2017 EXAMINATION FINDINGS REPORT

December 6, 2017

Best Execution

Best execution is a significant investor protection requirement that essentially obligates a broker-dealer to exercise reasonable care to execute a customer's order in a way to obtain the most advantageous terms for the customer. As the circumstances of each order and trading environment vary, so does the determination of what is best execution. Broker-dealers must be cognizant of the duty of best execution they owe customers when they receive, handle, route or execute customer orders in equities, options and debt securities. If a broker-dealer receives an order-routing inducement, such as payment for order flow, or trades as principal with customer orders, it must not let those factors interfere with its duty of best execution nor take them into account in analyzing market quality.

Generally, FINRA Rule 5310 requires 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.

In lieu of an order-by-order review, the rule permits firms that route customer orders to other broker-dealers for execution on an automated, non-discretionary basis, as well as firms that internalize customer order flow, to conduct a periodic (at least quarterly) regular and rigorous review of execution quality likely to be obtained from different market centers.10

FINRA observed firms that established, maintained, and enforced policy and supervisory procedures regarding regular and rigorous reviews for execution quality, including a description of the reviews performed and how the conduct and results of the reviews should be documented. Those firms documented their conduct of such reviews, the data and other information considered, order routing decisions and the rationale used. This is important not only to allow firms to make appropriate routing decisions, but also so that a regulator will understand what information was considered and why.

Selected Examination Findings

FINRA had concerns regarding the duty of best execution at firms of all sizes that receive, handle, route or execute customer orders in equities, options and fixed income securities.11 FINRA found that some firms failed to implement and conduct an adequate regular and rigorous review of the quality of the executions of their customers’ orders. These deficiencies included:

  • failing to compare the quality of the executions firms obtained via their order routing and execution arrangements (including the internalization of order flow) against the quality of the executions they could have obtained from competing markets;
  • failing to conduct reviews of certain types of orders (i.e., market, marketable limit and non-marketable limit orders); and
  • failing to consider certain factors set forth in FINRA Rule 5310 when conducting a regular and rigorous review, such as speed of execution, price improvement and the likelihood of execution, among others.

As a result of such deficiencies, these firms failed to assure that order flow was directed to markets providing the most beneficial terms for their customers' orders. FINRA notes that conducting a regular and rigorous review of customer execution quality is critical to the supervision of best execution practices, particularly if a firm routes customer orders to an alternative trading system in which the firm has a financial interest or market centers that provide order routing inducements, such as payment for order flow arrangements and order routing rebates.12

End Notes

10 FINRA has noted in recent guidance that it believes order-by-order review of execution quality is increasingly possible for a range of orders in all equity securities and standardized options. See Regulatory Notice 15-46. If a firm chooses not to conduct an order-by-order analysis, a member must determine, based on its regular and rigorous review, 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.

11 FINRA bases its observations here on findings from our cycle examination program as well as a sweep FINRA conducted. The information request for the sweep can be found here.

12 FINRA recently initiated targeted exams regarding the impact of order routing inducements on a firm's order routing practices and decisions. The information request for the sweep can be found here.