Proposed Regulation Best Execution Standard

SEC 

FINRA 

MSRB 

Rules 1100-1102 

Rule 5310 

Rule G-18 

Rule 1100 under proposed Regulation Best Execution would set forth the best execution standard. Specifically, 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 the broker-dealer) would be required to 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. 

(a)(1) 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. Among the factors that will be considered in determining whether a member has used "reasonable diligence" are: 

• the character of the market for the security (e.g., price, volatility, relative liquidity, and pressure on available communications); 
• the size and type of transaction; 
• the number of markets checked; 
• accessibility of the quotation; and 
• the terms and conditions of the order which result in the transaction, as communicated to the member and persons associated with the member. 

(a) 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 the resultant price to the customer is as favorable as possible under prevailing market conditions. Among the factors that will be considered in determining whether a dealer has used “reasonable diligence,” with no single factor being determinative, are:

1. the character of the market for the security (e.g., price, volatility, and relative liquidity);
2. the size and type of transaction;
3. the number of markets checked;
4. the information reviewed to determine the current market for the subject security or similar securities; 
5. the accessibility of quotations; and 
6. the terms and conditions of the customer’s inquiry or order, including any bids or offers, that result in the transaction, as communicated to the dealer.

(a)(2) In any transaction for or with a customer or a customer of another broker-dealer, no member or person associated with a member shall interject a third-party between the member and the best market for the subject security in a manner inconsistent with paragraph (a)(1) of this Rule.

(b) In any transaction for or with a customer or a customer of another dealer, a dealer must not interject a third-party between itself and the best market for the subject security in a manner inconsistent with paragraph (a) of this rule. 

Exemption: 
Rule 1100 would exempt a broker-dealer from this standard when:  

1. another broker-dealer is executing a customer order against the broker-dealer’s quotation;  
2. an institutional customer, exercising independent judgment, executes its order against the broker-dealer’s quotation; or  
3. the broker-dealer receives an unsolicited instruction from a customer to route its 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. 

(b) When a member 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 member.

.08 Customer Instructions Regarding Order Handling

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. Members are, however, still required to process that customer's order promptly and in accordance with the terms of the order. Where a customer has directed that an order be routed to another specific broker-dealer that is also a FINRA member, the receiving broker-dealer to which the order was directed would be required to meet the requirements of Rule 5310 with respect to its handling of the order.

.09 Exemption for Municipal Fund Securities

The provisions of this rule do not apply to transactions in municipal fund securities. 

.07 Customer Instructions Regarding Handling of Bids or Offers

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. Dealers are, however, still required to process that customer’s transaction promptly and in accordance with the terms of the customer’s bid or offer. 

(c) Failure to maintain or adequately staff an over-the-counter order room or other department assigned to execute customers' orders cannot be considered justification for executing away from the best available market; nor can channeling orders through a third-party as described above as reciprocation for service or business operate to relieve a member of its obligations under this rule.

.02 Maintenance of Adequate Resources

A dealer’s failure to maintain adequate resources (e.g., staff or technology) is not a justification for executing away from the best available market. The level of resources that a dealer maintains should take into account the nature of the dealer’s municipal securities business, including its level of sales and trading activity.

(d) A member, through which an order is channeled and that knowingly is a party to an arrangement whereby the initiating member has not fulfilled its obligations under this rule, will also be deemed to have violated the rule.

(e) The obligations described in paragraphs (a) through (d) above exist not only where the member acts as agent for the account of its customer but also where transactions are executed as principal. Such obligations are distinct from the reasonableness of commission rates, markups or markdowns, which are governed by Rule 2121 and its supplementary material.

(c) The obligations described in paragraphs (a) and (b) above apply to transactions in which the dealer is acting as agent and transactions in which the dealer is acting as principal. These obligations are distinct from the fairness and reasonableness of commissions, markups or markdowns, which are governed by Rule G-30. 

Proposed Rule 1101(a) would require policies and procedures to address how broker-dealers will comply with the best execution standard and how they will determine the best market and make routing or execution decisions for customer orders. 

