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 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. Where a firm may choose to not conduct an order-by-order review—to the extent consistent with Rule 5310 and associated guidance—it must have procedures in place to confirm it periodically conducts “regular and rigorous” reviews of the execution quality of its customers’ orders.
Best execution obligations apply to any member firm that receives customer orders—for purposes of handling and execution—including firms that receive orders directly from customers, as well as those that receive customer orders from other firms for handling and execution, such as wholesale market makers.14 These obligations also apply when a firm acts as agent for the account of its customer and executes transactions as principal. Any firm subject to FINRA Rule 5310 cannot transfer its duty of best execution to another person; additionally, any firm that routes all of its customer orders to another firm without conducting an independent review of execution quality would violate its duty of best execution.
- How does your firm determine whether to employ order-by-order or “regular and rigorous” reviews of execution quality?
- If applicable, how does your firm implement and conduct an adequate “regular and rigorous” review of the quality of the executions of its customers’ orders and orders from a customer of another broker-dealer?
- If applicable, 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 compare the execution quality received under its existing order routing and execution arrangements (including the internalization of order flow) to the quality of the executions it could obtain from competing markets (whether or not the firm already has routing arrangements with them), including off-exchange trading venues?
- How does your firm address potential conflicts of interest in order routing decisions, including those involving:
- affiliated entities (e.g., affiliated broker-dealers, affiliated alternative trading systems (ATSs));
- market centers, including off-exchange trading venues, that provide payment for order flow (PFOF) or other order-routing inducements; and
- orders from customers of another broker-dealer for which your firm provides PFOF?
- If your firm provides PFOF to another broker-dealer, how does your firm prevent those payments from interfering with your firm’s best execution obligations (including situations where you provide PFOF and execute the covered orders)?
- 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?
- How does your firm meet 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 affecting pricing 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 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.
- 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 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 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.
Targeted Reviews of Wholesale Market Makers
FINRA is conducting targeted best execution reviews of wholesale market makers concerning their relationships with broker-dealers that route orders to them as well as their own order routing practices and decisions (with respect to these orders). These targeted reviews are evaluating:
- whether wholesale market makers are conducting adequate execution quality reviews;
- whether order routing, handling and execution arrangements (including PFOF agreements) with retail broker-dealers have an impact on the wholesale marker makers’ order handling practices and decisions, and fulfillment of their best execution obligations; and
- any modified order handling procedures that the wholesale market makers implemented during volatile or extreme market conditions.
- Exception Reports – Using exception reports and surveillance reports to support firms’ efforts to meet their best execution obligations.
- 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.
- Continuous Updates – Updating WSPs and best execution analysis to address market and technology changes.
- 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)
- FINRA Report Center
- Equity Report Cards
- Best Execution Outside-of-the-Inside Report Card