation Best Execution
A. Proposed Rule 1100--The Best Execution Standard
B. Proposed Rule 1101(a)--Best Execution Policies and Procedures
1. Proposed Rule 1101(a)(1)--Framework for Compliance With the
Best Execution Standard
2. Proposed Rule 1101(a)(2)--Best Market Determination
C. Proposed Rule 1101(b)--Policies and Procedures and
Documentation for Conflicted Transactions
1. Proposed Rules 1101(b)(1) and (2)--Policies and Procedures
for Conflicted Transactions
2. Proposed Rule 1101(b)(3)--Documentation for Conflicted
Transactions
3. Application of Proposed Rule 1101(b) to NMS Stock Market
Conflicts of Interest
4. Application of Proposed Rule 1101(b) to the Options Market
5. Application of Proposed Rule 1101(b) to the Corporate and
Municipal Bond Markets and Government Securities Markets
D. Proposed Rule 1101(c)--Regular Review of Execution Quality
E. Proposed Rule 1101(d)--Introducing Brokers
1. Definition of Introducing Broker and Executing Broker
2. Review of Executing Broker's Execution Quality
F. Proposed Rule 1102--Annual Report
G. Recordkeeping Requirements Under Rule 17a-4
V. Economic Analysis
A. Introduction
B. Baseline
1. Current Legal and Regulatory Framework
2. Best Execution Review Processes
3. Description of Markets and Broker-Dealer Order Handling and
Execution Practices
4. Broker-Dealer Services and Revenue
C. Economic Effects and Effects on Efficiency, Competition, and
Capital Formation
1. Benefits
2. Costs
3. Efficiency, Competition, and Capital Formation
D. Reasonable Alternatives
1. SEC Adopts FINRA Rule 5310 and MSRB Rule G-18 Best Execution
Rules
2. Require Order Execution Quality Disclosure for Other Asset
Classes
3. Utilize FINRA and MSRB Approach to Introducing Broker
4. Ban or Restrict Off-Exchange PFOF
5. Require Broker-Dealers To Utilize Best Execution Committees
6. Require Order-by-Order Documentation for Conflicted or All
Transactions
7. Staggered Compliance Dates
E. Request for Comments
VI. Paperwork Reduction Act
A. Summary of Collection of Information
1. Required Policies and Procedures and Related Obligations
2. Annual Report
B. Proposed Use of Information
1. Required Policies and Procedures and Related Obligations
2. Annual Report
C. Respondents
D. Total Initial and Annual Reporting and Recordkeeping Burdens
1. Required Policies and Procedures and Related Obligations
2. Annual Report
E. Total Paperwork Burden
F. Collection of Information Is Mandatory
G. Confidentiality of Responses to Collection of Information
H. Retention Period for Recordkeeping Requirements
I. Request for Comment
VII. Consideration of Impact on the Economy
[[Page 5441]]
VIII. Initial Regulatory Flexibility Act Analysis
A. Reasons for and Objectives of the Proposed Action
B. Legal Basis
C. Small Entities Subject to the Proposed Rule
D. Projected Compliance Requirements of the Proposed Rule for
Small Entities
1. Required Policies and Procedures and Related Obligations
2. Annual Report
E. Duplicative, Overlapping, or Conflicting Federal Rules
F. Significant Alternatives
1. Adopt FINRA Rule 5310 and MSRB Rule G-18 Concerning Best
Execution
2. Require Order Execution Quality Disclosure for Other Asset
Classes
3. Define ``Introducing Broker'' To Include Those Entities That
Qualify for Relief Under FINRA and MSRB Rules
4. Ban or Restrict Off-Exchange Payment for Order Flow
5. Require Broker-Dealers To Utilize Best Execution Committees
6. Require Order-by-Order Documentation for Conflicted or All
Transactions
7. Staggered Compliance Dates
G. General Request for Comment
Statutory Authority and Text of the Proposed Rule
I. Introduction
The duty of best execution requires a broker-dealer to execute
customers' trades at the most favorable terms reasonably available
under the circumstances,\1\ and customers benefit from broker-dealers'
robust considerations of execution opportunities that may provide
customers with the most favorable terms. Accordingly, promoting the
best execution of customer orders is of fundamental importance to
investors and the markets, and is an important aspect of investor
protection. The Financial Industry Regulatory Authority, Inc.
(``FINRA''), a national securities association, and the Municipal
Securities Rulemaking Board (``MSRB'') currently have rules and
guidance directly addressing the duty of best execution. The Commission
has made statements concerning the duty over the years, but has never
itself established a rule addressing best execution. While the
Commission believes the existing regulatory framework concerning the
duty of best execution has helped broker-dealers fulfill their duty to
their customers, the Commission believes this regulatory framework can
be made more effective. In particular, while FINRA and the MSRB have
established best execution rules and provided guidance on how broker-
dealers should achieve best execution in a variety of contexts, and
generally require broker-dealers to have procedures for compliance with
relevant laws and rules, the Commission believes it is appropriate to
propose its own comprehensive and detailed best execution requirements.
The Commission understands that, currently, broker-dealers' best
execution policies and procedures, and the documentation relating to
their best execution practices, may vary. However, as described in
section III.A below, the Commission believes that customers would
benefit from consistently robust best execution practices by broker-
dealers, and the execution of retail customer orders by broker-dealers
that have certain order handling conflicts of interest warrants
heightened attention by those broker-dealers.\2\
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\1\ See infra note 21 and accompanying text.
\2\ See infra Section V.A (describing the ``principal--agent''
problem that may exist between a broker-dealer and its customer and
how that can be exacerbated by other conflicts of interest).
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The Commission believes that having Commission rules providing a
policies and procedures-based best execution framework, along with
regular reviews and related documentation, would help broker-dealers
maintain consistently robust best execution practices and result in
vigorous efforts by broker-dealers to achieve best execution, including
in situations where broker-dealers have order handling conflicts of
interest with retail customers. The Commission also believes that
detailed policies and procedures, regular reviews, and related
documentations would allow broker-dealers to effectively assess their
best execution practices and assist the Commission and self-regulatory
organizations (``SROs'') to effectively examine and enforce broker-
dealers' compliance with the proposed rules.
Proposed Regulation Best Execution would establish through a
Commission rule a best execution standard for broker-dealers.\3\
Proposed Regulation Best Execution would also specifically require
broker-dealers to establish, maintain, and enforce written policies and
procedures reasonably designed to comply with that best execution
standard. Those policies and procedures would be required to address:
(1) how the broker-dealer will comply with the proposed standard of
best execution, including by identifying material potential liquidity
sources, incorporating material potential liquidity sources into its
order handling practices, and ensuring that the broker-dealer can
efficiently access each source, and (2) how the broker-dealer will
determine the best market for customer orders received, including by
assessing reasonably accessible and timely pricing information and
opportunities for price improvement.
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\3\ The proposed best execution standard is consistent with the
best execution standards set forth in FINRA and MSRB rules.
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In addition, for retail customer transactions that present
conflicts of interest, such as payment for order flow or
internalization, that could create incentives for a broker-dealer to be
less diligent in its search for better executions and potentially
result in broker-dealers not providing best execution to customer
orders, proposed Regulation Best Execution would require the broker-
dealer's policies and procedures to address how it will comply with the
best execution standard in light of such conflicts, including how it
would assess a broader range of markets than it would for non-
conflicted transactions. Proposed Regulation Best Execution would also
require broker-dealers to document their compliance with the best
execution standard and the basis for their determinations that best
execution would be achieved through conflicted transactions.
Proposed Regulation Best Execution would also require broker-
dealers to review the execution quality of their customer orders at
least quarterly, compare it with the execution quality that might have
been obtained from other markets, and revise their best execution
policies and procedures accordingly.
Proposed Regulation Best Execution would exempt from specified
requirements under the proposed rules an introducing broker (as defined
in the proposed rules) that establishes, maintains, and enforces
policies and procedures that require it to regularly review the
execution quality obtained from its executing broker, compares that
execution quality with the execution quality it might have obtained
from other executing brokers, and revises its order handling practices
accordingly.
Finally, proposed Regulation Best Execution would require broker-
dealers to review and assess the overall effectiveness of their best
execution policies and procedures, including their order handling
practices, on at least an annual basis, and prepare a report detailing
the results of such review and assessment that would be presented to
the broker-dealer's board of directors (or equivalent governing body).
The Commission recognizes the importance of providing a broker-
dealer flexibility to exercise its expertise and judgment when
executing customer orders, and proposed Regulation Best Execution
primarily would be a policies and procedures-based rule, similar to
[[Page 5442]]
the Order Protection Rule,\4\ the Risk Management Controls for Brokers
or Dealers with Market Access Rule,\5\ and Regulation Systems
Compliance and Integrity.\6\ Under proposed Regulation Best Execution,
a broker-dealer's failure to achieve the most favorable price possible
under prevailing market conditions (``most favorable price'') for
customer orders would be part of the consideration of whether the
broker-dealer's policies and procedures are reasonably designed and
whether the broker-dealer is enforcing its policies and procedures. A
broker-dealer's failure to achieve the most favorable price for
customer orders would not necessarily be a violation of the proposed
best execution standard, because it may not be the result of a failure
by the broker-dealer to use reasonable diligence to ascertain the best
market and to buy or sell in such market so that the customer receives
the most favorable price.\7\ However, a failure to establish and
maintain reasonably designed policies and procedures applicable to all
customer orders, or a failure to enforce those policies and procedures,
would be a violation of the policies and procedures requirement under
proposed Regulation Best Execution.
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\4\ See 17 CFR 242.611.
\5\ See 17 CFR 240.15c3-5.
\6\ See 17 CFR 242.1001.
\7\ See also MSRB Rule G-18.01 (``A failure to have actually
obtained the most favorable price possible will not necessarily mean
that the dealer failed to use reasonable diligence.''). Whether a
broker-dealer has met the proposed best execution standard would
turn on an objective assessment of the facts and circumstances at
the time of the broker-dealer's transactions for or with the
customer (and not in hindsight).
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II. Duty of Best Execution
A. Current Regulatory Framework
A broker-dealer has a legal duty to seek best execution of customer
orders. The duty of best execution predates the Federal securities laws
and is derived from an implied representation that a broker-dealer
makes to its customers.\8\ The duty is established from ``common law
agency obligations of undivided loyalty and reasonable care that an
agent owes to [its] principal.'' \9\ This obligation requires that a
``broker-dealer seek to obtain for its customer orders the most
favorable terms reasonably available under the circumstances.'' \10\
While there is no Commission rule or standard addressing a broker-
dealer's duty of best execution, the duty is addressed in FINRA and
MSRB rules, as described in sections II.C and IV below.\11\
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\8\ See, e.g., Newton v. Merrill, Lynch, Pierce, Fenner & Smith,
Inc., 135 F.3d 266, 270 (3d Cir.), cert. denied, 525 U.S. 811
(1998).
\9\ See id.
\10\ See id. See also Securities Exchange Act Release No. 37619A
(Sept. 6, 1996), 61 FR 48290 (Sept. 12, 1996) (``Order Execution
Obligations Adopting Release''). A Report of the Special Study of
Securities Markets stated that, according to an NASD District
Business Conduct Committee in a 1952 proceeding, ``[t]he integrity
of the industry can be maintained only if the fundamental principle
that a customer should at all times get the best available price
which can reasonably be obtained for him is followed.'' See SEC,
Report of the Special Study of Securities Markets, H.R. Doc. No. 95,
88th Cong., 1st Sess. Pt. II, 624 (1963) (``Special Study''),
available at <a href="https://www.sechistorical.org/collection/papers/1960/1963_SSMkt_Chapter_07_2.pdf">https://www.sechistorical.org/collection/papers/1960/1963_SSMkt_Chapter_07_2.pdf</a>.
\11\ The Commission also oversees investment advisers, which
have a similar duty. As part of its duty of care, an investment
adviser has a duty to seek best execution of a client's transactions
where the adviser has responsibility to select broker-dealers to
execute client trades, and the Commission previously has described
the contours of that duty. See Commission Interpretation Regarding
Standard of Conduct for Investment Advisers, Advisers Act Release
No. 5248 (June 5, 2019), 84 FR 33669, 33674-75 (July 12, 2019). In
addition, the Commission has brought a variety of enforcement
actions against registered investment advisers in connection with
their alleged failure to satisfy their duty to seek best execution.
See, e.g., In the Matter of Aventura Capital Management, LLC,
Investment Advisers Act Release No. 6103 (Sept. 6, 2022) (settled
action); In the Matter of Madison Avenue Securities, LLC, Investment
Advisers Act Release No. 6036 (May 31, 2022) (settled action).
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The Commission is proposing Regulation Best Execution pursuant to,
among other provisions, sections 11A and 15 of the Exchange Act.\12\ In
section 11A, Congress identified key national market system objectives,
including the practicability of brokers executing investors' orders in
the best market.\13\ The Commission has rulemaking authority to further
the section 11A objectives.\14\ Separately, section 15 of the Exchange
Act provides authority for rules that are reasonably designed to
prevent fraudulent acts or practices. Specifically, section 15(c)(2)(A)
provides that no broker or dealer may make use of the mails or any
means or instrumentality of interstate commerce to effect any
transaction in, or to induce or attempt to induce the purchase or sale
of, any security (other than an exempted security \15\ or commercial
paper, bankers' acceptances, or commercial bills) otherwise than on a
national securities exchange of which it is a member, in connection
with which such broker or dealer engages in any fraudulent, deceptive,
or manipulative act or practice, or makes any fictitious quotation.\16\
Section 15(c)(2)(B) prohibits brokers, dealers, and municipal
securities dealers from engaging in such activity in ``any municipal
security.'' \17\ Section 15(c)(2)(C) prohibits government securities
brokers and government securities dealers from engaging in such
activity in any ``government security.'' \18\ Section 15(c)(2)(D)
authorizes the Commission to adopt rules that define, and prescribe
means reasonably designed to prevent, such acts and practices as are
fraudulent, deceptive, or manipulative and such quotations as are
fictitious.\19\ When a broker-dealer violates its duty of best
execution, it could be in violation of section 15(c) of the Exchange
Act.\20\
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\12\ 15 U.S.C. 78k-1; 15 U.S.C. 78o.
\13\ 15 U.S.C. 78k-1(a)(1)(C).
\14\ 15 U.S.C. 78k-1(a)(2).
\15\ See 15 U.S.C. 78c(a)(12) (defining the term ``exempted
security'' to include, among other things, government securities and
municipal securities, as defined in sections 3(a)(42) and 3(a)(29)
of the Exchange Act, respectively).
\16\ 15 U.S.C. 78o(c)(2)(A).
\17\ See 15 U.S.C. 78o(c)(2)(B). See also 15 U.S.C. 78c(a)(29)
(defining municipal securities).
\18\ See 15 U.S.C. 78o(c)(2)(C). See also 15 U.S.C. 78c(a)(42)
(defining government securities).
\19\ 15 U.S.C. 78o(c)(2)(D).
\20\ See, e.g., In the Matter of Knight Securities L.P.,
Securities Exchange Act Release No. 50867 (Dec. 16, 2004) (settled
action) (finding that the broker-dealer defrauded its institutional
customers by failing to provide best execution in violation of
section 15(c) of the Exchange Act).
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B. Prior Commission Statements
The Commission has made statements concerning the duty of best
execution in various contexts over the years. The following are some of
the statements that the Commission has made with respect to the duty of
best execution. The Commission solicits comment below, however, on
whether any of these prior statements should be revised in light of the
proposed rules.
The Commission has previously stated that the duty of best
execution requires a broker-dealer to execute customers' trades at the
most favorable terms reasonably available under the circumstances,
i.e., at the best reasonably available price.\21\ The Commission has
also recognized that price is a critical concern for investors.\22\ In
addition, the
[[Page 5443]]
Commission has described a non-exhaustive list of factors that may be
relevant to broker-dealers' best execution analysis. These factors
include the size of the order, speed of execution, clearing costs, the
trading characteristics of the security involved, the availability of
accurate information affecting choices as to the most favorable market
center for execution and the availability of technological aids to
process such information, and the cost and difficulty associated with
achieving an execution in a particular market center.\23\
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\21\ Securities Exchange Act Release No. 51808 (June 9, 2005),
70 FR 37496, 37538 (June 29, 2005) (``Regulation NMS Adopting
Release''). See also Geman v. SEC, 334 F.3d 1183, 1186 (10th Cir.
2003) (``[T]he duty of best execution requires that a broker-dealer
seek to obtain for its customer orders the most favorable terms
reasonably available under the circumstances.'') (quoting Newton,
supra note 8, 135 F.3d at 270); Kurz v. Fidelity Management &
Research Co., 556 F.3d 639, 640 (7th Cir. 2009) (describing the
``duty of best execution'' as ``getting the optimal combination of
price, speed, and liquidity for a securities trade'').
\22\ See Securities Exchange Act Release No. 43590 (Nov. 17,
2000), 65 FR 75414, 75418 (Dec. 1, 2000) (``Order Execution and
Routing Practice Release'') (``The Commission strongly believes,
however, that most investors care a great deal about the quality of
prices at which their orders are executed, and that an opportunity
for more vigorous competition among market participants to provide
the best quality of execution will enhance the efficiency of the
national market system.'').
\23\ See id., at 75422; Regulation NMS Adopting Release, supra
note 21, 70 FR 37538.
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Over the years, the Commission has stated the need for broker-
dealers to continue to modernize their best execution practices. For
example, the Commission has stated that broker-dealer practices for
achieving best execution, including the data, technology, and types of
markets they access, must constantly be updated as markets evolve.\24\
In particular, the Commission has stated that the scope of the duty of
best execution must evolve as changes occur in the market that give
rise to improved executions for customer orders, including
opportunities to trade at more advantageous prices.\25\ As these
changes occur, a broker-dealer's procedures for seeking best execution
for its customer orders also must be modified to consider price
opportunities that become reasonably available.\26\ In doing so,
broker-dealers must take into account price improvement opportunities
\27\ and whether different markets may be more suitable for different
types of orders or particular securities.\28\
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\24\ See Regulation NMS Adopting Release, supra note 21, 70 FR
at 37538; Order Execution Obligations Adopting Release, supra note
10, 61 FR at 48322-23.
\25\ See Order Execution Obligations Adopting Release, supra
note 10, 61 FR 48323.