.06 Orders Involving Securities with Limited Quotations or Pricing Information

One of the areas where a member must be especially diligent to ensure it has met its best execution obligations is customer orders involving securities for which there is limited pricing information or quotations available. Each member must have written policies and procedures in place that address how the member will determine the best inter-dealer market for such a security in the absence of pricing information or multiple quotations and must document its compliance with those policies and procedures 
 
.07 Orders Involving Foreign Securities

Even though a security does not trade in the U.S., members still have an obligation to seek best execution for customer orders involving any foreign security. Consequently, a member that handles customer orders involving foreign securities that do not trade in the U.S. must have specific written policies and procedures in place regarding its handling of customer orders for these securities. The policies and procedures should be reasonably designed to obtain the most favorable terms available for the customer, taking into account differences that may exist between U.S. markets and foreign markets. While best execution obligations take into account differing market structures, best execution obligations must also evolve as changes occur in the market that may give rise to improved executions, including opportunities to trade at more advantageous prices. As such, members must also regularly review these policies and procedures to assess the quality of executions received and update or revise the policies and procedures as necessary. 
 
09 Regular and Rigorous Review of Execution Quality

(a) A member that routes customer orders to other broker-dealers for execution on an automated, non-discretionary basis, as well as a member that internalizes customer order flow, must have procedures in place to ensure the member periodically conducts regular and rigorous reviews of the quality of the executions of its customers' orders if it does not conduct an order-by-order review.

.06 Securities with Limited Quotations or Pricing Information

One of the areas where a dealer must be especially diligent to ensure it has met its best execution obligations is customer transactions involving securities for which there is limited pricing information or quotations available. Each dealer must have written policies and procedures in place that address how the dealer will make its best-execution determinations with respect to such a security in the absence of pricing information or multiple quotations, and must document its compliance with those policies and procedures. 

Broker-dealers that engage in conflicted transactions with respect to retail customer orders would be subject to additional obligations under proposed Rule 1101(b). A conflicted transaction would be any transaction where a broker-dealer:

1. executes an order as principal, including riskless principal;
2. routes an order to or receives an order from an affiliate for execution; or
3. provides or receives payment for order flow.

Proposed Rule 1101(b) would require additional policies and procedures for conflicted transactions and would require broker-dealers to document their compliance with the best execution standard for such transactions and any arrangement concerning payment for order flow.

.01 Execution of Marketable Customer Orders

A member must make every effort to execute a marketable customer order that it receives fully and promptly. 

.01 Purpose

The principal purpose of this rule is to promote dealers’ use of reasonable diligence for customer transactions in accordance with paragraph (a). A failure to have obtained the most favorable price possible will not necessarily mean that the dealer failed to use reasonable diligence. 
 
.03 Execution of Customer Transactions

A dealer must make every effort to execute a customer transaction promptly, taking into account prevailing market conditions. In certain market conditions a dealer may need more time to use reasonable diligence to ascertain the best market for the subject security.

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. 

.02 Definition of "Market"

For the purposes of Rule 5310 and the accompanying Supplementary Material, the term “market” or “markets” is to be construed broadly, and it encompasses a variety of different venues, including, but not limited to, market centers that are trading a particular security. This expansive interpretation is meant to both inform broker-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 broker-dealers, exchange markets, and markets other than exchange markets, as well as any other venue that may emerge, by not mandating that certain trading venues have less relevance than others in the course of determining a firm's best execution obligations. 

.04 Definition of “Market” 

The term “market” or “markets,” for the purposes of this rule, unless the context requires otherwise, 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. The term 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 to both inform dealers of 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.

.03 Best Execution and Debt Securities

Rule 5310(a)(1)(D) provides that one of the factors used to determine if a member has used reasonable diligence in exercising best execution is the "accessibility of the quotation." In the context of the debt market, this means that, when quotations are available, FINRA will consider the accessibility of such quotations when examining whether a member has used reasonable diligence. For purposes of debt securities, the term “quotation” refers to either dollar (or other currency) pricing or yield pricing. Accessibility is only one of the non-exhaustive reasonable diligence factors set out in Rule 5310(a)(1). In the absence of accessibility, members are not relieved from taking reasonable steps and employing their market expertise in achieving the best execution of customer orders.

