Interpretive Letter to Leonard Mayer, Schwab Capital Markets, L.P.
May 1, 2000
Mr. Leonard Mayer, President
Schwab Capital Markets L.P.
111 Pavonia Ave. East, 15th Flr.
Jersey City, New Jersey 07310
Dear Mr. Mayer:
This is in response to your letter dated April 12, 2000 in which you requested NASD Regulation, Inc.’s interpretation of Rule 2320, "Best Execution and Interpositioning," as applied to the provision of automated execution for orders in OTC Bulletin Board ("OTCBB") securities. According to your letter, Schwab Capital Markets L.P. ("Schwab") is considering implementing an automated execution system whereby certain customer orders to purchase or sell OTCBB securities would be automatically executed at the best price displayed on the OTCBB. Your letter states that depending on the market conditions and the terms of an order, Schwab believes that automatic execution at the best bid or offer disseminated by the OTCBB would result in customers’ receiving a better execution than is currently obtained manually.
Rule 2320 provides in part that "[i]n any transaction for or with a customer, a member and persons associated with a member shall use reasonable diligence to ascertain the best inter-dealer 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." Paragraph (g) of the Rule provides that "[i]n any transaction for or with a customer pertaining to the execution of an order in a non-Nasdaq security (as defined in the Rule 6700 Series), a member or person associated with a member, shall contact and obtain quotations from three dealers (or all dealers if three or less) to determine the best inter-dealer market for the subject security." NASD Notice to Members 92-50, Question #41, provides that if the OTCBB displays three firm quotations in a particular security, a member does not have to contact the market makers to verify their quotations appearing on the OTCBB as required in Rule 2320(g). A broker/dealer need only note on the order ticket the identity of the broker/dealers and the firm quotations obtained from the OTCBB.
As the NASD has stated, executing transactions at the best bid and/or offer does not necessarily mean a broker/dealer has met its best execution obligations. Best execution is a facts and circumstances analysis, which involves more than just determining the best bid and/or offer. As provided in Rule 2320(a)(1), the factors to be considered include, but are not limited to, volatility, relative liquidity, pressure on available communications, the size and type of the transactions, the number of primary markets checked and the location and accessibility of primary markets and quotation sources.
Historically, because of the nature of the quotes, trading and types of issuers on the OTCBB, the staff informally has not sanctioned a member’s use of automated execution systems for OTCBB securities. The OTCBB, however, has evolved considerably over the past several years. While the prices in OTCBB securities have remained low, the share volume has increased more than ten-fold from 1994. In 1999, the OTCBB had an average daily volume of 301,478,066. The OTCBB has developed into a much more active market, spurred by increased participation by individual investors, online trading, and a proliferation of stock information provided through the Internet.
Consistent with these changes in the OTCBB, NASD Regulation staff believes that automated routing or execution of customer orders for an actively traded OTCBB security when a minimum of three firm quotations are displayed, as currently required by Rule 2320(g),1 is not necessarily inconsistent with best execution. Nonetheless, a broker/dealer’s use of such a system does not assure that it has fulfilled its duty of best execution.2 That remains a facts and circumstances analysis, taking into account all relevant factors, which can include whether limit order protection applies to the security, what other customer limit orders in the security the member is holding and the nature of the pricing for the security at issue. The duty of best execution also requires, at a minimum, that a broker/dealer that routes orders for automated execution periodically assess the quality of competing inter-dealer quotation systems to assure that its order flow is directed to systems providing the most beneficial terms for its customer’s orders. In this regard, if better prices consistently are available on an inter-dealer quotation system not accessed or captured by the member’s automated system, the member would be expected to reassess its system.
I hope this letter is responsive to your inquiry. Please note that the opinions expressed herein are staff opinions only and have not been reviewed or endorsed by the Board of Directors of NASD Regulation. This letter responds only to the issues that you have raised based on the facts you have described, and does not address any other rule or interpretation of the Association, or all the possible regulatory and legal issues involved.
Alden S. Adkins
Senior Vice President and General Counsel
1 It is important to note that on April 13, 2000, NASD Regulation filed with the Securities and Exchange Commission ("SEC") a proposed rule change to amend Rule 2320(g). See SR-NASD-00-20. Among other things, the proposed rule change would eliminate the requirement that members executing a customer order in a non-Nasdaq security contact and obtain quotations from three dealers, if two or more priced quotations are displayed in an inter-dealer quotation system that permits quotation updates on a real-time basis (such as the OTCBB). Prior to becoming effective, proposed rule changes must be approved by the SEC, typically after publication in the Federal Register and a public comment period.
2 Regardless of the form of routing or execution of an order, the broker/dealer is required to note on the order ticket the identity of the broker/dealers and the firm quotations displayed on the OTCBB. It is important to note, however, that, as referenced in footnote 1 above, NASD Regulation is proposing a rule change that would eliminate the requirement that members indicate on the order ticket the name of the dealer and quotation displayed in those cases where two or more priced quotations are displayed in an inter-dealer quotation system that permits quotation updates on a real-time basis and NASD Regulation has access to the quotation data. See SR-NASD-00-20.