\26\ See id.; Regulation NMS Adopting Release, supra note 21, 70
FR 37516 (stating that broker-dealers must examine their procedures
for seeking best execution in light of market and technology changes
and modify those practices if necessary to enable their customers to
obtain the best reasonably available prices).
\27\ See Order Execution Obligations Adopting Release, supra
note 10, 61 FR 48323 n.357 (stating that price improvement means the
difference between execution price and the best quotes prevailing in
the market at the time the order arrived at the market or market
maker, and that any evaluation of price improvement opportunities
would have to consider not only the extent to which orders are
executed at prices better than the prevailing quotes, but also the
extent to which orders are executed at inferior prices).
\28\ See id.
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In addition, the Commission has expressed concerns regarding
interpositioning and the duty of best execution. Interpositioning can
occur when a broker-dealer places a third party between itself and the
best market for executing a customer trade in a manner that results in
a customer not receiving the best available market price.\29\
Interpositioning can violate the broker-dealer's duty of best execution
when it results in unnecessary transaction costs at the expense of the
customer.\30\
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\29\ See Edward Sinclair, et al., Securities Exchange Act
Release No. 9115, 1971 WL 120487 (Mar. 24, 1971) (Comm'n op.),
aff'd, 444 F2d. 399 (2d Cir. 1971) (order clerk in OTC department of
broker-dealer interposed a broker-dealer between his firm and best
available market price in return for split of profits with the
interposed broker); H.C. Keister & Co., et al., Securities Exchange
Act Release No. 7988, 1966 WL 84120 (Nov. 1, 1966) (Comm'n op.) (in
exchange for payments, trader for a large broker-dealer
interpositioned a small broker-dealer between its customers' orders
and the best available market prices); Synovus Securities, Inc.,
Securities Exchange Act Release No. 34313, 1994 WL 323096 (July 5,
1994) (settled order) (broker-dealer and its president placed
customer orders with person who was able to promptly sell the bonds
to or buy the bonds from other brokers at a profit and customers did
not get the best market price). See also SEC v. Ridenour, 913 F.2d
515 (8th Cir. 1990) (a bond salesman violated the antifraud
provisions based on his secret interpositioning of his personal
trading account between his customers' securities transactions and
the fair market price of the trades).
\30\ See Thomson & McKinnon, Securities Exchange Act Release No.
8310, 1968 WL 87637 (May 8, 1968) (Comm'n op.) (a National
Association of Securities Dealers (``NASD'') member firm interposed
broker-dealers between itself and the best available market, and the
added transaction cost was borne by its customers; the Commission
found that, ``[i]n view of the obligation of a broker to obtain the
most favorable price for his customer, where he interposes another
broker-dealer between himself and a third broker-dealer, he prima
facie has not met that obligation and he has the burden of showing
that the customer's total cost or proceeds of the transaction is the
most favorable obtainable under the circumstances'').
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The Commission has also discussed its views with respect to the
application of best execution to different order types. With regard to
the handling of limit orders, broker-dealers must take into account
material differences in execution quality, such as the likelihood of
execution among the various markets or market centers to which limit
orders may be routed.\31\ Broker-dealers are also subject to the duty
of best execution when executing customer orders at the beginning of
regular trading hours and should take into account alternative methods
when considering how to execute these orders.\32\
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\31\ See Order Execution Obligations Adopting Release, supra
note 10, 61 FR 48323.
\32\ See Order Execution and Routing Practice Release, supra
note 22, 65 FR 75422 (recognizing that customer orders in listed
securities were executed at one opening price in an auction whereas
customer orders in Nasdaq securities at the time traded at the
quoted bids and offers resulting in a liquidity premium for a large
number of orders that effectively cross each other at a single point
in time).
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Moreover, the Commission has recognized practical challenges
associated with the handling of a large volume of orders. In
particular, the Commission acknowledged in 1994 that although it may be
impractical for a broker-dealer that handles a heavy volume of orders
to make an individual determination regarding where to route each order
it receives, the broker-dealer must use due diligence to seek the best
execution possible given all facts and circumstances.\33\ At that time,
the Commission reasoned that, in such circumstances, the duty of best
execution requires a broker-dealer to periodically assess the quality
of competing markets to ensure that order flow is directed to the
markets providing the most beneficial terms for its customer
orders.\34\
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\33\ See Securities Exchange Act Release No. 34902 (Oct. 27,
1994), FR Document 94-27109 (Nov. 2, 1994) (``Payment for Order Flow
Release'').
\34\ See id. See also Regulation NMS Adopting Release, supra
note 21, 70 FR 37516.
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The Commission has further identified the types of data needed by
broker-dealers to fulfill their duty of best execution. For example,
quotation information contained in the public quotation system must be
considered in seeking best execution of customer orders.\35\ In
adopting Rules 605 and 606 of Regulation NMS,\36\ the Commission
recognized that the reports required of market centers would provide
statistical disclosures regarding certain factors, such as execution
price and speed of execution, relevant to a broker-dealer's order
routing decision and that these public disclosures of execution quality
should help broker-dealers fulfill their duty of best execution.\37\
More recently, the Commission stated that broker-dealers should
consider the availability of consolidated market data, including the
various elements of data content and the timeliness, accuracy, and
reliability of the data in developing and maintaining their best
execution
[[Page 5444]]
policies and procedures.\38\ However, recognizing that best execution
analysis varies depending upon the characteristics of customers and
orders handled and the large array of potential scenarios, the
Commission stated that it cannot specify the data elements that may be
relevant to every specific situation.\39\
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\35\ See Order Execution Obligations Adopting Release, supra
note 10, 61 FR 48324.
\36\ See 17 CFR 242.605, 242.606.
\37\ See Order Execution and Routing Practice Release, supra
note 22, 65 FR 75413. The Commission further stated that the rules
were designed to generate uniform, general purpose statistics that
will prompt more vigorous competition on execution quality. The
information provided by these reports is not, by itself, sufficient
to support conclusions regarding the provision of best execution,
and any such conclusions would require a more in-depth analysis of
the broker-dealer's order routing practices than will be available
from the disclosures required by the rules. See id. at 75420.
\38\ See Securities Exchange Act Release No. 90610 (Dec. 9,
2020), 86 FR 18596, 18605-06 (Apr. 9, 2021) (``MDI Adopting
Release''). The Commission stated that it was not establishing
minimum data elements needed to achieve best execution nor mandating
consumption of the expanded data content. The Commission also
acknowledged that different market participants and different
trading applications have different market data needs. See id.
(citing Securities Exchange Act Release No. 88216 (Feb. 14, 2020),
85 FR 16726, 16734, 16755 (Mar. 24, 2020) (``Market Data
Infrastructure Proposing Release'')).
\39\ See MDI Adopting Release, supra note 38, 86 FR at 18606.
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The Commission has also stated the importance of price improvement
opportunities in the context of listed and over-the-counter (``OTC'')
equities.\40\ Simply routing customer order flow for automated
executions or internalizing customer orders on an automated basis at
the best bid or offer would not necessarily satisfy a broker-dealer's
duty of best execution for small orders in listed and OTC equities.\41\
Rather, broker-dealers handling small orders in listed and OTC equities
should look for price improvement opportunities when executing these
orders.\42\ And the expectation of price improvement for customer
orders is particularly important when broker-dealers receive payments
in return for routing their customer orders.\43\
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\40\ See Order Execution Obligations Adopting Release, supra
note 10, 61 FR at 48323. See also id. at 48323 n.357.
\41\ See id. at 48323.
\42\ See id.
\43\ See Payment for Order Flow Release, supra note 33, 59 FR at
55008. See also 17 CFR 240.10b-10(d)(8) (defining ``payment for
order flow'' as any monetary payment, service, property, or other
benefit that results in remuneration, compensation, or consideration
to a broker or dealer from any broker or dealer, national securities
exchange, registered securities association, or exchange member in
return for the routing of customer orders by such broker or dealer
to any broker or dealer, national securities exchange, registered
securities association, or exchange member for execution, including
but not limited to: research, clearance, custody, products or
services; reciprocal agreements for the provision of order flow;
adjustment of a broker or dealer's unfavorable trading errors;
offers to participate as underwriter in public offerings; stock
loans or shared interest accrued thereon; discounts, rebates, or any
other reductions of or credits against any fee to, or expense or
other financial obligation of, the broker or dealer routing a
customer order that exceeds that fee, expense or financial
obligation). Retail broker-dealers receiving cash payments from
wholesale market makers in return for routing their customers'
orders to the market maker for execution is a common example of
payment for order flow. See Memorandum to the SEC Equity Market
Structure Advisory Committee from the SEC Division of Trading and
Markets, Certain Issues Affecting Customers in the Current Equity
Market Structure 5-6 (Jan. 26, 2016). Staff reports, Investor
Bulletins, and other staff documents (including those cited herein)
represent the views of Commission staff and are not a rule,
regulation, or statement of the Commission. The Commission has
neither approved nor disapproved the content of these staff
documents and, like all staff statements, they have no legal force
or effect, do not alter or amend applicable law, and create no new
or additional obligations for any person.
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C. FINRA and MSRB Best Execution Rules
FINRA, an SRO,\44\ has a best execution rule (Rule 5310) and has
issued interpretive regulatory notices concerning its members' duty to
provide best execution to customer orders.\45\ FINRA Rule 5310 states
that, ``[i]n any transaction for or with a customer or customer of
another broker-dealer, a member and persons associated with a member
must 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.'' Over the years, FINRA and its predecessor, the
NASD, have modified the rule and issued interpretations to account for
changes in market practices and market structure, and to account for
new technologies and new data available to broker-dealers that handle
and execute customer orders.\46\
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\44\ While the MSRB is an SRO for only certain purposes of the
Exchange Act, see Exchange Act section 3(a)(26), 15 U.S.C.
78c(a)(26), MSRB rules are rules of an SRO, see Exchange Act section
3(a)(28), 15 U.S.C. 78c(a)(28). FINRA and the MSRB are both referred
to herein as SROs.
\45\ For ease of discussion and consistency, this release refers
to FINRA members as broker-dealers when discussing the FINRA rules
that are applicable to FINRA members.
\46\ See, e.g., FINRA Regulatory Notices 21-23 (June 23, 2021),
21-12 (Mar. 18, 2021), 18-29 (Sept. 12, 2018), 15-46 (Nov. 2015),
and 09-58 (Oct. 2009); NASD Notices to Members 01-22 (Apr. 2001),
00-42 (June 2000), and 99-12 (Feb. 1999).
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Modeled on FINRA Rule 5310,\47\ MSRB Rule G-18 is the best
execution rule for transactions in municipal securities \48\ and
similarly requires broker-dealers to ``use reasonable diligence to
ascertain the best market for the subject security and to buy or sell
in that market so that the resultant price to the customer is as
favorable as possible under prevailing market conditions.''
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\47\ In proposing Rule G-18, the MSRB stated that a best
execution rule should be generally harmonized with FINRA Rule 5310
for purposes of regulatory efficiency, but appropriately tailored to
the characteristics of the municipal securities markets. See
Securities Exchange Act Release No. 73764 (Dec. 5, 2014), 79 FR
73658 (Dec. 11, 2014) (``MSRB Best Execution Approval Order'').
While proposed Regulation Best Execution does not include different
requirements for markets with different characteristics, proposed
Regulation Best Execution is designed to enable broker-dealers to
tailor their compliance based on the different characteristics of
the markets.
\48\ MSRB Rule G-18 applies to brokers, dealers, and municipal
securities dealers. For ease of discussion and consistency, when
discussing the MSRB rule, the release refers to these entities
collectively as broker-dealers. Furthermore, the term ``municipal
securities'' throughout this release is referred to as either
``municipal bonds'' or ``municipal securities.''
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The Commission describes the elements in FINRA Rule 5310 and MSRB
Rule G-18, as well as the differences between those rules and the
proposed rules, in section IV below.
III. Existing Order Handling Practices and Overview of Proposed
Regulation Best Execution
A. Existing Order Handling Practices
1. General Broker-Dealer Practices
In the past few decades, there has been a proliferation of markets
and increasingly accessible prices across asset classes. For example,
broker-dealers have numerous execution venues from which to choose in
the NMS stock market. These include 16 registered equities exchanges,
an increase from 11 registered equities exchanges approximately 12
years ago.\49\ In the options markets, the number of options exchanges
continues to increase, with 6 new options exchanges in the last 10
years and 16 registered options exchanges operating today. In the
corporate and municipal bond markets and government securities markets,
traditional OTC voice trading protocols and customer liquidity
provision by principal trading desks of broker-dealers are being
supplemented by other methods of execution that are both electronic and
multilateral in nature. As of October 31, 2022, there are 21 corporate
bond alternative trading systems (``ATSs''), 7 municipal securities
ATSs, and 14 government securities ATSs, each operating pursuant to a
Form ATS currently on file with the Commission.
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\49\ See Securities Exchange Act Release No. 61358 (Jan. 14,
2010), 75 FR 3594 (Jan. 21, 2010) (``Concept Release on Equity
Market Structure'').
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The Commission believes that customers would benefit from broker-
dealers' robust considerations of liquidity sources and price
improvement opportunities, which may provide customers with the most
favorable prices. In the NMS stock market, for example, broker-dealers
that primarily service the accounts of individual investors (``retail
broker-dealers'') route more than 90% of their customers' marketable
orders to a small group of off-exchange dealers, known as
wholesalers,\50\ and the Commission
[[Page 5445]]
believes that customers would benefit from considerations by these
retail broker-dealers of whether other markets may provide customer
orders, or a portion of those orders, with potentially better
executions than wholesalers.
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\50\ See Table 8, infra section V.B.3.(a).i.d..
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For NMS stock orders that receive price improvement from
wholesalers, approximately 18.6% of those shares receive an amount of
price improvement of less than 0.1 cent per share when executed by the
wholesaler.\51\ Moreover, for stocks priced higher than $30, between
approximately 46-63% of shares executed by wholesalers received price
improvement that was less favorable than the midpoint of the prevailing
national best bid and offer (``NBBO'') at the time the wholesaler
received the order.\52\ For stocks priced higher than $30, it appears
that for between 60-93% of the shares executed by the wholesaler in a
principal capacity at a price less favorable than the NBBO midpoint
there was midpoint liquidity that was available on exchanges and ATSs
at the time the wholesaler executed the order.\53\ Retail broker-
dealers often do not route customer orders to execute against midpoint
liquidity that may be present on other markets prior to routing for
execution by wholesalers.\54\ While a retail broker-dealer's decision
to route orders to a wholesaler that provides price improvement may
indeed be consistent with its duty of best execution in many cases,\55\
the Commission believes that customers would benefit from robust
considerations by retail broker-dealers regarding, for example, the
possibility of available liquidity priced at the midpoint of the NBBO
at other markets.
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\51\ See Table 8, infra section V.B.3.(a).i.d.
\52\ The percentage ranges are based on stock prices, the
liquidity of the stock, whether or not the stock was in the S&P 500
Index, and whether or not the stock is an exchange-traded fund
(``ETF''). See Table 8, infra section V.B.3.(a).i.d (analysis
showing that depending on the type of NMS stock, its price, and
liquidity, between 46% and 73% of retail marketable order shares are
internalized by a wholesaler at a price worse than the NBBO
midpoint).
\53\ See Table 8, infra section V.B.3.(a).i.d (analysis showing
that, depending on the type of NMS stock, its price, and its
liquidity, between 40% and 93% of the shares in marketable retail
orders that wholesalers internalize at prices less favorable than
the NBBO midpoint had midpoint liquidity available at a better price
on an exchange or ATS).
\54\ See Table 3, infra section V.B.3.(a).i.d (according to
Table 3, retail brokers appear to outsource handling of over 87% of
customer orders and over 90% of customer marketable orders to
wholesalers).
\55\ For example, wholesalers appear to provide customers with
executions in NMS stocks at the midpoint or better (based on the
NBBO at the time the wholesaler received the order) for almost 46%
of the customer orders executed by the wholesaler in a principal
capacity. See Table 7, infra section V.B.3.(a).i.d . But see supra
note 53 and accompanying text (describing that for stocks priced
higher than $30, it appears that between 60-93% of the shares
executed by the wholesaler in a principal capacity at a price less
favorable than the NBBO midpoint had liquidity available at the NBBO
midpoint on an exchange or ATS).
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Similar considerations are present with the order handling and
routing practices of wholesalers in the NMS stock market.\56\ While the
prices that wholesalers provide to a customer may often justify the
determination by the wholesaler that it is the best market for the
customer order, the specific amount of price improvement for orders
that are executed internally is largely within the discretion of the
wholesaler. The wholesaler typically first determines whether or not it
desires to transact with a particular customer order in a principal
capacity. Should it choose to do so, the wholesaler determines what
amount of price improvement it will provide for the order, and the data
described above shows that wholesalers often do not execute customer
orders at the NBBO midpoint. When the wholesaler has determined that it
does not want to transact with a customer order in a principal
capacity, the wholesaler may attempt to route such order to other
markets.
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\56\ Wholesalers owe a duty of best execution to the customers
of retail broker-dealers under FINRA Rule 5310. See FINRA Rule
5310(a) (applying its best execution requirements to any transaction
for or with a customer or a customer of another broker-dealer).
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As discussed in section III.A.2, the Commission believes that
customers would benefit from robust considerations by broker-dealers of
liquidity sources and price improvement opportunities in the options
market, particularly with respect to transactions that involve order
handling conflicts of interest.
The corporate and municipal bond markets and the government
securities markets are different from the NMS stock market in
substantial ways that can impact how a broker-dealer fulfills its duty
of best execution. For example, market participants do not have the
same level of price transparency in these markets as they do in the NMS
stock market. While the corporate and municipal bond markets
disseminate post-trade price information, this information often is not
available immediately upon execution of a bond transaction as FINRA and
MSRB rules permit a trade to be reported within 15 minutes of the
transaction.\57\ In the government securities market, there is no real-
time public dissemination of post-trade price information. Despite the
increase in electronic trading and the use of ATSs, these markets are
decentralized with most trading occurring through broker-dealers that
make markets in securities they have underwritten or hold in
inventory.\58\ There is virtually no exchange trading of these
bonds.\59\ Generally, trades occur both by voice and through the use of
electronic systems that provide trading facilities and communication
protocols with varying degrees of execution functionality and access to
pre-trade pricing information.\60\ However, market participants in the
corporate and municipal bond markets and the government securities
markets are increasingly utilizing technology to trade these
securities, and electronic trading is growing.\61\ The lower level of
price transparency in, and the decentralized nature of, the corporate
and municipal bond and government securities markets make it more
difficult for customers to evaluate their transactions and highlights
the importance of robust best execution considerations by broker-
dealers in these markets.
