Regulatory Obligations and Related Considerations
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 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. Firms must conduct a “regular and rigorous” review of the execution quality of customer orders if the firm does not conduct an order-by-order review. Where “regular and rigorous” reviews are used instead of order-by-order reviews, the reviews must be performed at a minimum on a quarterly basis and on a security-by-security, type-of-order basis (e.g., limit order, market order and market on open order). If a firm identifies material differences in execution quality among the markets that trade the securities under review, it should modify its routing arrangements or justify why it is not doing so.
- How does your firm determine whether to employ order-by-order or “regular and rigorous” reviews of execution quality?
- How does your firm implement and conduct an adequate “regular and rigorous” review of the quality of the executions of its customers’ orders?
- How does your firm document its “regular and rigorous” reviews, the data and other information considered, order routing decisions and the rationale used, and address any deficiencies?
- How does your firm address potential conflicts of interest in order-routing decisions, including those relating to its routing of orders to affiliated alternative trading systems (ATSs), affiliated broker-dealers, or affiliated exchange members? When routing orders to an affiliate, how does your firm ensure that its order-routing decisions are based upon best execution considerations and not unduly influenced by these affiliations?
- How does your firm address potential conflicts of interest in order-routing decisions, including those related to its routing of orders to market centers that provide payment for order flow (PFOF) or other-routing inducements?
- When routing to market centers that provide PFOF or other inducements, how does your firm ensure that its order-routing decisions are based upon best execution considerations and not unduly influenced by these economic incentives?
- If your firm engages in fixed income and options trading, has it established targeted controls to perform 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?
- Does your firm perform its best execution obligations with respect to trading conducted in both regular and extended trading hours?
- Does your firm consider the risk of information leakage when assessing the execution quality of orders routed to a particular venue?
- 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?
Exam Findings and Effective Practices
- No Assessment of Execution vs. 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.
- No Review of Certain Order Types – Not conducting adequate reviews on a type-of-order basis, including, for example, on market, marketable limit or non-marketable limit orders.
- No Evaluation of Required Factors – Not considering certain factors set forth in FINRA Rule 5310 when conducting a “regular and rigorous review,” including, among other things, speed of execution, price improvement and the likelihood of execution of limit orders; and using routing logic that was not necessarily based on quality of execution.
- Conflicts of Interest – Not considering and addressing potential conflicts of interest relating to routing of orders to affiliated broker-dealers, ATSs or market centers that provide PFOF or other routing inducements, such as PFOF from wholesale market makers and exchange liquidity rebates.
- Inadequate SEC Rule 606 Disclosures – Not providing material disclosures in order-routing reports, such as the specific, material aspects of the non-directed order flow routed to firms’ trading desks, including that they stand to share in 100 percent of the profits generated by their trading as principal with their customers’ orders; material aspects of their relationships with each of the significant venues identified on their reports, including descriptions and terms of all arrangements for PFOF (including the amounts of PFOF on a per share or per order basis) and profit-sharing relationships that may have influenced the firms’ order routing decisions.
Targeted Examination Letter on Zero Commissions
As part of FINRA’s ongoing 2020 targeted review of firms’ decisions to move to “zero-commission” trading, we are evaluating:
- whether the “zero-commission” model adversely affected firms’ compliance with their best execution obligations;
- how firms used other practices, such as Cash Management Accounts and PFOF, to potentially offset lost commission revenue; and
- whether firms prominently communicated restrictions and limitations of “zero-commission” structures and other fees charged to customers.
- Exception Reports – Using exception reports and surveillance reports to support firms’ efforts to meet their best execution obligations.
- PFOF Order Routing Impact Review – Reviewing how PFOF affects the order-routing 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 basis, but depending on the firm’s business model, conducting reviews more frequently than quarterly (such as monthly).
- Continuous Updates – Updating WSPs and best execution analysis to address account, market and technology changes.
- 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)
- Report Center, Equity Report Cards – FINRA’s Best Execution Outside-of-the-Inside Report Card