.04 Best Execution and Executing Brokers

A member's duty to provide best execution in any transaction “for or with a customer of another broker-dealer” does not apply in instances when another broker-dealer is simply executing a customer order against the member's quote. The duty to provide best execution to customer orders received from other broker-dealers arises only when an order is routed from the broker-dealer to the member for the purpose of order handling and execution. This clarification is intended to draw a distinction between those situations when the member is acting solely as the buyer or seller in connection with orders presented by a broker-dealer against the member's quote, as opposed to those circumstances when the member is accepting order flow from another broker-dealer for the purpose of facilitating the handling and execution of such orders.

.05 Best Execution and Executing Brokers

A dealer’s duty to provide best execution in any transaction “for or with” “a customer of another dealer” does not apply in instances when the other dealer is simply executing a customer transaction against the dealer’s quote. A dealer’s duty to provide best execution to customer orders received from other dealers arises only when an order is routed from another dealer to the dealer for handling and execution. 

.05 Use of a Broker's Broker 

Paragraph (b) of the rule provides that when a member 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 member. 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.

.06 Orders Involving Securities with Limited Quotations or Pricing Information

Although the best execution requirements in Rule 5310 apply to orders in all securities, markets for securities differ dramatically. One of the areas in which a member must be especially diligent to ensure it has met its best execution obligations is with respect to customer orders involving securities when there is limited pricing information or quotations available. Each member must have written policies and procedures in place that address how the member will determine the best inter-dealer market for such a security in the absence of pricing information or multiple quotations and must document its compliance with those policies and procedures. For example, a member should analyze pricing information based on other data, such as previous trades in the security, to determine whether the resultant price to the customer is as favorable as possible under prevailing market conditions. In these instances, a member should generally seek out other sources of pricing information or potential liquidity, which may include obtaining quotations from other sources (e.g., other firms that the member previously has traded with in the security).

.06 Securities with Limited Quotations or Pricing Information  

Although the best-execution requirements in this rule apply to transactions in all municipal securities (other than municipal fund securities), markets for municipal securities may differ dramatically. One of the areas in which a dealer must be especially diligent to ensure it has met its best-execution obligations is customer transactions involving securities when there is limited pricing information or quotations available. Each dealer must have written policies and procedures in place that address how the dealer will make its best-execution determinations with respect to such a security in the absence of pricing information or multiple quotations, and must document its compliance with those policies and procedures. For example, a dealer generally should seek out other sources of pricing information and potential liquidity for such a security, including other dealers that the dealer has previously traded with in the security. Additionally, a dealer generally should, in determining whether the resultant price to the customer is as favorable as possible under prevailing market conditions, analyze other data to which it reasonably has access. 

07. Orders Involving Foreign Securities

The obligation in Rule 5310(a) that a member use “reasonable diligence” to exercise best execution applies to customer orders in both domestic and foreign securities. However, Rule 5310(a) also recognizes that the markets for different securities can vary dramatically, and the standard of “reasonable diligence” must be assessed by examining specific factors, including “the character of the market for the security” and the “accessibility of the quotation.” Accordingly, the determination whether a member has satisfied its best execution obligations necessarily involves a “facts and circumstances” analysis. 
 
The handling of customer orders in foreign securities that do not trade in the U.S. can differ substantially from the handling of orders in U.S.-traded securities. In particular, the character of the particular foreign market and the accessibility of quotations in certain foreign markets may vary significantly. Some foreign jurisdictions, for example, may not have similar best execution requirements as those imposed by Rule 5310, or may not have comparable access and pre-trade or post-trade transparency standards. 
 