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\57\ However, both FINRA and the MSRB recently solicited comment
about shortening the applicable transaction reporting window to one
minute. See FINRA Regulatory Notice 22-17 (Aug. 2, 2022); MSRB
Notice 2022-07 (Aug. 2, 2022).
\58\ See, e.g., Maureen O'Hara & Xing (Alex) Zhou, Anatomy of a
Liquidity Crisis: Corporate Bonds in the COVID-19 Crisis, 142 J.
Fin. Econ. 46 (2021).
\59\ A small percentage of corporate bonds are exchange-traded
on trading systems such as NYSE Bonds and the Nasdaq Bond Exchange.
See generally, <a href="https://www.nyse.com/markets/bonds">https://www.nyse.com/markets/bonds</a> and <a href="https://www.nasdaq.com/solutions/nasdaq-bond-exchange">https://www.nasdaq.com/solutions/nasdaq-bond-exchange</a>. Trading volume in
exchange-traded bonds was reported to be around $19 billion as of
January 2020. See Securities Exchange Act Release No. 94062 (Jan.
26, 2022), 87 FR 15496 (Mar. 18, 2022) (``Government Securities ATS
Proposing Release''), at 15604 n.863 (citing Eric Uhlfelder, A
Forgotten Investment Worth Considering: Exchange-Traded Bonds, Wall
St. J. (Jan. 5, 2020), <a href="https://www.wsj.com/articles/a-forgotten-investment-worth-considering-exchange-traded-bonds-11578279781">https://www.wsj.com/articles/a-forgotten-investment-worth-considering-exchange-traded-bonds-11578279781</a>).
\60\ See Government Securities ATS Proposing Release, supra note
59, 87 FR 15606.
\61\ For example, according to one industry group, approximately
32% of investment-grade and 23% of high-yield corporate bond daily
dollar volumes are executed electronically. See id., at 15606 n.890.
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Commission analysis shows significant differences in the
variability of execution prices among interdealer trades \62\ compared
to the variability of execution prices among customer trades in the
same bonds on the same trading day. For example, in the corporate bond
market, the dispersion, or standard deviation, of customer execution
prices for transactions under $100,000 was almost 3 times more than
that of interdealer execution prices.\63\
[[Page 5446]]
Similarly, in the municipal bond market, the dispersion of customer
execution prices for transactions under $100,000 was more than 4 times
greater than that of interdealer trades.\64\ And in the government
securities market, the dispersion of customer execution prices for
transactions under $100,000 was almost 40 percent greater than that of
interdealer trades.\65\ The variability of prices for customer
transactions suggests that some customers may be paying or receiving
worse prices than other customers in the same security on the same day
because their broker-dealers may not be evaluating as many markets for
those transactions as other broker-dealers. While it is possible that
some of the variability of prices paid by customers may be attributable
to variations in broker-dealer compensation as reflected in the markups
or markdowns charged by broker-dealers when they transact with
customers in a principal capacity, the Commission does not believe that
this is the only reason for customer price dispersion in the same bonds
on the same day.\66\ For example, Commission analysis shows that in the
corporate bond market, for trades that were reported by the broker-
dealer as not involving any collection of commissions, markups or
markdowns, the dispersion of customer execution prices was still 65%
greater than that of interdealer trades.\67\ Because the variability in
the customer execution prices suggests that some broker-dealers may not
be exercising as much diligence in identifying the best market for
customer orders, the Commission believes that customers would benefit
from consistently robust best execution considerations by broker-
dealers, including considerations of the various markets that may
provide their customers with the most favorable prices.
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\62\ It is well-established that interdealer prices can reflect
the prevailing market value for a bond. See, e.g., FINRA Rule 2121.
\63\ See Table 17, infra section V.B.3.b.i.
\64\ See Table 17, infra section V.B.3.b.i and V.B.3.b.ii.
\65\ See Table 17, infra section V.B.31.b.i and V.B.3.b.iii .
\66\ See, e.g., John M. Griffin, Nicholas Hirschey, and Samuel
Kruger, Do Municipal Bond Dealers Give their Customers `Fair and
Reasonable' Pricing? J. Fin., Forthcoming (Aug. 4, 2022) (``Instead
of delivering uniform pricing, dealer transactions with customers
take place at highly variable markups relative to both reoffering
prices and dealer costs. On the same day, customers frequently buy
the same bond at different prices from different dealers, and prices
even vary across different customers purchasing the same bond from
the same dealer on the same day. These price differences are not
explained by trade characteristics or by dealer costs. Some dealers
provide customers with low and consistent markups, but this does not
appear to be the industry norm. Pricing at quarter or eighth price
or yield increments is common and is seemingly a method to deliver
higher markups.'').
\67\ See infra note 478.
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2. Order Handling Conflicts of Interest
The Commission also believes that execution of retail customer
orders by broker-dealers that have order handling conflicts of interest
warrants heightened attention by those broker-dealers. These order
handling conflicts of interest include payment for order flow,
principal trading, and routing customer orders to affiliates.
Payment for order flow \68\ creates a conflict of interest because
it creates an incentive for a broker-dealer to send customer orders to
a market, such as a wholesaler or an exchange, which agrees to pay the
broker-dealer for sending its customer orders.\69\ Payment for order
flow may harm customers because the broker-dealer may be making order
handling decisions to benefit itself at the expense of its
customer.\70\ Because payment for order flow is a form of economic
inducement that has the potential to influence the way a broker-dealer
handles customer orders, the Commission has stated that such
arrangements must be considered as part of a broker-dealer's best
execution assessment.\71\
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\68\ When discussing payment for order flow in the context of
the proposed rules, the Commission uses the term as defined in
Exchange Act Rule 10b-10(d)(8). This definition includes payment for
order flow from wholesalers to retail broker-dealers, as well as
exchange rebates that are paid to broker-dealers in return for
sending orders to the exchange. See 17 CFR 240.10b-10 (defining
payment for order flow and requiring a broker-dealer to disclose to
the customer whether payment for order flow is received by the
broker-dealer for the customer transaction and the fact that the
source and nature of the compensation received in connection with
the particular transaction will be furnished upon written request of
the customer).
\69\ See, e.g., Payment for Order Flow Release, supra note 33,
FR Doc No: 94-27109; FINRA Regulatory Notice 21-23; Robinhood
Financial, LLC, Letter of Acceptance, Waiver and Consent (FINRA Case
No. 2017056224001) (Dec. 2019) (``Robinhood FINRA'') (describing
violations of FINRA's best execution rule where the firm routed its
customers' orders to four broker-dealers that all paid for order
flow and ``did not exercise reasonable diligence to ascertain
whether these four broker-dealers provided the best market for the
subject securities to ensure its customers received the best
execution quality from these as compared to other execution
venues''); In the Matter of Robinhood Financial, LLC, Securities
Exchange Act Release No. 90694 (Dec. 17, 2020) (settled action)
(``Robinhood SEC''). Broker-dealers that accept payment for order
flow must disclose certain information concerning the payments
publicly. See 17 CFR 242.606(a)(1)(iv) (requiring a description of
any arrangement for payment for order flow and any profit-sharing
relationship and a description of any terms of such arrangements,
written or oral, that may influence a broker-dealer's order routing
decision).
\70\ See, e.g., Robinhood FINRA, supra note 69; Robinhood SEC,
supra note 69 (finding that the retail broker-dealer explicitly
offered to accept less price improvement for its customers than what
the wholesalers were offering, in exchange for receiving a higher
rate of payment for order flow for itself).
\71\ See Payment for Order Flow Release, supra note 33, FR Doc
No: 94-27109.
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While the Commission has stated that a broker-dealer's receipt of
payment for order flow is not a violation of its duty of best execution
as long as it periodically assesses the quality of the markets to which
it routes order flow, a broker-dealer must not allow payment for order
flow to interfere with its efforts to obtain best execution.\72\
Likewise, FINRA has stated that broker-dealers may not negotiate the
terms of order routing arrangements for customer orders in a manner
that reduces the price improvement opportunities that, absent payment
for order flow, otherwise would be available to those customer
orders.\73\ FINRA has also stated that obtaining price improvement is a
heightened consideration when a broker-dealer receives payment for
order flow and it is especially important to determine that customers
are receiving the best price and execution quality opportunities
notwithstanding the payment for order flow.\74\ Accordingly, the
Commission believes that the receipt of payment for customer order flow
continues to warrant heightened attention by broker-dealers.\75\
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\72\ See id.
\73\ See FINRA Regulatory Notice 21-23 (June 23, 2021).
\74\ See id., at 3-4. FINRA has also stated that ``inducements
such as payment for order flow and internalization may not be taken
into account in analyzing market quality.'' See id. at 4.
\75\ Commission staff, in a recent report, stated that
wholesaler payment for order flow to retail broker-dealers is
``individually negotiated prior to trading between the retail
broker-dealer and the [wholesaler], and the rates and amounts can
vary substantially depending on the broker-dealer and its customer
order flow. [Wholesalers] may give the retail broker the choice of
how to allocate those funds--either by applying some or all of that
payment to improve the prices of its customers' orders or by
allowing the retail broker-dealer to keep part of the payment for
itself.'' Commission staff stated that these payments can create a
conflict of interest for the retail broker-dealer. See Staff Report
on Equity and Options Market Structure Conditions in Early 2021
(Oct. 14, 2021), available at <a href="https://www.sec.gov/files/staff-report-equity-options-market-struction-conditions-early-2021.pdf">https://www.sec.gov/files/staff-report-equity-options-market-struction-conditions-early-2021.pdf</a>.
Additionally, Rule 606(a) of Regulation NMS requires broker-dealers
to make publicly available on a quarterly basis certain aggregated
order routing disclosures for held orders that provide, among other
things, detailed disclosure of payments received from or paid to
certain trading centers, as well as a discussion of the material
aspects of broker-dealers' relationships with those trading centers,
including a description of any arrangements for payment for order
flow and any profit-sharing relationships and a description of any
terms of such arrangements, written or oral, that may influence
broker-dealers' order routing decisions. See 17 CFR 242.606(a).
---------------------------------------------------------------------------
A significant portion of retail orders in the NMS stock and listed
options market is routed in return for payment
[[Page 5447]]
for order flow. In the first quarter of 2022, wholesalers paid more
than $796 million dollars to retail broker-dealers for order flow in
NMS stocks and listed options.\76\ Listed options represented
approximately 70% of the total payment for order flow with more than
$561 million paid to retail broker-dealers by wholesalers.\77\ Payment
for order flow creates an incentive for the retail broker-dealer to
adopt order handling and execution practices that may not result in
best execution for their customers.\78\ For example, as discussed more
fully in section V, analysis in the NMS stock market appears to show
that payment for order flow can harm customer execution quality. More
specifically, the orders of broker-dealers that receive more payment
for order flow from wholesalers are internalized by wholesalers with
(1) higher effective spreads, (2) higher execution quality ratios, and
(3) slightly smaller price improvement when compared with the orders of
broker-dealers that do not receive payment for order flow and that are
internalized by wholesalers.\79\ In the context of exchange rebates in
the options market, one study finds that some brokers seemingly route
non-marketable orders to exchanges that offer large liquidity rebates
to maximize the value of order flow and suggests that broker-dealers
can enhance non-marketable limit order execution quality by routing
those orders to exchanges that do not offer liquidity rebates to non-
marketable limit orders.\80\
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\76\ See Table 12, infra section V.B.3.(a).iii.a.
\77\ See id. See also Thomas Ernst & Chester S. Spatt, Payment
for Order Flow and Asset Choice, 40 (NBER Working Paper No. w29883,
May 2022), <a href="https://ssrn.com/abstract=4068065">https://ssrn.com/abstract=4068065</a> (retrieved from
Elsevier database) (finding that approximately 65% of all payment
for order flow is attributable to the options market). In addition
to payment for order flow paid by wholesalers to retail broker-
dealers, some exchanges administer ``marketing fee'' programs
pursuant to rules filed with the Commission, that result in payment
for order flow directed by exchange market makers to order flow
providers, which can include retail broker-dealers. See, e.g.,
Nasdaq Phlx LLC Options 7, Section 4; Miami International Securities
Exchange LLC Fee Schedule Section (1)(a)(xi); NYSE American LLC
Options Fee Schedule Section I.A. Under these programs, the
exchanges assess fees on market makers who then typically direct the
disbursement of some or all of the marketing fees to selected market
participants in return for retail order flow directed to the market
makers from the broker-dealer recipients of the marketing fees. If
the directed market maker is quoting at the NBBO when the order is
received, exchange rules typically guarantee the market maker a
certain allocation of the incoming directed order, typically
determined by the number of other market makers quoting at the NBBO
at the time the order is received. See, e.g., PHLX Options 3,
Section 10(a)(1)(C) (describing the directed market maker priority).
\78\ The Commission and FINRA settled claims against a retail
broker-dealer for, among other things, failing to provide best
execution to customer orders for which it received payment for order
flow. See supra note 69. The inherent trade-off between payment for
order flow for a retail broker-dealer and price improvement for
their customers was discussed in the Commission's settled
enforcement action against the retail broker. See Robinhood SEC,
supra note 69. The Commission found that the retail broker-dealer
had negotiated with a number of wholesalers about potentially
routing customer orders to those firms and that, in the course of
those negotiations, certain of the wholesalers told the retail
broker-dealer that there was a trade-off between payment for order
flow on the one hand and price improvement on the other. See id. The
Commission also found that the retail broker-dealer explicitly
offered to accept less price improvement for its customers than what
the wholesalers were offering, in exchange for receiving a higher
rate of payment for order flow for itself. See id. Subsequently, the
retail broker-dealer conducted a more extensive internal analysis,
which showed that its execution quality and price improvement
metrics were substantially worse than other retail broker-dealers in
many respects, including the percentage of orders that received
price improvement and the amount of price improvement, measured on a
per order, per share, and per dollar traded basis. See id.
\79\ See Table 16, infra section V.B.3.b..iii.b.
\80\ See Robert Battalio et al., Do (Should) Brokers Route Limit
Orders to Options Exchanges That Purchase Order Flow?, 56 J. Fin. &
Quantitative Analysis 183 (2020).
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The Commission has also acknowledged that the opportunity for a
broker-dealer to trade with a customer order as principal is an order
routing inducement that could interfere with the broker-dealer's duty
of best execution.\81\ Internalizing customer orders may create a
conflict of interest because broker-dealers do so for the opportunity
to capture the spread,\82\ and may thereby provide broker-dealers an
incentive to trade with orders as principal. In the NMS stock market
and listed options market, principal trading with retail customers is a
common practice. As stated above in section III.A.1, a significant
portion of retail customer orders are routed to wholesalers for
handling and execution. Once the wholesaler receives retail customer
orders for handling and execution, it often trades with those customer
orders as principal. Wholesalers internalize over 90% of the dollar
value of the marketable order flow retail broker-dealers send them.\83\
The Commission believes that the incentive to trade in a principal
capacity at a price most advantageous for the wholesaler itself rather
than the customer warrants heightened attention by the wholesaler.
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\81\ See Order Execution Obligations Adopting Release, supra
note 10, 61 FR 48323.
\82\ See Internalized/Affiliate Practices, Payment for Order
Flow and Order Routing Practices, Securities Exchange Act Release
No. 34903 (Oct. 27, 1994), 59 FR 55014, 55014 (Nov. 2, 1994)
(recognizing several commenters who described this conflict of
interest).
\83\ See Table 7, infra Section V.B.3.a.i.d.
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Principal trading in the listed options market is also common.
Options exchange trading and priority rules, which must be filed with
the Commission under section 19(b) of the Exchange Act \84\ and Rule
19b-4 thereunder,\85\ provide wholesalers with a number of methods to
internalize customer orders. For example, the wholesaler or an
affiliate is often either a specialist or directed market maker on one
or more of the options exchanges. Exchange rules typically provide the
specialist or directed market maker with the right to trade with a
certain portion of incoming order flow regardless of whether other
market participants may also be quoting at the same price as the
specialist or directed market maker.\86\ These ``allocation
guarantees'' effectively allow the wholesaler to internalize a minimum
amount of the customer orders by routing the customer orders to
exchanges where the wholesaler or its affiliate is designated as a
specialist or directed market maker. Similarly, many options exchanges
provide small order guarantees that permit the specialist (which
potentially can be an affiliate of the wholesaler) to trade with 100%
of all orders sent to the exchange for five contracts or less.\87\
Moreover, options exchanges' two-sided auctions (``price improvement
auctions'') allow a wholesaler to internalize a customer order by
submitting a proposed transaction between the wholesaler and a customer
at a specified price.\88\ Other market participants are permitted to
compete with the wholesaler for the opportunity to trade with the
customer order. These price improvement auctions, however, generally
afford the wholesaler with certain advantages over other market
participants that may be interested in competing for the right to trade
with a customer order.\89\ The Commission estimates that wholesalers in
the listed options market generally internalize approximately 31% of
the executed
[[Page 5448]]
orders routed to option exchanges, with approximately 73% of orders
routed to price improvement auctions being internalized and
approximately 17% of orders routed to the limit order book being
internalized.\90\ The Commission believes that the incentive to trade
in a principal capacity at a price most advantageous for the wholesaler
itself rather than the customer warrants heightened attention by the
wholesaler.
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\84\ 15 U.S.C. 78s(b).
\85\ 17 CFR 240.19b-4.
\86\ See, e.g., BOX Exchange LLC Rule 7135(c); Miami
International Securities Exchange LLC Rule 514(g)-(i); Nasdaq Phlx
LLC Options 3, Section 10(a)(1); Nasdaq ISE, LLC Options 3, Section
10(c)(1); NYSE American LLC Rule 964NY(b)(2).
\87\ See, e.g., Nasdaq ISE, LLC Options 3, Section 10(c)(1)(D);
Nasdaq Phlx LLC Options 3, Section 10(a)(1)(D); BOX Exchange LLC
Rule 7135(c)(2)(iii); NYSE American LLC Rule 964NY(b)(2)(C)(iv).
\88\ Customer orders that are submitted into price improvement
auctions are guaranteed complete execution at a minimum execution
price and are electronically auctioned for price improvement. See,
e.g., Nasdaq ISE, LLC Options 3, Section 13; Nasdaq Phlx LLC Options
3, Section 13; Miami International Securities Exchange LLC Rule
515A; BOX Exchange LLC Rule 7150; NYSE American LLC Rule 971.1NY;
Cboe Exchange, Inc. Rule 5.37.
