Regulatory Obligations and Related Considerations
Regulatory Obligations
FINRA Rule 5310(Best Execution and Interpositioning) requires that, in any transaction for or with a customer or a customer of another broker-dealer, a member firm and persons associated with a member firm 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. A member firm must have procedures in place to ensure it conducts “regular and rigorous” reviews of the execution quality of its customers’ orders if it doesn’t conduct an order-by-order review. (MSRB Rule G-18 (Best Execution) sets forth similar obligations with respect to transactions in municipal securities.)
Best execution obligations apply to any member firm that receives customer orders for purposes of handling and execution, including firms that receive customer orders from other firms for handling and execution.1 These obligations apply whether a member firm acts in a principal or an agency capacity. A member firm cannot transfer its duty of best execution to another person. Additionally, any member firm that routes all its customer orders to another firm without conducting an independent review of execution quality would violate its duty of best execution.
Related Considerations
Execution Quality Reviews
- How does your firm determine the appropriate method and frequency of its execution quality reviews?
- If applicable, does your firm conduct “regular and rigorous” reviews of the quality of the executions of its customers’ orders and customer orders from other broker-dealers, including a comparison of the execution quality available at competing markets?
- If applicable, how does your firm document its “regular and rigorous” reviews, including the data and other information considered, order routing decisions and the rationale for such decisions, and actions to address any deficiencies?
- If applicable, does your firm conduct an independent review of the execution quality obtained by another firm to which your firm routes all of its customer orders?
Payment for Order Flow
- If your firm provides payment for order flow (PFOF) to, or receives PFOF from, another broker-dealer, how does your firm prevent those payments from interfering with your firm’s best execution obligations?
Fixed Income and Options Trading
- If your firm engages in fixed income and options trading, has it established targeted policies and procedures to address its best execution obligations for these products?
- Does your firm consider differences among security types within these products, such as the different characteristics and liquidity of U.S. Treasury securities compared to other fixed income securities?
- If applicable, how does your firm monitor options exchange order exposure requirements, auction mechanism usage and venue routing? How does your firm monitor such requirements when routing orders to an affiliated entity or another broker-dealer that provides PFOF?
Other Best Execution Considerations
- How does your firm meet its best execution obligations with respect to trading conducted in both regular and extended trading hours?
- What data sources does your firm use for its routing decisions and execution quality reviews for different order types and sizes, including odd lots?
- How does your firm handle fractional share investing in the context of its best execution obligations?
- Does your firm consider liquidity priced better than the National Best Bid and Offer (NBBO), including liquidity available via Retail Liquidity Programs and odd lot liquidity displayed via direct feeds?
- How does your firm assess order routing arrangements to ensure that third parties are not interpositioned between the firm and the best market in a manner that is inconsistent with your firm’s best execution obligations?
Findings and Effective Practices
Findings
- No Assessment of Execution in Competing Markets: Not comparing the quality of the execution obtained via firms’ existing order-routing and execution arrangements against the quality of execution they could have obtained from competing markets; failing to modify routing arrangements or justify why routing arrangements are not being modified; and using routing logic that is not based on execution quality.
- No Review of Certain Order Types: Not conducting adequate reviews on a type-of-order basis, including, for example, for market, marketable limit, or non-marketable limit orders.
- Unreasonable “Regular and Rigorous Reviews”: Not conducting periodic “regular and rigorous reviews” or, when conducting such reviews, not considering certain execution quality factors set forth in Rule 5310, Supplementary Material .09.
- Conflicts of Interest: Not considering and addressing potential conflicts of interest relating to routing or exposing orders to affiliated broker-dealers, affiliated ATSs, or market centers that provide routing inducements, such as PFOF from wholesale market makers and exchange liquidity rebates.
Effective Practices
- Exception Reports: Using exception reports and surveillance reports to support firms’ efforts to meet their best execution obligations.
- Full and Prompt Execution of Marketable Customer Orders: Regularly evaluating the thresholds your firm uses to generate exceptions as part of the firm’s supervisory systems designed to achieve compliance with the firm’s “full and prompt” obligations; and modifying such thresholds to reflect current promptness standards for marketable order execution, including statistics available from FINRA, other relevant indicators of industry standards and the firm’s internal data.
- PFOF Order Handling Impact Review: Reviewing how PFOF affects the order-handling process, including the following factors: any explicit or implicit contractual arrangement to send order flow to a third-party broker-dealer; terms of these agreements; whether it is on a per-share basis or per-order basis; and whether it is based upon the type of order, size of order, type of customer or the market class of the security.
- Risk-Based “Regular and Rigorous Reviews”: Conducting “regular and rigorous” reviews, at a minimum, on a quarterly or more frequent basis (such as monthly), depending on the firm’s business model, that consider the potential execution quality available at various trading centers, including those to which a firm does not send order flow.
- Support of Analysis: Being prepared to explain and evidence the firm’s best execution analysis, including internalized orders, on a “regular and rigorous” or order-by-order basis, as applicable.
- Continuous Updates: Updating WSPs and best execution analysis to address market and technology changes.
- Best Execution Committees: Establishing committees that meet quarterly or more frequently to conduct “regular and rigorous” reviews, and determine, if necessary, to modify the firm's order routing and execution arrangements.
- Supervision: Ensuring supervisory procedures, systems and controls address the execution of the entirety of the firm’s marketable order flow, including order types such as activated stop orders, all or none orders, and odd lot orders.
- Monitoring Orders: Monitoring the handling of marketable orders of all types fully and promptly, including market orders, marketable limit orders, activated stop orders, all or none orders, odd lot orders, marketable orders in illiquid securities, and marketable orders in preferred securities.
Additional Resources
- FINRA Report Center
- Regulatory Notices
- Regulatory Notice 22-04 (FINRA Reminds Member Firms of Obligation to Execute Marketable Customer Orders Fully and Promptly)
- Regulatory Notice 21-23 (FINRA Reminds Member Firms of Requirements Concerning Best Execution and Payment for Order Flow)
- Regulatory Notice 21-12 (FINRA Reminds Member Firms of Their Obligations Regarding Customer Order Handling, Margin Requirements and Effective Liquidity Management Practices During Extreme Market Conditions)
- Regulatory Notice 15-46 (Guidance on Best Execution Obligations in Equity, Options and Fixed Income Markets)
- Notice to Members 01-22(NASD Regulation Reiterates Member Firm Best Execution Obligations And Provides Guidance to Members Concerning Compliance)
1 In this situation, the routing firm and receiving firm may have different best execution obligations. See Supplementary Material .09 to FINRA Rule5310.