Even though a security does not trade in the U.S., members still have an obligation to seek best execution for customer orders involving any foreign security. Consequently, a member that handles customer orders involving foreign securities that do not trade in the U.S. must have specific written policies and procedures in place for handling of customer orders for these securities that are reasonably designed to obtain the most favorable terms available for the customer, taking into account differences that may exist between U.S. markets and foreign markets. While best execution obligations take into account differing market structures, best execution obligations must also evolve as changes occur in the market that may give rise to improved executions, including opportunities to trade at more advantageous prices. As such, members must also regularly review these policies and procedures to assess the quality of executions received and update or revise the policies and procedures as necessary.

Rule 1101(c) would require broker-dealers to review at least quarterly the execution quality of their customer transactions, compare it with the execution quality that might have been obtained from other markets, revise their best execution policies and procedures accordingly, including order handling practices, and document the results of the review. 

.09 Regular and Rigorous Review of Execution Quality

(a) No member can transfer to another person its obligation to provide best execution to its customers' orders. A member that routes customer orders to other broker-dealers for execution on an automated, non-discretionary basis, as well as a member that internalizes customer order flow, must have procedures in place to ensure the member periodically conducts regular and rigorous reviews of the quality of the executions of its customers' orders, if it does not conduct an order-by-order review. The review must be conducted on a security-by-security type-of-order basis (e.g., limit order, market order, and market on open order). At a minimum, a member must conduct such reviews on a quarterly basis; however, members should consider whether more frequent reviews are needed based on the firm's business.

(b) When conducting its regular and rigorous review, a member must determine whether any material differences in execution quality exist among the markets trading the security and, if so, modify the member's routing arrangements or justify why it is not modifying its routing arrangements. To assure that order flow is directed to markets providing the most beneficial terms for their customers' orders, the member must compare, among other things, the quality of the executions the member is obtaining via current order routing and execution arrangements (including the internalization of order flow) to the quality of the executions that the member could obtain from competing markets. In reviewing and comparing the execution quality of its current order routing and execution arrangements to the execution quality of other markets, a member should consider the following factors: 

1. Price improvement opportunities (i.e., the difference between the execution price and the best quotes prevailing at the time the order is received by the market) 
2. Differences in price disimprovement (i.e., situations when a customer receives a worse price at execution than the best quotes prevailing at the time the order is received by the market) 
3. The likelihood of execution of limit orders 
4. The speed of execution 
5. The size of execution 
6. Transaction costs 
7. Customer needs and expectations 
8. The existence of internalization or payment for order flow arrangements

(c) A member that routes its order flow to another member that has agreed to handle that order flow as agent for the customer (e.g., a clearing firm or other executing broker-dealer) can rely on that member's regular and rigorous review as long as the statistical results and rationale of the review are fully disclosed to the member and the member periodically reviews how the review is conducted, as well as the results of the review.

Rule 1101(d) would provide an exemption to “introducing brokers” from complying with proposed Rules 1101(a), (b), and (c) if they establish, maintain, and enforce policies and procedures that require them to regularly review the execution quality obtained from their executing broker, compare it with the execution quality they might have obtained from other executing brokers, and revise their order handling practices accordingly. Introducing brokers would be required to document the results of the review.

Rule 1102 would require broker-dealers to review their best execution policies and procedures at least annually, including their order handling practices. Broker-dealers would be required to document such reviews and prepare and present written reports detailing the results of the reviews to their boards of directors or equivalent governing bodies. 

.08 Review of Policies and Procedures and Execution Quality 
 
(a) A dealer must, at a minimum, conduct annual reviews of its policies and procedures for determining the best available market for the execution of its customers’ transactions. While no more frequent interval is specifically required, a dealer must conduct these reviews at a frequency reasonably related to the nature of its municipal securities business, including but not limited to its level of sales and trading activity. When conducting its periodic reviews, a dealer must assess whether its policies and procedures are reasonably designed to achieve best execution, taking into account the quality of the executions the dealer is obtaining under its current policies and procedures, changes in market structure, new entrants, the availability of additional pre-trade and post-trade data, and the availability of new technologies, and to promptly make any necessary modifications to such policies and procedures as may be appropriate in light of such reviews.