\89\ See infra notes 137-140 and accompanying text.
\90\ See infra Section V.B.3.a.ii.
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Finally, the practice of routing customer orders to affiliates
raises a conflict of interest for the broker-dealer. When a broker-
dealer chooses to route customer orders to an affiliate, it may do so
because of financial incentives, and these incentives can vary
depending on the business model or business lines of the broker-dealer.
For example, broker-dealers may have conflicts of interest to the
extent that they operate or are affiliated with an entity that operates
a trading venue, such as an ATS, because the broker-dealer or its
affiliate receives financial benefits when the broker-dealer operator
chooses to route customer orders to its ATS for execution (e.g., by
routing an order to its ATS, a broker-dealer operator that does not
pass through trading fees to its customers may be able to avoid paying
fees that it otherwise would have to pay when routing and executing
orders on unaffiliated trading venues).\91\ A broker-dealer operator
also benefits by routing to its ATS because it creates higher volume on
the ATS, which can attract additional order flow to the ATS, ultimately
increasing the ATS' market share and associated revenue.\92\ Another
example of affiliate routing conflicts of interest relates to a
financial services firm that may have an organizational structure that
separates its retail facing business from its order handling and
execution business. The retail broker-dealer that receives a customer
order may have a financial incentive to send the customer order to its
affiliated executing broker-dealer because the affiliated executing
broker-dealer may wish to trade as principal with the customer order.
While an affiliated executing broker-dealer could provide best
execution for customer orders, the incentive to send customer orders to
an affiliate may influence the broker-dealer to route the customer
order in a manner that maximizes the broker-dealer's interest, rather
than route the customer order to another market consistent with its
duty of best execution.\93\ Accordingly, the Commission believes that
the impact of this practice on customer orders continues to warrant
heightened attention by broker-dealers.
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\91\ See Amber Anand et al., Institutional Order Handling and
Broker-Affiliated Trading Venues, 34 Rev. Fin. Stud. 3364, 3366
(July 2021) (``Anand'') (recognizing the conflict between obtaining
the best outcome for the customer and maximizing the broker-dealer's
revenue due to avoiding a fee that is typically borne by the broker-
dealer). This study found that ``institutional brokers who route
more orders to affiliated [ATSs] are associated with lower execution
quality (i.e., lower fill rates and higher implementation shortfall
costs).'' Id. See also Regulation of NMS Stock Alternative Trading
Systems, Securities Exchange Act Release No. 83663 (July 18, 2018),
83 FR 38768, 38775, 38834 (Aug. 7, 2018).
\92\ See Anand, supra note 91, at 3366.
\93\ Recently, FINRA has entered into settlements with broker-
dealers for best execution violations of FINRA rules involving
affiliated routing practices. In one case, FINRA found that the
broker-dealer ``failed to consider whether alternate routing
arrangements could have provided price improvement opportunities and
better speed of execution'' for customer orders despite its
consideration of certain execution quality factors for orders routed
to an affiliated ATS. FINRA also stated that ``although [the firm]
reviewed fill rates in [its affiliated ATS] during the relevant
period, the firm failed to consider alternate routing arrangements
when the firm showed that fill rates in [its affiliated ATS] were
inferior to fill rates at some competing execution venues.'' FINRA
found that this practice violated FINRA's best execution rule. See
Barclays Capital Inc., Letter of Acceptance, Waiver, and Consent No.
2014041808601 (Oct. 4, 2022), available at <a href="https://www.finra.org/sites/default/files/2022-10/Barclays-Capital-AWC-100522.pdf">https://www.finra.org/sites/default/files/2022-10/Barclays-Capital-AWC-100522.pdf</a>. In
another case, FINRA found that the broker-dealer routinely routed
institutional customer orders to its affiliated ATS prior to routing
such orders to exchanges or to other ATSs. According to FINRA's
findings, the broker-dealer routed to its affiliated ATS despite
having evidence that (1) orders that were sent to the affiliated ATS
had lower fill rates as compared to orders sent directly to
exchanges, and (2) other ATSs consistently ranked higher in the
firm's rankings for execution quality than the affiliated ATS. FINRA
found that this affiliated routing practice violated FINRA's best
execution rule 5310. See Deutsche Bank Securities Inc., Letter of
Acceptance, Waiver, and Consent No. 2014041813501 (Mar. 7, 2022),
available at <a href="https://www.finra.org/sites/default/files/2022-03/deutsche-bank-awc-030722.pdf">https://www.finra.org/sites/default/files/2022-03/deutsche-bank-awc-030722.pdf</a>.
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3. Crypto Asset Securities
As discussed in section II.A above, a broker-dealer has a legal
duty to seek best execution of customer orders in securities. Proposed
Regulation Best Execution would apply to all securities, including any
digital asset that is a security or a government security under the
Federal securities laws. The term ``digital asset'' refers to an asset
that is issued and/or transferred using distributed ledger or
blockchain technology (``distributed ledger technology''), including,
but not limited to, so-called ``virtual currencies,'' ``coins,'' and
``tokens.'' \94\
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\94\ See Custody of Digital Asset Securities by Special Purpose
Broker-Dealers, Securities Exchange Act Release No. 90788 (Dec. 23,
2020), 86 FR 11627, 11627 n.1 (Feb. 26, 2021) (``Crypto Asset
Securities Custody Release''). A digital asset may or may not meet
the definition of a ``security'' under the Federal securities laws.
See, e.g., Report of Investigation Pursuant to Section 21(a) of the
Securities Exchange Act of 1934: The DAO, Securities Exchange Act
Release No. 81207 (July 25, 2017) (``DAO 21(a) Report''), available
at <a href="https://www.sec.gov/litigation/investreport/34-81207.pdf">https://www.sec.gov/litigation/investreport/34-81207.pdf</a>. See
also SEC v. W.J. Howey Co., 328 U.S. 293 (1946). To the extent
digital assets rely on cryptographic protocols, these types of
assets also are commonly referred to as ``crypto assets'' and
``digital asset securities'' can be referred to as ``crypto asset
securities.'' For purposes of this release, the Commission does not
distinguish between the terms ``digital asset securities'' and
``crypto asset securities.''
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Unlike securities that are not issued or transferred using
distributed ledger technology, the Commission has limited information
about the order handling and best execution practices of broker-dealers
that engage in transactions for or with customers in crypto asset
securities.\95\ This information limitation is, in part, due to the
fact that only a small portion of crypto asset security trading
activity is occurring within entities that are registered with the
Commission and any of the SROs. For example, there are currently no
special purpose broker-dealers authorized to maintain custody of crypto
asset securities.\96\ Similarly, only a limited
[[Page 5449]]
amount of crypto asset security volume is executed on trading venues
under the Commission's ATS framework.\97\ This information limitation
is also, in part, due to the significant trading activity in crypto
asset securities that may be occurring in non-compliance with the
Federal securities laws.\98\
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\95\ See, e.g., Fin. Stability Oversight Council, Report on
Digital Asset Financial Stability Risks and Regulation 119 (2022)
(``FSOC Report''), available at <a href="https://home.treasury.gov/system/files/261/FSOC-Digital-Assets-Report-2022.pdf">https://home.treasury.gov/system/files/261/FSOC-Digital-Assets-Report-2022.pdf</a> (``The crypto-asset
ecosystem is characterized by opacity that creates challenges for
the assessment of financial stability risks.''); U.S. Dep't of the
Treasury, Crypto-Assets: Implications for Consumers, Investors, and
Businesses 12 (Sept. 2022) (``Crypto-Assets Treasury Report''),
available at <a href="https://home.treasury.gov/system/files/136/CryptoAsset_EO5.pdf">https://home.treasury.gov/system/files/136/CryptoAsset_EO5.pdf</a> (finding that data pertaining to ``off-chain
activity'' is limited and subject to voluntary disclosure by trading
platforms and protocols, with protocols either not complying with or
not subject to obligations ``to report accurate trade information
periodically to regulators or to ensure the quality, consistency,
and reliability of their public trade data''); Fin. Stability Bd.,
Assessment of Risks to Financial Stability from Crypto-assets 18-19
(Feb. 16, 2022) (``FSB Report''), available at <a href="https://www.fsb.org/wp-content/uploads/P160222.pdf">https://www.fsb.org/wp-content/uploads/P160222.pdf</a> (finding that the difficulty in
aggregating and analyzing available data in the digital asset space
``limits the amount of insight that can be gained with regard to the
[digital asset] market structure and functioning,'' including who
the market participants are and where the market's holdings are
concentrated, which, among other things, limits regulators' ability
to inform policy and supervision); Raphael Auer et al., Banking in
the Shadow of Bitcoin? The Institutional Adoption of
Cryptocurrencies 4, 9 (Bank for Int'l Settlements, Working Paper No.
1013, May 2022), available at <a href="https://www.bis.org/publ/work1013.pdf">https://www.bis.org/publ/work1013.pdf</a>
(stating that data gaps, which can be caused by limited disclosure
requirements, risk undermining the ability for holistic oversight
and regulation of cryptocurrencies); Int'l Monetary Fund, The Crypto
Ecosystem and Financial Stability Challenges, in Global Financial
Stability Report 41, 47 (Oct. 2021), available at <a href="https://www.imf.org/-/media/Files/Publications/GFSR/2021/October/English/ch2.ashx">https://www.imf.org/-/media/Files/Publications/GFSR/2021/October/English/ch2.ashx</a> (finding that digital asset service providers provide
limited, fragmented, and, in some cases, unreliable data, as the
information is provided voluntarily without standardization and, in
some cases, with an incentive to manipulate the data provided).
\96\ For background on Rule 15c3-3, 17 CFR 240.15c3-3, as it
relates to digital asset securities, see U.S. Sec. & Exch. Comm'n,
Joint Staff Statement on Broker-Dealer Custody of Digital Asset
Securities (July 8, 2019), <a href="https://www.sec.gov/news/public-statement/joint-staff-statement-broker-dealer-custody-digital-asset-securities">https://www.sec.gov/news/public-statement/joint-staff-statement-broker-dealer-custody-digital-asset-securities</a>; Fin. Indus. Regul. Auth., SEC Staff No-Action Letter,
ATS Role in the Settlement of Digital Asset Security Trades (Sept.
25, 2020), available at <a href="https://www.sec.gov/divisions/marketreg/mr-noaction/2020/finra-ats-role-in-settlement-of-digital-asset-security-trades-09252020.pdf">https://www.sec.gov/divisions/marketreg/mr-noaction/2020/finra-ats-role-in-settlement-of-digital-asset-security-trades-09252020.pdf</a>. To date, five offerings of crypto
asset securities have been registered or qualified under the
Securities Act of 1933, and five classes of crypto asset securities
have been registered under the Exchange Act. The Commission issued a
statement describing its position that, for a period of five years,
special purpose broker-dealers operating under the circumstances set
forth in the statement will not be subject to a Commission
enforcement action on the basis that the broker-dealer deems itself
to have obtained and maintained physical possession or control of
customer fully paid and excess margin digital asset securities for
purposes of Rule 15c3-3(b)(1) under the Exchange Act. See Crypto
Asset Securities Custody Release, supra note 94. To date, no such
special purpose broker-dealer registration applications have been
granted by FINRA.
\97\ ATSs that do not trade NMS stocks file with the Commission
a Form ATS notice, which the Commission does not approve. Form ATS
requires, among other things, that ATSs provide information about:
classes of subscribers and differences in access to the services
offered by the ATS to different groups or classes of subscribers;
securities the ATS expects to trade; any entity other than the ATS
involved in its operations; the manner in which the system operates;
how subscribers access the trading system; procedures governing
entry of trading interest and execution; and trade reporting,
clearance, and settlement of trades on the ATS. In addition, all
ATSs must file quarterly reports on Form ATS-R with the Commission.
Form ATS-R requires, among other things, volume information for
specified categories of securities, a list of all securities traded
in the ATS during the quarter, and a list of all subscribers that
were participants. To the extent that an ATS trades crypto asset
securities, the ATS must disclose information regarding its crypto
asset securities activities as required by Form ATS and Form ATS-R.
Form ATS and Form ATS-R are deemed confidential when filed with the
Commission. Based on information provided on these forms, a limited
number of ATSs have noticed on Form ATS their intention to trade
certain crypto asset securities and a subset of those ATSs have
reported transactions in crypto asset securities on their Form ATS-
R.
\98\ See also FSOC Report, supra note 95, at 5, 87, 94, 97
(emphasizing the importance of the existing financial regulatory
structure while stating that certain digital asset platforms may be
listing securities while not in compliance with exchange, broker-
dealer, or other registration requirements, which may impose
additional risk on banks and investors and result in ``serious
consumer and investor protection issues''); Crypto-Assets Treasury
Report, supra note 95, at 26, 29, 39, 40 (stating that issuers and
platforms in the digital asset ecosystem may be acting in non-
compliance with statutes and regulations governing traditional
capital markets, with market participants that actively dispute the
application of existing laws and regulations, creating risks to
investors from non-compliance with, in particular, extensive
disclosure requirements and market conduct standards); FSB Report,
supra note 95, at 4, 8, 18 (stating that some trading activity in
crypto assets may be failing to comply with applicable laws and
regulations, while failing to provide basic investor protections due
to their operation outside of or in non-compliance with regulatory
frameworks, thereby failing to provide the ``market integrity,
investor protection or transparency seen in appropriately regulated
and supervised financial markets'').
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The Commission believes that it is appropriate for a broker-dealer
that engages in transactions for or with customers or customers of
another broker-dealer in crypto asset securities to be subject to
proposed Regulation Best Execution. As discussed in section I above,
the duty of best execution is of fundamental importance to investors
and the markets, including investors in, and the market for, crypto
asset securities. For example, a customer transacting in crypto asset
securities should receive the protections afforded by the requirement
that broker-dealers exercise reasonable diligence to ascertain the best
market for the crypto asset securities and buy and sell in such market
so that the price to the customer is as favorable as possible under
prevailing market conditions. In doing so, broker-dealers should be
taking steps to ensure that they are evaluating the range of markets
that trade crypto asset securities and appropriately identifying those
markets that may be likely to provide customers with the most favorable
prices.
B. Overview of Proposed Regulation Best Execution
The Commission believes that proposed Regulation Best Execution
would further the Congressional goal set forth in Exchange Act Section
11A(a)(1)(C)(iv) regarding executing investors' orders in the best
market and reinforce broker-dealer obligations concerning the duty of
best execution. In particular, proposed Regulation Best Execution would
identify specific factors that must be addressed by a broker-dealer's
policies and procedures on best execution, impose additional
requirements for conflicted transactions, and impose best execution-
specific review and documentation requirements, all of which should
better protect investors by promoting consistently robust order
handling and execution practices.\99\
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\99\ See section IV for discussions of the differences between
the proposed rules and the existing FINRA and MSRB rules on best
execution. As discussed in detail in section IV, proposed Regulation
Best Execution is consistent with the FINRA and MSRB best execution
rules in some respects and, in some other respects, goes beyond
those rules imposing additional and/or more specific requirements.
---------------------------------------------------------------------------
Proposed Rule 1100 would set forth the standard of best execution,
requiring a broker-dealer to use reasonable diligence to ascertain the
best market for a 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. Proposed Rule 1101 would require a
broker-dealer to establish, maintain, and enforce written policies and
procedures that address specific elements that are designed to promote
the best execution of customer orders, and comply with certain
execution quality review and documentation requirements.
More specifically, proposed Rule 1101(a)(1) would require that a
broker-dealer's policies and procedures address how it will comply with
the best execution standard in proposed Rule 1100. In particular, a
broker-dealer's policies and procedures would be required to address
how it will: (1) obtain and assess reasonably accessible information
concerning the markets trading the relevant securities; (2) identify
markets that may be reasonably likely to provide the most favorable
prices for customer orders (``material potential liquidity sources'');
and (3) incorporate the material potential liquidity sources into its
order handling practices and ensure efficient access to each such
material potential liquidity source. The Commission believes this
aspect of the proposal would promote consistently robust order handling
practices by requiring each broker-dealer to establish a detailed
framework to achieve best execution, which involves an analysis of
relevant information, an evaluation of the range of liquidity sources,
and the identification of and ability to efficiently access liquidity
sources.
Proposed Rule 1101(a)(2) would require a broker-dealer's policies
and procedures to address how it will determine the best market and
make routing and execution decisions for the customer orders that it
receives. In particular, a broker-dealer's policies and procedures
would be required to address how it will: (1) assess reasonably
accessible and timely information, including information with respect
to the best displayed prices, opportunities for price improvement, and
order exposure opportunities that may result in the most favorable
price; (2) assess the attributes of customer orders and consider the
trading characteristics of the security, the size of the orders, the
likelihood of execution, and the accessibility of the market, and any
customer instructions in selecting the market most likely to provide
the most favorable price; and (3) reasonably
[[Page 5450]]
balance the likelihood of obtaining a better price with the risk that
delay could result in a worse price when determining the number and
sequencing of markets to be assessed. These considerations have been
recognized as relevant for a broker-dealer's duty of best
execution.\100\
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\100\ See, e.g., supra notes 21-23 and accompanying text; FINRA
Rules 5310(a)(1) and 5310.09(b)(1).
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As discussed in section IV.B below, the factors that must be
included in a broker-dealer's policies and procedures under proposed
Rule 1101(a) are generally consistent with the factors that FINRA and
the MSRB have identified as relevant to a broker-dealer's best
execution determinations. The Commission understands that, currently,
some broker-dealers incorporate various best execution factors from the
FINRA and MSRB best execution rules in their policies and procedures.
However, by requiring broker-dealers' best execution policies and
procedures to explicitly address these factors, proposed Rule 1101(a)
would help ensure that broker-dealers have established processes in
place for considering these factors and that broker-dealers follow
these processes when transacting for or with customers, which should
promote consistently robust order handling practices among broker-
dealers.\101\
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\101\ Moreover, requiring broker-dealers' best execution
policies and procedures to address factors similar to those that
FINRA and the MSRB have already identified as relevant to best
execution determinations would mitigate compliance costs associated
with the proposed rules.
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Proposed Rule 1101(b) would require broker-dealers that have
certain conflicts of interest to establish additional policies and
procedures to better position them to meet the best execution standard
in these circumstances. In particular, a broker-dealer's policies and
procedures for conflicted transactions would be required to address how
it will: (1) obtain and assess information beyond that required by
proposed Rule 1101(a)(1)(i) in identifying a broader range of markets
beyond the material potential liquidity sources; and (2) evaluate a
broader range of markets beyond the material potential liquidity
sources. Proposed Rule 1101(b) would also require broker-dealers to
document their compliance with the best execution standard for
conflicted transactions, including all efforts taken to enforce their
policies and procedures, and their basis and information relied on for
determining that their conflicted transactions would comply with the
proposed best execution standard. Such documentation would be required
to be done in accordance with written procedures. Proposed Rule 1101(b)
would also require broker-dealers to document any arrangements
concerning payment for order flow.\102\ These requirements for
conflicted transactions would be in addition to the current FINRA and
MSRB best execution rules, although the Commission understands that
some broker-dealers currently preserve information that allows them to
support their best execution determinations (e.g., information to
recreate the pricing information that was available at the time an
order was received). The Commission believes that these requirements
would encourage broker-dealers to exercise additional diligence with
respect to conflicted transactions in light of the incentives to handle
conflicted transactions in a manner that prioritizes their own
interests over their customers' interests, and are part of the
Commission's ongoing efforts to protect investors when conflicts of
interest exist.
---------------------------------------------------------------------------
\102\ See infra section IV.C.2 (discussing the proposed
requirement to document payment for order flow arrangements).
---------------------------------------------------------------------------
Proposed Rule 1101(c) would require broker-dealers to review the
execution quality of customer orders at least quarterly, and how such
execution quality compares with the execution quality that might have
been obtained from other markets, and revise their best execution
policies and procedures, including order handling practices,
accordingly. The Commission understands that, currently, broker-
dealers' reviews of execution quality vary in rigor,\103\ and the
Commission preliminarily believes that the proposed review requirement
would further ensure that broker-dealers evaluate the effectiveness of
their current order handling practices and enable broker-dealers to
make informed judgments regarding whether their policies and procedures
or practices need to be modified. This review requirement would also
apply to a broader range of broker-dealers than FINRA's rule that
governs the review of execution quality,\104\ and would be in addition
to the current MSRB best execution rule.
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\103\ See infra note 210 (discussing FINRA exam findings
relating to execution quality reviews).
\104\ See infra section IV.D (discussing the proposed execution
quality review requirement, including the scope of the proposed
requirement).
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Proposed Rule 1101(d) would exempt an introducing broker that
routes customer orders to an executing broker from separately complying
with proposed Rules 1101(a), (b), and (c), so long as the introducing
broker establishes, maintains, and enforces policies and procedures
that require the introducing broker to regularly review the execution
quality obtained from its executing broker, compare it with the
execution quality it might have obtained from other executing brokers,
and revise its routing practices accordingly. This provision would
provide a tailored exemption from certain provisions of proposed
Regulation Best Execution for broker-dealers that do not make decisions
or exercise discretion regarding the manner in which their customer
orders are handled and executed, beyond their determinations to engage
the services of executing brokers. This exemption would be provided to
a narrower group of broker-dealers than similar exemptions provided by
FINRA and the MSRB, and would require additional specific policies and
procedures that are not required under the FINRA and MSRB rules.\105\
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\105\ See infra section IV.E (describing the applicability of
the proposed exemption under proposed Rule 1101(d)).
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Proposed Rule 1102 would require each broker-dealer to review and
assess the design and overall effectiveness of their best execution
policies and procedures, including their order handling practices, on
at least an annual basis, and document such review and assessment in an
annual report that would be provided to the broker-dealer's governing
body. The Commission understands that, currently, broker-dealers
periodically review their policies and procedures (including those
related to best execution), although the frequency of review may
vary.\106\ However, proposed Rule 1102 would require the broker-dealer
to review and assess the policies and procedures it established under
proposed Regulation Best Execution, and the Commission believes that
these requirements would help ensure the effectiveness of broker-
dealers' best execution policies and procedures that are adopted
pursuant to the proposed rules.
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\106\ See infra notes 222, 223, and 224 and accompanying text
(describing the minimum frequency standards for review of execution
quality under the FINRA and MSRB rules and how broker-dealers may
need to review execution quality more frequently than the minimum
requirements depending on the circumstances).
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Finally, the Commission is proposing to amend Rule 17a-4 under the
Exchange Act\107\ to include record preservation requirements for
records made under proposed Regulation Best Execution.
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\107\ 17 CFR 240.17a-4.
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The Commission believes that proposed Regulation Best Execution
would also enhance its oversight of
[[Page 5451]]
broker-dealers through the broker-dealers' best execution policies and
procedures required by the proposal, as well as broker-dealers'
documentation of their compliance with proposed Regulation Best
Execution.\108\
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\108\ The Commission believes that Proposed Regulation Best
Execution will also provide certain investor protection benefits. As
discussed in Section V below, by having its own rule, the Commission
will be able to seek certain remedies and other sanctions for
violations of the Commission rule best execution violations that are
not necessarily available under the current regulatory framework. In
general, a best execution rule promulgated pursuant to the Exchange
Act will expand and enhance the Commission's flexibility when
pursuing best execution violations and produce efficiencies
resulting from that greater flexibility.
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Request for Comment
The Commission requests comment on its understanding of broker-
dealers' current best execution practices, and in particular:
1. Do commenters agree with the Commission's understanding that
some broker-dealers currently incorporate various best execution
factors from the FINRA and MSRB best execution rules in their policies
and procedures? Please explain whether, and the extent to which,
broker-dealers currently incorporate those factors in their policies
and procedures. For example, do broker-dealers currently incorporate
all of the best execution factors from the FINRA and MSRB rules in
their policies and procedures?
2. Do commenters agree with the Commission's understanding that
some broker-dealers currently preserve information that allows them to
support their best execution determinations, such as information to
recreate the pricing information that was available at the time of an
execution? Please explain whether broker-dealers currently preserve
information that allows them to support their best execution
determinations, and if so, the type of information that they preserve.
3. Do commenters agree with the Commission's understanding that,
currently, broker-dealers' reviews of execution quality vary in rigor?
Please explain how broker-dealers currently conduct execution quality
reviews of customer orders.
4. Do commenters agree with the Commission's understanding that,
currently, broker-dealers periodically review their best execution
policies and procedures, but with varying frequency? Please describe
how frequently broker-dealers currently review their best execution
policies and procedures.
IV. Discussion of Proposed Regulation Best Execution
As discussed in this section IV below, the Commission is proposing
Regulation Best Execution, which is consistent with the FINRA and MSRB
best execution rules in many respects and is different from those rules
in some respects. Proposed Regulation Best Execution would not affect a
broker-dealer's obligation to comply with the FINRA or MSRB best
execution rule. Accordingly, a broker-dealer would be required to
comply with proposed Regulation Best Execution, in addition to their
existing obligations to comply with the FINRA and MSRB best execution
rules, as applicable.\109\
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\109\ For example, where proposed Regulation Best Execution
would impose additional or more specific requirements as compared to
the FINRA or MSRB rules, a broker-dealer would be required to comply
with the additional or more specific requirements under the proposed
rules. See, e.g., infra section IV.A (discussing the application of
proposed Rule 1100 to transactions with sophisticated municipal
market professionals, which are exempted from the MSRB's best
execution rule). Similarly, where FINRA or the MSRB impose more
specific requirement than proposed Regulation Best Execution, a
broker-dealer would be required to continue to comply with those
requirements of FINRA and the MSRB. See, e.g., infra note 223 and
accompanying text (discussing the requirement under FINRA Rule 5310
for broker-dealers to conduct at least a quarterly review of
execution quality).
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A. Proposed Rule 1100--The Best Execution Standard
Proposed Rule 1100 would set forth the best execution standard for
broker-dealers.\110\ Specifically, proposed Rule 1100 states that, in
any transaction for or with a customer, or a customer of another
broker-dealer, a broker-dealer, or a natural person who is an
associated person of a broker-dealer,\111\ must use reasonable
diligence to ascertain the best market for the 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.\112\
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\110\ For purposes of this release and proposed Regulation Best
Execution, ``broker-dealer'' refers to a broker, dealer, government
securities broker, government securities dealer, and municipal
securities dealer, unless specifically indicated otherwise.
\111\ Section 3(a)(18) of the Exchange Act defines ``person
associated with a broker or dealer'' to mean any partner, officer,
director, or branch manager of the broker or dealer (or any person
occupying a similar status or performing similar functions), any
person directly or indirectly controlling, controlled by, or under
common control with the broker or dealer, or any employee of the
broker or dealer. 15 U.S.C. 78c(a)(18). Any person associated with a
broker or dealer whose functions are solely clerical or ministerial
is not included in the meaning this term for purposes of section
15(b) the Exchange Act (other than paragraph 6 thereof). See id.
Proposed Rule 1100 would apply to a natural person who is an
associated person of a broker-dealer, and would avoid the
application of proposed Rule 1100 to all associated persons of a
broker-dealer, as all associated persons would capture affiliated
entities of the broker-dealer and could extend the application of
proposed Rule 1100 to entities that are not themselves broker-
dealers.
\112\ FINRA Rule 5310.09(a) states that ``[n]o member can
transfer to another person its obligation to provide best execution
to its customers' orders.'' The standard proposed by the Commission
in Rule 1100 is consistent with the FINRA rule, and would not
establish any exception to allow a broker-dealer to transfer its
obligation to provide best execution to another person.
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The proposed best execution standard would apply to securities
transactions for or with a broker-dealer's own customers, as well as
securities transactions for or with customers of another broker-dealer.
A broker-dealer that initially receives customer orders may not
necessarily be the broker-dealer that engages in transactions for or
with those orders. Instead, the broker-dealer receiving the customer
orders may utilize the services of another broker-dealer to engage in
transactions for or with those orders (e.g., a wholesaler, executing
broker-dealer, or clearing firm that handles or executes those orders).
Even though the other broker-dealer does not have a direct relationship
with the customers of the receiving broker-dealer, the other broker-
dealer (or natural persons who are associated persons of that broker-
dealer) would be required to comply with the proposed best execution
standard because it would be engaged in transactions for or with a
customer.
In addition, the proposed best execution standard would apply to
transactions for or with a customer, regardless of whether the broker-
dealer is transacting for or with the customer on an agency basis or in
a principal capacity.\113\ For example, the proposed best execution
standard would apply to broker-dealers that internalize their
customers' orders, as well as to wholesalers or clearing firms that
trade
[[Page 5452]]
as principal with the customer orders routed to them from other broker-
dealers.
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\113\ The proposed application of the standard to both agency
and principal trades is consistent with FINRA and MSRB rules. See
FINRA Rule 5310(e) (stating that the best execution obligations in
FINRA Rule 5310(a)-(d) exist not only where the broker-dealer acts
as agent for the account of its customer but also where transactions
are executed as principal); MSRB Rule G-18(c) (stating that the best
execution obligations in MSRB Rule G-18(a)-(b) apply to transactions
in which the broker-dealer is acting as agent and transactions in
which the broker-dealer is acting as principal). In addition, the
application of the existing duty of best execution in both agency
and principal transactions is well-established in common law. See,
e.g., Newton, 135 F.3d 266, 270 (3d Cir.), cert. denied, 525 U.S.
811 (1998); E.F. Hutton & Co., Exchange Act Rel. No. 25887, 49 SEC.
829, 832 (1988) (``A broker-dealer's determination to execute an
order as principal or agent cannot be `a means by which the broker
may elect whether or not the law will impose fiduciary standards
upon him in the actual circumstances of any given relationship or
transaction.' '') (citations omitted).
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Proposed Rule 1100 would provide exemptions from the best execution
standard for a broker-dealer, or a natural person who is an associated
person of a broker-dealer, when the broker-dealer is (i) quoting a
price for a security where another broker-dealer routes a customer
order for execution against that quote or (ii) an institutional
customer, exercising independent judgment, executes its order against
the broker-dealer's quotation.\114\ These exemptions distinguish
between a broker-dealer that is acting solely as the buyer or seller of
securities (it would be exempt) from a broker-dealer that is accepting
order flow from another broker-dealer or institutional customer for the
purpose of facilitating the handling and execution of those orders (it
would not be exempt).
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\114\ The first proposed exemption is consistent with FINRA Rule
5310.04, which states that a broker-dealer's duty to provide best
execution does not apply in circumstances when another broker-dealer
is simply executing a customer order against the broker-dealer's
quote, and MSRB Rule G-18.05, which states that a broker-dealer's
duty to provide best execution does not apply in circumstances when
the other broker-dealer is simply executing a customer transaction
against the broker-dealer's quote. The second proposed exemption is
new. Like the first proposed exemption, the second would exempt a
broker-dealer that is acting solely as a buyer or seller of a
securities. However, under the second exemption, the broker-dealer
would be acting solely as a buyer or seller of securities in
transactions directly with an institutional customer. In the
corporate and municipal bond and government securities markets, for
example, institutional customers often handle and execute their own
orders. Institutional customers in these markets commonly request
prices from broker-dealers for particular securities (prices for any
given security are often not quoted and made widely available) and
exercise their own discretion concerning the execution of a
particular transaction. In these instances, a broker-dealer is
simply responding to the institutional customer's request (e.g.,
through widely known request for quote (``RFQ'') mechanisms) and the
institutional customer is exercising independent discretion over the
handling and execution of its orders. Accordingly, the Commission
believes that the broker-dealer in these circumstances should be
exempted from the best execution standard under proposed Rule 1100.
However, in these circumstances, the broker-dealer would still be
subject, if applicable, to FINRA Rule 2121 and MSRB Rule G-30
concerning fair prices and the fairness and reasonableness of
commission rates and markups or markdowns. See FINRA Rule 2121; MSRB
Rule G-30.
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Proposed Rule 1100 would also provide a third exemption from the
best execution standard for a broker-dealer or a natural person who is
an associated person of a broker-dealer, when the broker-dealer
receives an unsolicited instruction from a customer to route that
customer's order to a particular market for execution and the broker-
dealer processes that customer's order promptly and in accordance with
the terms of the order. In this scenario, the customer has determined
the market where it wants to execute its order and is not relying on
its broker-dealer to determine the best market for that order.\115\
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\115\ This exemption is consistent with FINRA and MSRB rules.
See FINRA Rule 5310.08 (stating that if a member receives an
unsolicited instruction from a customer to route that customer's
order to a particular market for execution, the member is not
required to make a best execution determination beyond the
customer's specific instruction); MSRB Rule G-18.07 (stating that if
a dealer receives an unsolicited instruction from a customer
designating a particular market for the execution of the customer's
transaction, the dealer is not required to make a best-execution
determination beyond the customer's specific instruction).
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Under proposed Rule 1100, the term ``market'' could include broker-
dealers (e.g., a broker-dealer's principal trading desk), exchange
markets, markets other than exchange markets, and any other venues that
emerge as markets evolve. The term ``market'' also could encompass the
wide range of mechanisms operated by any given market that a broker-
dealer may use to transact for or with customers. For example, markets
may include different execution protocols, such as limit order books
(some of which may provide for midpoint liquidity), floor auction
facilities, or electronic auction mechanisms. This description of
``market'' is expansive and would require a broker-dealer to take into
consideration a broad range of potential trading and market centers and
venues that may provide the best market for customers' orders so that
the resulting prices to the customers are as favorable as possible
under prevailing market conditions.\116\
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\116\ This expansive description of ``market'' is consistent
with how FINRA and the MSRB describe the term in their rules, and
therefore should be familiar to broker-dealers. In particular, FINRA
and the MSRB also broadly construe the term ``market'' for purposes
of their best execution rules. See FINRA Rule 5310.02 (stating that
``market'' encompasses a variety of different venues, including, but
not limited to, market centers that are trading a particular
security); MSRB Rule G-18.04 (stating that ``market'' encompasses a
variety of different venues, including but not limited to broker's
brokers, alternative trading systems or platforms, or other
counterparties, which may include the dealer itself as principal).
MSRB Rule G-18.04 also states that the term market ``is to be
construed broadly, recognizing that municipal securities currently
trade over the counter without a central exchange or platform. This
expansive interpretation is meant both to inform dealers as to the
breadth of the scope of venues that must be considered in the
furtherance of their best-execution obligations and to promote fair
competition among dealers (including broker's brokers), alternative
trading systems and platforms, and any other venue that may emerge,
by not mandating that certain trading venues have less relevance
than others in the course of determining a dealer's best-execution
obligations.'' Pursuant to FINRA guidance, broker-dealers are also
expected to consider new markets that become available as venues to
which the broker-dealer could potentially route customer orders for
execution. See FINRA Regulatory Notice 15-46, at 5. In doing so,
broker-dealers should consider the execution quality of venues to
which they are not connected and determine whether they should
connect to new markets. See id., at 4.
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Proposed Rule 1100 would codify, in a Commission rule, a best
execution standard that is consistent with how the Commission and the
courts have described the duty of best execution over the years.\117\
The proposed standard is also consistent with the best execution
standards under FINRA Rule 5310 \118\ and MSRB Rule G-18.\119\ However,
with respect to municipal securities, while MSRB Rule G-48 exempts
transactions with sophisticated municipal market participants
(``SMMPs'') \120\ from the MSRB best
[[Page 5453]]
execution rule, proposed Regulation Best Execution does not include a
similar exemption for SMMPs from Rule 1100.\121\ Unlike the MSRB rules,
proposed Rule 1100 is designed to apply broadly to transactions in all
securities and is not limited to transactions in municipal securities.
The Commission also preliminary believes that customers that meet the
MSRB's definition of SMMP would benefit from the protections offered by
proposed Regulation Best Execution, just as customers that do not meet
the definition of SMMP or customers that transact in securities other
than municipal securities would.\122\ At the same time, the Commission
believes that proposed Regulation Best Execution contains several
provisions that would mitigate the burdens on the broker-dealers that
engage in transactions for or with customers that meet the MSRB's
definition of SMMP, and proposed Regulation Best Execution would result
in similar treatment as MSRB Rule G-18 and G-48 in many instances. For
example, as discussed above in this section, a broker-dealer would be
exempt from proposed Rule 1100 if an institutional customer is
exercising independent judgment and executing its orders against a
broker-dealer's quotation, and is not providing the broker-dealer with
orders for handling and execution. Additionally, a broker-dealer would
be exempt from proposed Rule 1100 if a customer gave the broker-dealer
an unsolicited instruction to send its order to a particular market and
the broker-dealer processes that customer's order promptly and in
accordance with the terms of the order. Finally, as discussed in
section IV.B.2 below, if a customer provides the broker-dealer with
other instructions concerning the handling of its orders, the broker-
dealer's compliance with the best execution standard would be informed
by such customer instructions.
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\117\ See, e.g., Regulation NMS Adopting Release, supra note 21,
70 FR 37538 (stating that the duty of best execution requires, among
other things, a broker-dealer to execute customers' trades at the
most favorable terms reasonably available under the circumstances,
i.e., at the best reasonably available price); Newton, supra note 8,
135 F.3d at 270 (noting that a broker-dealer's duty of undivided
loyalty to its customer requires that it ``seek to obtain for its
customer orders the most favorable terms reasonably available under
the circumstances''). As discussed below throughout this section IV,
the Commission is also proposing requirements designed to help
ensure compliance with the proposed best execution standard.
\118\ FINRA Rule 5310(a)(1) provides that, in 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. FINRA Rule 5310 applies to transactions by any FINRA
member in government securities. See FINRA Rule 0150(c).
\119\ MSRB Rule G-18(a) provides that, in any transaction in a
municipal security for or with a customer or a customer of another
broker, dealer, or municipal securities dealer (``dealer''), a
dealer must use reasonable diligence to ascertain the best market
for the subject security and buy or sell in that market so that the
resultant price to the customer is as favorable as possible under
prevailing market conditions.
\120\ MSRB Rule D-15 defines SMMP by three requirements: the
nature of the customer; a determination of sophistication by the
dealer; and an affirmation by the customer. Specifically, the rule
states that the customer must be: (i) a bank, savings and loan
association, insurance company, or registered investment company;
(ii) an investment adviser registered either with the Commission
under section 203 of the Investment Adviser Act of 1940 or with a
state securities commission; or (iii) any other person or entity
with total assets of at least $50 million. To achieve a
determination of customer sophistication, the broker-dealer must
have a reasonable basis to believe that the customer is capable of
evaluating investment risks and market value independently, both in
general and with regard to particular transactions and investment
strategies in municipal securities. Finally, the customer must
affirmatively indicate that it is exercising independent judgment in
evaluating: (a) the recommendations of the broker-dealer; (b) the
quality of execution of the customer's transactions by the broker-
dealer; and (c) the transaction price for non-recommended secondary
market agency transactions as to which (i) the broker-dealer's
services have been explicitly limited to providing anonymity,
communication, order matching, and/or clearance function and (ii)
the broker-dealer does not exercise discretion as to how or when the
transactions are executed. The affirmation may be given orally or in
writing, and may be given on a transaction-by-transaction basis, a
type-of-municipal security basis, or an account-wide basis.
\121\ Additionally, MSRB Rule G-18.09 states that Rule G-18 does
not apply to municipal fund securities. While proposed Regulation
Best Execution does not contain a similar exemption for municipal
fund securities, the Commission believes that the Commission's
proposal and MSRB Rule G-18 would result in similar treatment for
municipal fund securities. Transactions in municipal fund securities
must be executed directly with the issuer. For this reason, there is
only one market that can be accessed to fill a customer order in
this type of security and, therefore, only one way to comply with
Rule 1100 with respect to the handling and execution of a customer
order in a municipal fund security.
\122\ When the Commission approved the MSRB's exemption for
transactions with SMMPs from its best execution rule, the Commission
stated that the exemption ``will facilitate transactions in
municipal securities and help perfect the mechanism of a free and
open market in municipal securities by avoiding the imposition of
regulatory burdens if they are not needed.'' See MSRB Best Execution
Approval Order, supra note 47, 79 FR 73664. For the reasons
discussed in this section, the Commission believes that the proposed
rules are designed to mitigate the regulatory burdens for broker-
dealers that transact for or with SMMP customers, while providing
the benefit of the protections offered by the proposed rules under
appropriate circumstances.
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Request for Comment
The Commission requests comment on all aspects of proposed Rule
1100, and in particular:
5. Is the proposed best execution standard appropriate? Why or why
not? Has the Commission identified all the differences between the
proposed best execution standard and the standards under FINRA Rule
5310 and MSRB Rule G-18? If not, please explain any differences that
the Commission has not identified and any potential issues resulting
from those differences.
6. Are the differences between the proposed best execution standard
and the standards under FINRA Rule 5310 and MSRB Rule G-18 appropriate?
Why or why not?
7. Do commenters agree that proposed Rule 1100 is consistent with
prior Commission statements, including those described in section II.B
above? Why or why not? If not, should the Commission revise any of its
statements in light of the proposal? Please explain.
8. Do commenters agree that the proposed best execution standard
should apply to natural persons who are associated persons of a broker-
dealer? Why or why not?
9. Are there alternative definitions of ``natural person who is an
associated person'' that the Commission should use instead? Is the
application of proposed Rule 1100 appropriately limited to ``a natural
person who is an associated person'' of a broker-dealer? Please
explain.
10. Would the proposed best execution standard pose any challenges
or burdens for entities that are dually-registered broker-dealers and
investment advisers? As discussed above,\123\ an investment adviser has
its own duty to seek best execution of a client's transactions where
the adviser has the responsibility to select broker-dealers to execute
client trades. What effect, if any, would the proposed best execution
standard have on investment advisers and their duty to seek best
execution?
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\123\ See supra note 11.
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11. Are there elements of an investment adviser's duty to seek best
execution that are relevant in assessing the proposed best execution
standard for a broker-dealer?
12. Is it appropriate to provide an exemption from the proposed
best execution standard to a broker-dealer when another broker-dealer
is executing a customer order against the first broker-dealer's quote?
Why or why not?
13. Is it appropriate to provide an exemption from the proposed
best execution standard to a broker-dealer when an institutional
customer, exercising independent judgment, executes its order against
the broker-dealer's quotations? Why or why not?
14. Should the Commission define ``institutional customer'' for
purposes of proposed Rule 1100? If so, how should ``institutional
customer'' be defined? For example, should the Commission define
``institutional customer'' as any person that is a qualified
institutional buyer (``QIB'') as defined in Rule 144A under the
Securities Act of 1933?\124\ Why or why not?
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\124\ 17 CFR 230.144A (defining ``QIB'' to mean a variety of
entities such as insurance companies, investment companies
registered under the Investment Company Act of 1940, and investment
advisers registered under the Investment Advisers Act of 1940, among
others, that in the aggregate own or invest on a discretionary basis
at least $100 million).
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15. Should the Commission define ``institutional customer'' to
include a broader set of institutional customers than the QIB
definition, such as those entities that are included in the FINRA
definition of ``institutional account'' under FINRA Rule 4512(c)?\125\
Please explain.
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\125\ FINRA Rule 4512(c) defines ``institutional account'' as
the account of: (1) a bank, savings and loan association, insurance
company or registered investment company; (2) an investment adviser
registered either with the Commission under section 203 of the
Investment Advisers Act or with a state securities commission (or
any agency or office performing like functions); or (3) any other
person (whether a natural person, corporation, partnership, trust or
otherwise) with total assets of at least $50 million.
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16. Should the exemption concerning institutional customers in
proposed Rule 1100 be limited to situations where the broker-dealer
seeking the exemption has a reasonable basis to believe that the
institutional customer (i) has the capacity to evaluate independently
the prices offered by the broker-dealer and (ii) is exercising
independent judgment in deciding to enter into the transaction, such as
is provided for in FINRA Rule 2121 concerning suitability for
institutional customers? Please explain.
17. Should the Commission define ``institutional customer'' for
purposes of
[[Page 5454]]
the proposed exemption in Rule 1100 to be consistent with the MSRB's
definition of SMMP? For example, should an institutional customer be
required to make an affirmation to the broker-dealer concerning its
exercise of independent judgment in evaluating the quality of execution
of its transaction with the broker-dealer? Are there other affirmations
relevant to best execution that should be required?\126\ Please
explain.
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\126\ For example, the MSRB's definition of SMMP requires a
variety of other affirmations (e.g., relating to suitability, access
to timely information, fair pricing for agency transactions) as
broker-dealers are also exempt from other non-best execution related
obligations in transactions with SMMPs pursuant to MSRB Rules G-
48(a)-(d).
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18. If an institutional customer affirmation should be required,
how should such affirmation be provided? Should an institutional
customer be permitted to provide the affirmation to the broker-dealer
orally or in writing? Should an institutional customer be permitted to
provide its affirmation on a trade-by-trade basis, a type-of-
transaction basis, a type-of-security basis (e.g., municipal security,
including general obligation, revenue, variable rate municipal
security; corporate bond, including investment grade and non-investment
grade; OTC equity; NMS security), or an account-wide basis? Please
explain.
19. Should a broker-dealer seeking the exemption in proposed Rule
1100 in transactions with institutional customers be required to
disclose to the institutional customer that it is not required to
comply with the best execution standard of proposed Rule 1100 for the
relevant transactions? Should this disclosure be provided in lieu of or
in addition to a customer affirmation, if such affirmation should be
provided by the institutional customer? Please explain. If disclosure
should be required, what standards should apply to the disclosure? For
example, should a broker-dealer be required to make a disclosure to the
institutional customer on a transaction-by-transaction basis? If not,
what would be the appropriate manner for this disclosure? Please
explain. Should the disclosure be in writing or should a broker-dealer
be permitted to provide the disclosure orally to the institutional
customer? Please explain.
20. Should the proposed exemption concerning institutional
customers in Rule 1100 be limited to only certain types of securities
or only certain types of trading protocols where the institutional
customer is executing against the broker-dealer's quote? For example,
should the exemption be limited only to transactions in fixed income
securities? Should it be limited to transactions that occur through
multilateral RFQ systems where the institutional customer is able to
put multiple broker-dealers and other market participants in
competition when soliciting quotes? Should the exemption be available
to a broker-dealer that is responding to a request for quote by an
institutional customer in a bilateral communication, whether over the
phone or through another communication protocol? Please explain.
21. Should the Commission provide a broader exemption from the
proposed best execution standard for a broker-dealer when it engages in
any transaction for or with institutional customers, similar to the
exemption provided to broker-dealers under MSRB Rule G-48(e) for SMMPs?
Please explain why such exemption should or should not be provided.
22. If a broader exemption for transactions with institutional
customers should be provided, how should the Commission define
``institutional customer''? Similar to the requests for comment above,
should the Commission define institutional customer as ``QIB'' as
defined in Rule 144A under the Securities Act of 1933, an
``institutional account'' as defined in FINRA Rule 4512(c), or an SMMP
as defined in MSRB Rule D-15? Is there another definition that would be
appropriate? Please explain. Should other conditions apply to the
exemption, as requested above, such as broker-dealer disclosure to the
institutional customer, broker-dealer assessment of the institutional
customer's ability to evaluate the transaction, and institutional
customer affirmations? Please explain.
23. What are the typical order handling practices of broker-dealers
for the municipal bond orders of SMMPs? Do these order handling
practices vary depending on the type of SMMP under MSRB Rule D-15(a)?
Do SMMPs typically provide broker-dealers with orders to handle and
execute, or do SMMPs typically handle and execute their own orders?
Please explain. Do broker-dealers exercise any discretion in handling
the orders of SMMPs, whether executing such order on an agency or
principal basis? Please explain.
24. Do commenters agree that the proposed rules are designed to
mitigate the regulatory burdens for broker-dealers that transact for or
with SMMP customers, while providing the benefit of the protections
offered by the proposed rules under appropriate circumstances? Why or
why not?
25. Should the Commission provide an exemption from the proposed
best execution standard for a broker-dealer that engages in
transactions for or with sophisticated market professionals in asset
classes other than municipal securities? Please explain why such
exemption should or should not be provided.
26. Is it appropriate to provide an exemption from the proposed
best execution standard to a broker-dealer that receives an unsolicited
instruction from a customer to route that customer's order to a
particular market for execution, where the broker-dealer processes that
customer's order promptly and in accordance with the terms of the
order? Why or why not?
27. Should the Commission provide an exemption from the proposed
best execution standard for transactions in municipal fund securities
(which include interests in 529 college savings plans)? Should such
exemption only apply to municipal fund securities that are interests in
529 college savings plans? If the Commission were to provide an
exemption, should it apply similarly or differently to direct-sold and
advisor-sold municipal fund securities? Please explain why such
exemption should or should not be provided.
28. Should the Commission provide an exemption for mutual fund
securities, such as equity and corporate bond mutual funds? Should the
Commission provide an exemption for any other type of security? Please
explain why such exemption should or should not be provided.
29. Should the Commission provide any other exemptions from the
proposed best execution standard? If so, please explain.
30. Should proposed Regulation Best Execution be the sole best
execution rule applicable to broker-dealers? Why or why not?
B. Proposed Rule 1101(a)--Best Execution Policies and Procedures
Proposed Rule 1101(a) would require a broker-dealer that effects
any transaction for or with a customer or a customer of another broker-
dealer to establish, maintain, and enforce written policies and
procedures reasonably designed to comply with the best execution
standard under proposed Rule 1100 (``best execution policies and
procedures''). As discussed in sections IV.B.1 and 2 below, a broker-
dealer's best execution policies and procedures would be required to
address: (1) how the broker-dealer would comply with the best execution
standard; and (2) how the broker-dealer would determine the
[[Page 5455]]
best market for the customer orders that it receives.
Proposed Rule 1101 does not include specific requirements regarding
the manner in which broker-dealers would comply with the best execution
standard. Rather, proposed Rule 1100 would require a broker-dealer to
use reasonable diligence to ascertain the best market for a 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, and proposed Rule 1101 would additionally require a broker-
dealer to establish and maintain written policies and procedures
reasonably designed to comply with the proposed standard. The policies
and procedures would be required to reflect the elements specified in
proposed Rule 1101(a) (e.g., best displayed prices, opportunities for
price improvement including midpoint executions, attributes of
particular customer orders, the trading characteristics of the
security). For example, a broker-dealer could have policies and
procedures that are tailored for different types of customers (e.g.,
retail customers, institutional customers) or for securities with
different trading characteristics (e.g., NMS stocks, municipal
securities).\127\ All customer orders must be covered by a broker-
dealer's best execution policies and procedures, and the broker-dealer
would be required to enforce such policies and procedures.
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\127\ Similar to this proposal, FINRA and MSRB rules also
recognize that broker-dealers' best execution practices would be
tailored for securities with different characteristics. For example,
FINRA Rule 5310 recognizes that the markets for different securities
can vary and the standard of reasonable diligence must be assessed
by examining specific factors, such as the character of the market
for the security and the accessibility of the quotation. See, e.g.,
FINRA Rules 5310.03 (Best Execution and Debt Securities); 5310.06
(Orders Involving Securities with Limited Quotations or Pricing
Information); 5310.07 (Orders Involving Foreign Securities). See
also MSRB Rule G-18.06 (Securities with Limited Quotations or
Pricing Information) (recognizing that markets for municipal
securities may differ dramatically and referring to heightened
diligence with respect to customer transactions involving securities
with limited pricing information or quotations).
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While FINRA's best execution rule does not require broker-dealers
to have the same type of detailed best execution policies and
procedures as proposed Rule 1101,\128\ FINRA Rule 3110(b)(1) \129\
requires broker-dealers to have procedures for compliance with FINRA
rules and Federal securities laws and regulations. The MSRB's best
execution rule reflects a requirement for broker-dealers to have
policies and procedures for determining the best available market for
the executions of their customers' transactions.\130\ In addition, MSRB
Rule G-28 requires broker-dealers to have procedures for compliance
with MSRB rules and the Exchange Act and rules thereunder.\131\ The
Commission understands that broker-dealers currently have policies and
procedures relating to their compliance with the FINRA and MSRB best
execution rules, as applicable. However, unlike the FINRA and MSRB
rules, proposed Rule 1101(a)(1) would require broker-dealers' best
execution policies and procedures to include specific elements, as
discussed in sections IV.B.1 and 2 below.
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\128\ FINRA Rule 5310.
\129\ FINRA Rule 3110(b)(1) requires a FINRA member to
establish, maintain, and enforce written procedures to supervise the
types of business in which it engages and the activities of its
associated persons that are reasonably designed to achieve
compliance with applicable securities laws and regulations, and with
applicable FINRA rules. Separately, FINRA Rules 3130(b) and (c)
require the chief executive officer (or equivalent officer) of a
FINRA member to certify annually that the member has in place
processes to establish, maintain, review, test and modify written
compliance policies and written supervisory procedures reasonably
designed to achieve compliance with applicable FINRA rules, MSRB
rules, and Federal securities laws and regulations.
\130\ MSRB Rule G-18.08 states that a broker-dealer must, at a
minimum, conduct annual reviews of its policies and procedures for
determining the best available market for the executions of its
customers' transactions, including assessing whether its policies
and procedures are reasonably designed to achieve best execution,
taking into account the quality of the executions the broker-dealer
is obtaining under its current policies and procedures, among other
things.
\131\ MSRB Rule G-28 requires broker-dealers to adopt, maintain
and enforce written supervisory procedures reasonably designed to
ensure that the conduct of the municipal securities activities of
the broker-dealer and its associated persons are in compliance with
MSRB rules and the applicable provisions of the Exchange Act and
rules thereunder.
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1. Proposed Rule 1101(a)(1)--Framework for Compliance With the Best
Execution Standard
Proposed Rule 1101(a)(1) would require a broker-dealer's best
execution policies and procedures to address how it will comply with
the proposed best execution standard by: (i) obtaining and assessing
reasonably accessible information, including information about price,
volume, and execution quality, concerning the markets trading the
relevant securities; (ii) identifying markets that may be reasonably
likely to provide material potential liquidity sources (as defined
above); and (iii) incorporating material potential liquidity sources
into its order handling practices and ensuring that it can efficiently
access each such material potential liquidity source.
Proposed Rule 1101(a)(1)(i) would require a broker-dealer to have
policies and procedures for obtaining and assessing reasonably
accessible information regarding the markets trading the relevant
securities.\132\ Market information is relevant to a broker-dealer's
best execution analysis,\133\ and the Commission has previously
identified price and execution quality information as among the factors
relevant to that analysis.\134\ The Commission believes that the
ability of markets to attract trading interest as measured by trading
volume would also be relevant to a broker-dealer's best execution
analysis, because trading volume can be an indicator of whether
sufficient interest exists on a particular market to execute customer
orders.\135\
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\132\ Proposed Rule 1101 would not establish minimum data
elements needed to comply with the proposed best execution standard.
Rather, it would require broker-dealers to establish, maintain, and
enforce policies and procedures reasonably designed to comply with
the proposed best execution standard. In implementing its policies
and procedures (both for non-conflicted and conflicted
transactions), including policies and procedures that address how
the broker-dealer would obtain and assess reasonably accessible
information or how the broker-dealer would obtain and assess other
information for conflicted transactions (as discussed in section
IV.C below), a broker-dealer may determine that it is appropriate to
purchase certain proprietary data. See also supra note 38
(describing the Commission's statements in the MDI Adopting Release
that the Commission was not establishing minimum data elements
needed to achieve best execution nor mandating consumption of
certain data content, and acknowledging that different market
participants and different trading applications have different
market data needs).
\133\ See, e.g., Order Execution Obligations Adopting Release,
supra note 10, 61 FR at 48322-23 (stating that a broker-dealer's
practices for achieving best execution, including the data,
technology, and types of markets it accesses, must constantly be
updated as markets evolve); Order Execution and Routing Practice
Release, supra note 22, 65 FR at 75418 (stating that quotation
information contained in the public quotation system must be
considered in seeking best execution of customer orders); MDI
Adopting Release, supra note 38, 86 FR at 18605 (stating that
broker-dealers should consider the availability of consolidated
market data, including the various elements of data content and the
timeliness, accuracy, and reliability of the data in developing and
maintaining their best execution policies and procedures).
\134\ See, e.g., Order Execution Obligations Adopting Release,
supra note 10, 61 FR 48323 (identifying price improvement and
execution quality as among the relevant factors for a best execution
analysis); MDI Adopting Release, supra note 38, 86 FR 18605
(identifying order size, trading characteristics of the security,
speed of execution, clearing costs, and the cost and difficulty of
executing an order in a particular market as relevant factors for a
best execution analysis).
\135\ FINRA Rule 5310(a)(1) and MSRB Rule G-18(a) set forth
similar factors that are relevant to a best execution analysis,
including the character of the market for the security (e.g., price,
volatility, relative liquidity, and pressure on available
communications). However, unlike proposed Rule 1101(a), FINRA and
MSRB rules do not explicitly require relevant factors to be included
in a broker-dealer's best execution policies and procedures. The
considerations in FINRA and MSRB rules concerning volatility,
relative liquidity, and pressure on available communications could
be included as part of the best market policies and procedures in
proposed Rule 1101(a)(2), which requires consideration of the
trading characteristics of a security. See also FINRA Rule 5310.09
(requiring a member to conduct regular and rigorous reviews of the
quality of the executions of its customers' orders); MSRB Rule G-
18.08 (requiring a dealer to conduct periodic reviews of its best
execution policies and procedures, taking into account the quality
of the executions the dealer is obtaining under its current policies
and procedures, among other things).
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[[Page 5456]]
More specifically with respect to execution quality, the Commission
believes that the level of competition within a market can impact the
execution quality of that market and, therefore, broker-dealers should
generally consider including the level of competition of a market as an
element of its best execution policies and procedures.\136\
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\136\ This could include considerations of auction features,
such as allocation guarantees and fees, the types of market
participants that can participate in an auction, the breadth of
participation in an auction, and the accessibility of auction
processes. This assessment of auction mechanisms would apply to a
broker-dealer that is handling a customer order that is subject to
the proposed requirements in the Order Competition Rule (known as a
``segmented order''). See Securities Exchange Act Release No. 34-
96495 (Dec. 14, 2022). Were the Commission to adopt the proposed
Order Competition Rule, a broker-dealer that desires to trade as
principal with a segmented order would, absent an exception, be
required to expose certain orders to competition through use of
``qualified auctions,'' as defined by the proposed Order Competition
Rule. If the proposed Order Competition Rule were adopted, a broker-
dealer when evaluating which qualified auction to use for segmented
orders under proposed Regulation Best Execution (if adopted) would
have to have policies and procedures addressing how the broker-
dealer will assess the execution quality of different qualified
auctions and identify those that are likely to result in the most
favorable price for customer orders.
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With respect to price improvement auctions offered by options
exchanges, while the Commission believes that such auctions could
provide better executions for customer orders than routing such orders
to execute at the prevailing best bid or offer on an exchange, the
selection of a particular price improvement auction could impact the
execution quality of customer orders. A broker-dealer should generally
consider addressing in its policies and procedures how it would assess
the features of options price improvement auctions, how those features
might affect the level of competition and the execution quality offered
by the auctions, and whether those features would allow an auction to
provide the most favorable prices under prevailing market conditions.
For example, price improvement auctions have features, which have been
implemented pursuant to proposed rule changes filed with the
Commission, that allow a wholesaler to trade with much or all of the
customer orders represented in an auction.\137\ The current fee
structures for price improvement auctions may also affect market
participants' determination of whether to compete with a wholesaler for
customer orders and provide more favorable prices.\138\ As reflected in
the table below, as of May 25, 2022, the vast majority of options
exchanges charge market participants that may desire to compete for
customer orders response fees of $0.50 per contract (for options
classes priced in $0.01 increments (``penny classes'')) and $1.00 or
more per contract (for options classes priced in $0.05 increments
(``non-penny classes'')). These response fees are not charged to
wholesalers that initiate the price improvement auctions.
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\137\ See, e.g., Nasdaq ISE, LLC Options 3, Section 13; Nasdaq
Phlx LLC Options 3, Section 13; Miami International Securities
Exchange LLC Rule 515A; BOX Exchange LLC Rule 7150; NYSE American
LLC Rule 971.1NY; Cboe Exchange, Inc. Rule 5.37.
\138\ See Nasdaq ISE LLC Options 7, Section 3; Nasdaq GEMX LLC
Options 7, Section 3; Nasdaq MRX LLC Options 7, Section 3.A.; Nasdaq
Phlx LLC Options 7, Section 6.A.; BOX Exchange LLC Fee Schedule
Section IV.B.; Miami International Securities Exchange LLC Fee
Schedule Section (1)(a)(v); NYSE American LLC Options Fee Schedule
Section I.G.; Cboe Exchange, Inc. Fee Schedule; Cboe EDGX Exchange,
Inc. Options Fee Schedule n.6.
----------------------------------------------------------------------------------------------------------------
Auction market Auction market
Fees for maker response maker response
Exchange initiating fees (penny fees (non-penny
orders classes) classes)
----------------------------------------------------------------------------------------------------------------
CBOE...................................................... 0.07 0.50 1.05
EDGX...................................................... 0.05 0.50 1.05
PHLX...................................................... 0.07 0.25 0.40
MRX....................................................... 0.02 0.50 1.10
ISE....................................................... 0.10 0.50 1.10
GEMX...................................................... 0.05 0.50 0.94
AMEX...................................................... 0.05 0.50 1.05
MIAX...................................................... 0.05 0.50 1.10
BOX....................................................... 0.05 0.50 1.15
----------------------------------------------------------------------------------------------------------------
In addition, allocation guarantees, which permit the wholesaler to
trade with a significant portion of the customer order, may affect
competing market participants' determinations of whether and how to
participate in price improvement auctions.\139\ Likewise, ``auto-
match'' features, which enable the wholesaler to automatically match
the best prices submitted by competing market participants, may affect
competing market participants' determinations of whether and how to
participate in price improvement auctions.\140\
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\139\ See supra note 137.
\140\ See, e.g., Nasdaq ISE, LLC Options 3, Section 13(d)(3);
Nasdaq Phlx LLC Options 3, Section 13(b)(1); Miami International
Securities Exchange LLC Rule 515A(a)(2)(i)(A); BOX Exchange LLC Rule
7150(f); NYSE American LLC Rule 971.1NY(c)(1); Cboe Exchange, Inc.
Rule 5.37(b)(5).
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As another example, in considering RFQ systems as material
potential liquidity sources for corporate and municipal bonds and
government securities, a broker-dealer's policies and procedures could
assess the filtering practices that may be applied by the RFQ system
operator and the impact that those practices may have on the execution
quality of those markets. If an RFQ system applies an automatic filter
that prevents a broker-dealer that initiates the RFQ from sending that
request to all participants on the RFQ system, a broker-dealer could
evaluate the potential impact that may have on that market's execution
quality. To the extent other RFQ systems do not apply such filters to
the broker-dealer's request, a broker-dealer could evaluate whether
these other RFQ systems would be a better alternative for executing
customer orders, taking into consideration other relevant information
that the broker-dealer may obtain concerning the RFQ systems.
[[Page 5457]]
Proposed Rule 1101(a)(1)(ii) would require a broker-dealer's
policies and procedures to address how it will identify material
potential liquidity sources, but it would not require a broker-dealer
to include in its policies and procedures a minimum number of markets
that it would need to identify as material potential liquidity sources.
Rather, under proposed Rules 1101(a)(1)(i) and (ii), a broker-dealer
would be required to follow its policies and procedures in assessing
reasonably accessible information and determining material potential
liquidity sources. The Commission believes a broker-dealer's
identification of material potential liquidity sources could be
influenced by the nature of the broker-dealer's business operation and
customer order flow. For example, some broker-dealers focus on the
handling and execution of institutional orders or large-size orders,
while some broker-dealers handle and execute retail orders or small-
size orders. These considerations may be relevant to the types of
markets or market information that the broker-dealer assesses for
purposes of identifying material potential liquidity sources. The
Commission further believes a broker-dealer's assessment of market
information and identification of material potential liquidity sources
could vary depending on the trading characteristics of the relevant
security, the level of transparency in the applicable market, and
accessibility of a market, including the cost of maintaining
connectivity, receiving market data, and transacting on the market. For
example, if a market charges unreasonably high fees for connectivity,
market data, or transactions, a broker-dealer could consider whether
such market's information is reasonably accessible and whether such
market should be identified as a material potential liquidity
source.\141\
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\141\ The Commission has previously described a non-exhaustive
list of factors that may be relevant to broker-dealers' best
execution analysis. These factors include the size of the order,
speed of execution, clearing costs, the trading characteristics of
the security involved, the availability of accurate information
affecting choices as to the most favorable market center for
execution and the availability of technological aids to process such
information, and the cost and difficulty associated with achieving
an execution in a particular market center. See supra note 23 and
accompanying text.
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While proposed Rules 1101(a)(1)(i) and (ii) do not include an
exhaustive list of the markets that might be considered material
potential liquidity sources, or the potential sources of reasonably
accessible information for different types of securities, some examples
may be helpful. For the NMS stock market, material potential liquidity
sources could include exchanges, ATSs, and broker-dealers, including
market makers and wholesalers. It could also include trading protocols
and auction mechanisms operated by these entities, including those that
may provide price improvement opportunities, such as exchange limit
order books, retail liquidity programs, midpoint liquidity, and
wholesaler price improvement guarantees. Concerning potential sources
of reasonably accessible information, the Commission has stated that
quotation data made publicly available must be considered by a broker-
dealer when seeking best execution of customer orders.\142\ In
addition, a broker-dealer generally should consider whether
consolidated trade information, exchange proprietary data feeds, odd
lot market data, and execution quality and order routing information
contained in reports made pursuant to Rules 605 and 606 of Regulation
NMS are readily accessible and needed in order for the broker-dealer to
identify material potential liquidity sources for its customers'
orders.\143\
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\142\ See Order Execution Obligations Adopting Release, supra
note 10, 61 FR 48324.
\143\ In a regulatory notice concerning its best execution rule,
FINRA has provided guidance regarding the relevance of proprietary
data feeds to a broker-dealer's best execution assessment. See FINRA
Regulatory Notice 15-46, at 13 n.12 (``[A] firm that regularly
accesses proprietary data feeds, in addition to consolidated data
from the Securities Information Processors (SIPs), for its
proprietary trading, would be expected to also use these data feeds
to determine the best market under prevailing market conditions when
handling customer orders.'').
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In the OTC equities market, a broker-dealer could consider whether
ATSs, wholesalers, and other OTC market makers may be potential
material liquidity sources. With regard to reasonably accessible
information, a broker-dealer could consider obtaining data from ATSs
and OTC market makers, in addition to obtaining the data concerning
transaction prices in OTC equities made publicly available through the
FINRA Over-the-Counter Reporting Facility (``ORF'').
In the options market, material potential liquidity sources could
include the options exchanges and the range of trading protocols and
auction mechanisms made available by them. These could include quotes
from market makers resting on exchange limit order books, price
improvement auctions, liquidity resting between the best bid and offer
that may be available on exchange limit order books, and floor trading
facilities that may provide a broker-dealer with the opportunity to
seek competitive prices from floor participants for larger or complex
options orders. Other broker-dealers in the options market could also
represent a type of market that generally should be considered when
assessing material potential liquidity sources. Specifically, many
options trades are arranged away from the exchanges by broker-dealers
and are often brought to the exchanges for order exposure and potential
price improvement prior to execution.\144\ Because options trades may
be arranged in this fashion, a broker-dealer would need to consider
whether other broker-dealers may represent material potential liquidity
sources for its customers' options orders. With regard to reasonably
accessible information, a broker-dealer should consider whether
proprietary data feeds and quarterly Rule 606 order routing reports are
readily accessible and needed to identify material potential liquidity
sources, in addition to consolidated trade and quotation data that is
made publicly available.
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\144\ See, e.g., Nasdaq ISE, LLC, Options 3, Section 11(b)-(e)
(providing exchange functionality for facilitation and solicitation
auctions, which permit an exchange member to attempt to execute
large-sized orders it represents as agent against principal interest
or contra-side orders it has solicited). See also, e.g., Miami
International Securities Exchange LLC Rule 515A(b); Cboe Exchange,
Inc. Rule 5.39. The ability to attempt to execute an agency order
against principal or solicited interest is also permitted in the
options exchange price improvement auctions. See supra note 137.
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In addition, a number of markets could be considered for purposes
of identifying material potential liquidity sources in the corporate
and municipal bond markets and government securities markets. These may
include, for example, ATS and non-ATS electronic trading systems, RFQ
systems, and other auction mechanisms. Material potential liquidity
sources in these fixed income markets could also include interdealer
brokers and other broker-dealers willing to be a counterparty upon
request.\145\ A broker-dealer's own principal trading desk could also
be a market for purposes of identifying material potential liquidity
sources.\146\ With respect to reasonably accessible information, a
broker-dealer could consider whether to obtain data from ATSs and other
trading platforms, such as RFQ systems, interdealer brokers, and
dealers that
[[Page 5458]]
handle and execute customer orders, in addition to obtaining
consolidated trade data in the corporate bond and municipal bond
markets made publicly available through FINRA's Trade Reporting and
Compliance Engine (``TRACE'') and the MSRB's Real-time Transaction
Reporting System (``RTRS'').\147\ A broker-dealer could also consider
obtaining relevant data from information sources that do not provide
execution services, such as price aggregator services or evaluated
pricing services.
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\145\ For example, for less widely-traded securities, broker-
dealers that have previously traded such securities or that are
otherwise known to trade in the securities can be markets for
certain segments of the fixed income market. See, e.g., MSRB
Implementation Guidance on MSRB Rule G-18, on Best Execution at Item
VI.1. (updated as of Feb. 7, 2019).
\146\ Principal trading with a customer by a broker-dealer would
be subject to more robust policies and procedures requirements under
proposed Rule 1101(b).
\147\ See, e.g., <a href="https://www.finra.org/filing-reporting/trace/data">https://www.finra.org/filing-reporting/trace/data</a> and <a href="https://emma.msrb.org/">https://emma.msrb.org/</a>.
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Proposed Rule 1101(a)(1)(iii) would require a broker-dealer to have
policies and procedures that address how the broker-dealer will
incorporate material potential liquidity sources into its order
handling practices and ensure that it can efficiently access each such
material potential liquidity source. This requirement is designed to
enhance a broker-dealer's ability meet the proposed best execution
standard by helping to ensure that the broker-dealer incorporates the
identified material potential liquidity sources into its order handling
practices so that it can execute customer orders in those markets as
appropriate.\148\
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\148\ FINRA Rule 5310(c) provides that a failure to maintain or
adequately staff an OTC order room or other department assigned to
execute customers' orders is not a justification for a broker-dealer
executing away from the best available market. The provision further
states that channeling orders through a third party as reciprocation
for service or business does not relieve a broker-dealer of its
obligation under FINRA Rule 5310. FINRA Rule 5310(d) also provides
that a broker-dealer through which orders are channeled and that
knowingly is a party to an arrangement whereby the initiating member
has not fulfilled its obligations under FINRA Rule 5310 will be
deemed to have violated the rule. Similarly, MSRB Rule G-18.02
states that a broker-dealer's failure to maintain adequate resources
is not a justification for executing away from the best available
market. The proposed rules likewise would not exempt these scenarios
from the proposed best execution standard. The Commission also
believes that these provisions reflect the concept of efficient
access to the best market so that the resulting price to a customer
is as favorable as possible under prevailing market conditions, and
therefore are consistent with the Commission's proposal to require a
broker-dealer's best execution policies and procedures to address
how the broker-dealer will efficiently access material potential
liquidity sources.
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Efficient access to each material potential liquidity source, as
specified by proposed Rule 1101(a)(1)(iii), may require different order
handling processes and arrangements in different markets, and would not
necessarily require that a broker-dealer directly connect to a market,
as it may be efficient in some circumstances for a broker-dealer to use
another broker-dealer to access a particular market for a customer
order. However, interposing a third-party between the broker-dealer and
the market reasonably likely to provide the most favorable price for
its customer would not be consistent with the concept of ``efficient
access,'' if the broker-dealer could access the market directly but
chose instead to access the market indirectly resulting in a worse
execution for the customer.\149\ As stated above, interpositioning can
violate the broker-dealer's duty of best execution when it results in
unnecessary transaction costs at the expense of the customer.\150\
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\149\ The proposed requirement that a broker-dealer's policies
and procedures address how it will be able to efficiently access any
material potential liquidity source is consistent with FINRA and
MSRB rules concerning interpositioning. Specifically, FINRA Rule
5310(a)(2) states that no broker-dealer or person associated with a
broker-dealer may interject a third party between the broker-dealer
and the best market for the subject security in a manner that would
be inconsistent with FINRA's best execution standard. FINRA Rule
5310(b) states that when a broker-dealer cannot execute directly
with a market but must employ a broker's broker or some other means
in order to ensure an execution advantageous to the customer, the
burden of showing the acceptable circumstances for doing so is on
the broker-dealer. And FINRA Rule 5310.05 states that examples of
acceptable circumstances are where a customer's order is ``crossed''
with another firm that has a corresponding order on the other side,
or where the identity of the firm, if known, would likely cause
undue price movements adversely affecting the cost or proceeds to
the customer. MSRB Rule G-18(b) similarly prohibits a broker-dealer
from interjecting a third party between itself and the best market
for the subject security in a manner inconsistent with the MSRB's
best execution standard. However, unlike proposed Rule 1101(a),
FINRA and MSRB rules do not require a broker-dealer's best execution
policies and procedures to explicitly address the incorporation of
liquidity sources into its order handling practices or the efficient
access of liquidity sources.
\150\ See supra notes 29-30 and accompanying text.
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Request for Comment
The Commission requests comment on all aspects of proposed Rule
1101(a)(1), and in particular:
31. Do commenters believe that proposed Rule 1101(a)(1)(i)
appropriately requires a broker-dealer's policies and procedures to
reflect how it will obtain and assess reasonably accessible
information, including information about price, volume, and execution
quality, concerning the markets trading the relevant securities? Why or
why not?
32. What factors would a broker-dealer consider in determining
whether information is ``reasonably accessible'' for purposes of its
best execution policies and procedures under the proposed rules? Please
explain.
33. Should the Commission specify the types of information that
would be ``reasonably accessible'' under proposed Rule 1101(a)(1)(i)?
For example, should the Commission specify that consolidated market
data distributed by the securities information processors is a type of
``reasonably accessible'' information under the proposed rule? Please
explain.
34. Do commenters agree that proposed Rule 1101(a)(1) is consistent
with prior Commission statements, including those described in section
II.B above? Why or why not? If not, should the Commission revise any of
its statements in light of the proposal? Please explain.
35. Do commenters believe that proposed Rule 1101(a)(1)(ii)
appropriately requires a broker-dealer's policies and procedures to
reflect how it will identify material potential liquidity sources? Why
or why not?
36. Do commenters believe the Commission has appropriately defined
material potential liquidity sources in proposed Rule 1101(a)(1)(ii)?
Please explain.
37. What factors would a broker-dealer consider in identifying
material potential liquidity sources under the proposed rules? Please
explain.
38. In identifying material potential liquidity sources, do broker-
dealers consider market connectivity fees and other access and
transaction fees? Please explain.
39. Do commenters agree that proposed Rule 1101(a)(1)(ii) is
consistent with prior Commission statements, including those described
in section II.B above? Why or why not? If not, should the Commission
revise any of its statements in light of the proposal? Please explain.
40. Do commenters believe that proposed Rule 1101(a)(1)(iii)
appropriately requires a broker-dealer's policies and procedures to
reflect how it will incorporate material potential liquidity sources
into its order handling practices? Why or why not?
41. Do commenters believe that proposed Rule 1101(a)(1)(iii)
appropriately requires a broker-dealer's policies and procedures to
reflect how it will ensure efficient access to each material potential
liquidity source? Why or why not?
42. What factors would a broker-dealer consider to ensure that it
can efficiently access a material potential liquidity source under the
proposed rules? Please explain.
43. Do commenters agree that proposed Rule 1101(a)(1)(iii) is
consistent with prior Commission statements, including those described
in section II.B above? Why or why not? If not, should the Commission
revise any of its statements in light of the proposal? Please explain.
[[Page 5459]]
44. Do commenters agree with the Commission's understanding that
broker-dealers currently have policies and procedures for how they
comply with the FINRA and MSRB best execution rules, as applicable?
Please describe the types of best execution policies and procedures
that broker-dealers currently have. In particular, do broker-dealers'
policies and procedures address how they obtain and assess reasonably
accessible information, including information about price, volume, and
execution quality, concerning the markets trading the relevant
securities? Do broker-dealers' policies and procedures address how they
identify material potential liquidity sources? Do broker-dealers'
policies and procedures address how they incorporate material potential
liquidity sources into their order handling practices, and how they
ensure that they can efficiently access each such material potential
liquidity source?
45. Do commenters believe that the Commission should provide
staggered compliance dates for proposed Rule 1101(a)(1) for broker-
dealers of different sizes, if the Commission adopts proposed
Regulation Best Execution? For example, should the Commission provide
longer compliance dates for smaller broker-dealers? If so, should the
Commission define a smaller broker-dealer as a broker-dealer that
qualifies as a ``small entity'' under the Regulatory Flexibility Act
pursuant to 17 CFR 240.0-10(c) for this purpose? \151\ Or should the
Commission define a smaller broker-dealer in a different way? Please
explain.
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\151\ 17 CFR 240.0-10(c) defines a smaller broker-dealer as one
that: (1) had total capital (net worth plus subordinated
liabilities) of less than $500,000 on the date in the prior fiscal
year as of which its audited financial statements were prepared
pursuant to Rule 17a-5(d) under the Exchange Act, or, if not
required to file such statements, had total capital (net worth plus
subordinated liabilities) of less than $500,000 on the last business
day of the preceding fiscal year (or in the time that it has been in
business, if shorter); and (2) is not affiliated with any person
(other than a natural person) that is not a small business or small
organization.
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2. Proposed Rule 1101(a)(2)--Best Market Determination
Proposed Rule 1101(a)(2) would require a broker-dealer's best
execution policies and procedures to address how it will determine the
best market and make routing or execution decisions for customer orders
that it receives by: (i) assessing reasonably accessible and timely
information with respect to the best displayed prices, opportunities
for price improvement, including midpoint executions, and order
exposure opportunities that may result in the most favorable price;
(ii) assessing the attributes of customer orders and considering the
trading characteristics of the security, the size of the order, the
likelihood of execution, the accessibility of the market, and any
customer instructions in selecting the market most likely to provide
the most favorable price; and (iii) in determining the number and
sequencing of markets to be assessed, reasonably balancing the
likelihood of obtaining better prices with the risk that delay could
result in worse prices.
In determining the best market for customer orders, the assessment
of reasonably accessible and timely information \152\ with respect to
the best displayed prices and opportunities for price improvement would
vary depending on the trading characteristics of particular securities.
Displayed prices can provide a useful reference price for a broker-
dealer to consider when assessing the best market in which to execute
customer orders, particularly in an asset class where there are
consolidated displays of the best prices across the market, or for
securities that are considered liquid and have firm prices that are
accessible. Accordingly, under proposed Rule 1101(a)(2)(i), a broker-
dealer's policies and procedures would be required to address how it
will assess reasonably accessible and timely information with respect
to the best displayed prices in any given market or security.\153\ In
addition, the Commission has previously stated that, when reviewing
their procedures for seeking to obtain best execution, ``broker-dealers
must take into account price improvement opportunities, and whether
different markets may be more suitable for different types of orders or
particular securities.'' \154\ Accordingly, under proposed Rule
1101(a)(2)(i), a broker-dealer's policies and procedures would be
required to specifically address how it will assess price improvement
opportunities,\155\ including midpoint execution opportunities.\156\
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\152\ See supra notes 132 and 141 and accompanying text.
\153\ For fixed income securities, FINRA has also recognized
that while a broker-dealer should consider using displayed prices on
electronic trading platforms as part of its reasonable diligence in
determining the best market for a security, executing a customer
order at the displayed price may not necessarily fulfill the broker-
dealer's best execution obligations. See FINRA Regulatory Notice 15-
46, at 8 (stating that displayed prices on electronic trading
platforms may not be the presumptive best prices, especially for
securities that are illiquid or trade infrequently). Accordingly,
the Commission believes that the concept of ``best displayed
prices'' is applicable to the fixed income securities market.
\154\ Regulation NMS Adopting Release, supra note 21, 70 FR
37538. See also Order Execution Obligations Adopting Release, supra
note 10, 61 FR 48323 n.357 (stating that any evaluation of price
improvement opportunities would have to consider not only the extent
to which orders are executed at prices better than the prevailing
quotes, but also the extent to which orders are executed at inferior
prices).
\155\ Price improvement is the execution of an order at a price
that is better than the best displayed buy or sell prices in the
market, and an execution between the best displayed bid and offer is
a form of price improvement. See, e.g., Order Execution Obligations
Adopting Release, supra note 10, 61 FR 48323 n.357 (stating that
price improvement means the difference between execution price and
the best quotes prevailing in the market at the time the order
arrived at the market or market maker); FINRA Rule 5310.09(b)(1)
(describing price improvement opportunities to mean the difference
between the execution price and the best quotes prevailing at the
time the order is received by the market).
\156\ These executions occur at the midpoint of the best
displayed buy and sell prices and may represent a significant amount
of price improvement as compared to executing at the best displayed
prices for customers seeking to trade immediately.
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In addition to displayed prices and opportunities for price
improvement, there may be other order exposure opportunities for
customer orders (e.g., order handling and execution protocols that may
provide exposure to a competitive process for customer orders). For
example, markets that operate limit order books and enable broker-
dealers to post customer limit orders could represent a best market for
customer orders. These markets may provide an opportunity for
executions at the prevailing best bid for customer buy orders or at the
prevailing best offer for customer sell orders, rather than executing
customer orders by crossing the prevailing bid-offer spread. As another
example, auctions may offer an opportunity to expose marketable
customer orders to prices that are more favorable than prices that
would be achieved by crossing the spread. Accordingly, under proposed
Rule 1101(a)(2)(i), a broker-dealer's policies and procedures would be
required to address how it will assess order exposure opportunities
that may result in the most favorable price.
FINRA Rule 5310(a)(1) and MSRB Rule G-18(a) also identify price
information as relevant when ascertaining the best market for a
security.\157\ MSRB Rule G-18(a) also includes as an additional factor:
the information reviewed to determine the current market for the
subject security
[[Page 5460]]
or similar securities.\158\ As described in section IV.B.1 above, FINRA
and MSRB rules reflect requirements for broker-dealers to have policies
and procedures for compliance with relevant laws and rules. However,
FINRA and MSRB rules do not require a broker-dealer's policies and
procedures to specifically address the elements that are relevant to
its best market determinations. The Commission understands that broker-
dealers currently generally have policies and procedures to ascertain
the best market for a security, although such policies and procedures
may need to be updated to address the elements specified in proposed
Rule 1101(a)(2).
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\157\ FINRA has also recognized the importance of considering
midpoint liquidity. See FINRA Regulatory Notice 15-46 at 4 n.25
(``For example, if a firm obtains price improvement at one venue of
$0.0005 per share, and it could obtain mid-point price improvement
at another venue of $0.025 per share, the firm should consider the
opportunity of such midpoint price improvement on that other venue
as part of its best execution analysis.''). In addition, FINRA Rule
5310.09(b)(1) recognizes the relevance of price improvement
opportunities.
\158\ This factor is consistent with proposed Rule 1101(a)(2)
because a broker-dealer's policies and procedures regarding the
assessment of reasonably accessible and timely best displayed prices
in the municipal bond market could include an assessment of
information to determine the current market for the subject security
or similar securities.
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For a retail broker-dealer in NMS stocks, its policies and
procedures for the best market determination could include assessments
of any assurances from a wholesaler that certain orders routed by the
retail broker-dealer to the wholesaler would be guaranteed midpoint
executions by the wholesaler or otherwise exposed to opportunities for
midpoint executions.\159\ If midpoint executions were not guaranteed by
a wholesaler, a retail broker-dealer's policies and procedures could
provide for assessments of whether customer orders would best be
executed with midpoint liquidity that may be available on an exchange,
ATS, or other market. Following an assessment of the opportunities for
midpoint executions, a broker-dealer's policies and procedures could
provide for an assessment of whether other price improvement
opportunities might be available, such as from wholesalers,\160\ from
resting liquidity between the best bid and offer on exchanges, through
auctions, or otherwise.
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\159\ If wholesalers do not have a practice of routinely seeking
and accessing midpoint liquidity as appropriate, the retail broker-
dealer's policies and procedures could address how it takes that
into account when assessing whether a wholesaler is the best market
for customer orders.
\160\ In considering wholesalers, such policies and procedures
could address how the retail broker-dealer assesses the price
improvement opportunities that may be available from different
wholesalers, including an assessment of guarantees for price
improvement that might be provided by wholesalers and the
performance of wholesalers, such as the execution quality that the
retail broker-dealer's customers received from the wholesalers in
the past.
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With respect to listed options, the Commission recognizes that
midpoint liquidity is not as commonly available on options exchanges as
it is in the NMS stock market.\161\ A broker-dealer's policies and
procedures nevertheless would be required to address how it will assess
potential midpoint executions, including to the extent additional
midpoint liquidity emerges. Following an assessment of potential
opportunities for midpoint executions, the Commission preliminarily
believes that a broker-dealer's policies and procedures could provide
for an assessment of other price improvement opportunities that might
be available. These price improvement opportunities could include
potential resting liquidity on exchange limit order books priced
between the best bid and offer. Price improvement opportunities may
also be available through exchange price improvement auctions.\162\ A
broker-dealer's policies and procedures could also address how it will
assess price improvement opportunities that may be available from
different wholesalers, including an assessment of guarantees for price
improvement that might be provided by wholesalers and the performance
of the wholesalers, including the execution quality that the retail
broker-dealer's customers received from the wholesalers in the past. In
doing so, a broker-dealer's policies and procedures could address how
it will assess the exchanges and exchange mechanisms that wholesalers
use, why they use those exchanges and mechanisms, and the relative
competitiveness of those exchanges and mechanisms in light of fee
differentials and functionality that can affect competitive responses
and facilitate internalization.
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\161\ Given the lack of order types concerning midpoint
liquidity, midpoint liquidity is not prevalent in the listed options
market.
\162\ Price improvement auctions currently available on options
exchanges are two-sided and thus may not be directly accessible by
many retail broker-dealers because they do not commit capital to
trade with customers. Specifically, options price improvement
auctions guarantee that a customer order will be executed by
requiring the broker-dealer initiating the auction to commit to
trade in a principal capacity with the customer order at a certain
price, with exposure to potential price improvement from competitive
responders. See, e.g., Nasdaq ISE, LLC Options 3, Section 13; Nasdaq
Phlx LLC Options 3, Section 13; Miami International Securities
Exchange LLC Rule 515A; BOX Exchange LLC Rule 7150; NYSE American
LLC Rule 971.1NY; Cboe Exchange, Inc. Rule 5.37. However, to the
extent one-sided auctions (or other trading protocols providing a
competitive process for exposing customer orders for the most
favorable price) exist or emerge, a broker-dealer's policies and
procedures generally should consider addressing whether such price
improvement opportunities represent the best market for customer
orders when making a routing or execution decision.
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The policies and procedures requirements under proposed Rule
1101(a)(2)(i) would also apply to wholesalers in the NMS stock and
options markets. For customer orders that a wholesaler intends to
execute at prices worse than the midpoint, its policies and procedures
could provide for an assessment of whether those orders would best be
executed with midpoint liquidity that may be available on an exchange,
ATS, or other market. A wholesaler's policies and procedures would also
need to address how it will consider other opportunities for price
improvement, which could include liquidity available on exchanges or
other markets priced between the best bid and offer. Finally, these
policies and procedures would need to address how the wholesaler will
assess order exposure opportunities for customer orders that may result
in the most favorable price for those orders.
In the corporate and municipal bond markets and government
securities markets, some broker-dealers display executable prices to
customers through proprietary customer-facing systems that enable
customers to transact at the displayed prices. Sometimes these prices
represent securities that are available on other venues such as ATSs,
interdealer brokers or otherwise, while other times these prices
represent securities held in inventory by the broker-dealer. The
policies and procedures of a broker-dealer in the corporate and
municipal bond markets and government securities markets would need to
address how it will assess reasonably accessible and timely information
with respect to the best displayed prices.
Information with respect to the best displayed prices would be
different between the corporate and municipal bond markets and
government securities markets, and the equities and options markets. In
particular, timely consolidated best prices are readily accessible in
the equities and options markets, but there are no similar consolidated
best prices in the corporate and municipal bond markets and government
securities markets. A broker-dealer's policies and procedures generally
should therefore be tailored to reflect best displayed price
information that is ``reasonably accessible and timely'' in the
corporate and municipal bond markets and government securities
markets.\163\
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\163\ FINRA Rule 5310 also states that ``when quotations are
available, FINRA will consider the accessibility of such quotations
when examining whether a member has used reasonable diligence.'' See
FINRA Rule 5310.03. FINRA has also discussed the importance of a
broker-dealer evaluating the quality of displayed prices in fixed
income securities. See FINRA Regulatory Notice 15-46, at 8 (``FINRA
also notes 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, especially for securities
that are illiquid or trade infrequently. Thus, although a firm
should consider using this information as part of its reasonable
diligence in determining the best market for the security, executing
a customer order at the displayed price may not fulfill the firm's
obligations, particularly if other sources of information indicate
the displayed price may not be the best price available. For
example, if . . . a firm regularly uses a reliable similar security
analysis to establish prices, that firm may need to use particular
care before executing a trade at a price that is displayed by a
trading system if its similar security analysis suggests that the
displayed price is not reflective of the market.'').
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[[Page 5461]]
The proposed rule requires policies and procedures of a broker-
dealer in the corporate and municipal bond markets and government
securities markets to also address how it will assess order exposure
opportunities that may result in the most favorable price, which could
include how it will assess RFQ mechanisms. These mechanisms may
represent the best market for customer orders in light of the trading
characteristics of these securities, where there may be limited
quotation or transaction pricing information available. In the absence
of reliable pricing information, such as bid, offer, or transaction
data for a security, a competitive auction mechanism may result in the
most favorable prices reasonably available.
The policies and procedures of a broker-dealer in the corporate and
municipal bond markets and government securities markets could also
assess how its use of RFQ systems may affect the opportunity to expose
a customer order to the most favorable price. For example, when a
customer wishes to buy or sell a bond, a broker-dealer may use an
electronic RFQ system to solicit prices from other participants on the
system.\164\ In this scenario, a broker-dealer's policies and
procedures could address how it will use ``filters'' and assess whether
the use of filters would affect the exposure for customer orders.
Specifically, a broker-dealer that submits an RFQ on behalf of a
customer typically has the option of deciding which participants it
wants to request prices from. While a broker-dealer may use filters in
a way that is consistent with its duty of best execution, a broker-
dealer could also potentially use filters to prevent
[…truncated; see source link]Indexed from Federal Register on January 27, 2023.
This is legal information, not legal advice. Laws vary by jurisdiction and change frequently. Always verify current law with official sources and consult a licensed attorney in your jurisdiction for advice on your specific situation.