Customer Order Handling: Best Execution and Order Routing Disclosures

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 firm and persons associated with a 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 firm must have procedures in place to ensure it conducts “regular and rigorous” reviews of the execution quality of its customers’ orders if it does not conduct an order-by-order review. MSRB Rule G-18 (Best Execution) sets forth similar obligations with respect to transactions in municipal securities. In addition, the SEC has interpreted the antifraud provisions to require broker-dealers to provide best execution, and the SEC has interpreted that obligation in particular circumstances. 

Best execution obligations apply to any 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 firm acts in a principal or in an agency capacity. A firm cannot transfer its duty of best execution to another person. Additionally, a firm that routes its order flow to another firm that has agreed to handle that order flow as agent for the customer must either conduct its own regular and rigorous review of the execution quality received, or periodically review the statistical results and rationale of the other firm’s regular and rigorous review of execution quality. 

Rule 606 of Regulation NMS requires broker-dealers to disclose information regarding the handling of their customers’ orders in NMS stocks and listed options. These disclosures are designed to help customers better understand how their firm routes and handles their orders, assess the quality of order handling services provided by their firm and ascertain whether the firm is effectively managing potential conflicts of interest that may impact their firm’s routing decisions. FINRA Rule 6151 requires members to submit their Rule 606 order routing reports to FINRA for centralized publication on the FINRA website.

Findings

Best Execution

  • 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, including ATSs and additional sources of liquidity; 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.
  • 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 FINRA Rule 5310, Supplementary Material .09.
  • 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.
  • Securities with Limited Quotations or Pricing Information: Failing to establish written policies and procedures with respect to trading in securities with limited quotations or pricing information as set forth in FINRA Rule 5310, Supplementary Material .06, including documenting compliance with those policies and procedures. 

Order Routing Disclosures

  • Inaccurate Quarterly Reports: Publishing incomplete or otherwise inaccurate information in the quarterly report on order routing, such as:
    • inaccurately classifying orders (e.g., classifying orders as “other orders” without considering whether such orders involve a customer request for special handling);2
    • incorrectly stating that the firm does not receive payment for order flow (PFOF) from execution venues;
    • not including payments, credits or rebates (whether received directly from an exchange or through a pass-through arrangement) in the “Net Payment Paid/Received” and “Material Aspects” sections of the quarterly report;
    • not including exchange pricing arrangements (e.g., tiered pricing) in the “Net Payment Paid/Received” and “Material Aspects” sections of the quarterly report;
    • not disclosing any amounts of “Net Payment Paid/Received,” when the firm receives PFOF for at least one of the four order types (i.e., Market Orders, Marketable Limit Orders, Non-Marketable Limit Orders, Other Orders);
    • reporting only held orders in listed options, instead of both held and not held orders; and
    • inaccurately identifying reported execution venues as “Unknown.”
  • Incomplete Disclosures: Not adequately describing material aspects of the firm’s relationships with disclosed venues in the Material Aspects disclosures portion of the quarterly report, such as:
    • inadequate descriptions of specific terms of PFOF and other arrangements (e.g., “average” amounts of PFOF rather than specific disclosure noting the payment types, specific amount received for each type of payment, terms and conditions of each type of payment);
    • ambiguous descriptions of receipt of PFOF (e.g., firm “may” receive payment);
    • incomplete descriptions of exchange credits or rebates; and
    • incomplete descriptions of tiered pricing arrangements, including the specific pricing received by the firm.
  • Insufficient WSPs: Either not establishing or not maintaining WSPs reasonably designed to achieve compliance with the requirements of Rule 606, including:
    • not describing the steps taken to review whether the firm has verified the integrity of information sent to, or received from, their third-party vendor—or not stating how the review would be evidenced;
    • not articulating a supervisory method of review to verify the accuracy, format, completeness, timely processing, and details of the Rule 606(b)(1) and (b)(3) reports, if requested, as well as documenting the performance of that review; and
    • when incorporating by reference another firm’s Rule 606(a)(1) quarterly report, not examining the report and having a reasonable basis to believe that the report does not materially misrepresent the order routing practices.

Effective Practices

Best Execution

  • Supervision of Order Flow: 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.
    • For firms relying on the regular and rigorous review of execution quality conducted by an executing firm, consolidator or other member that has agreed to handle the firm’s order flow as agent for the customer:
      • ensuring that the statistical results and rationale of the executing firm’s, consolidator’s or other member firm’s review are fully disclosed to the firm; and
      • periodically reviewing both the methodology and the results of the review.
  • Exception Reports: Using exception reports and surveillance reports to support the firm’s efforts to meet their best execution obligations.
  • Full and Prompt Execution of Marketable Customer Orders: Regularly evaluating the firm’s thresholds used 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 firm’s order-handling process, including:
    • any explicit or implicit contractual arrangement to send order flow to a third-party broker-dealer;
    • the 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 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 market centers, including competing markets 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.
    • Maintaining and regularly reviewing firm policies and procedures to comply with FINRA Rule 5310 and updating or revising such policies and procedures, as necessary.
  • 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.

Order Routing Disclosures

  • Supervision: Conducting regular, periodic supervisory reviews to ensure that:
    • public quarterly reports and customer-specific order disclosure reports are:
      • accurate (e.g., assuring that per-venue disclosures of net aggregate PFOF and other payments are accurately calculated); and
      • complete (e.g., assuring that the Material Aspects section adequately describes the firm’s PFOF and other payment arrangement for each execution venue, including all material aspects that may influence the firm’s order routing decisions); and
    • SEC Rule 606(a) Reports are provided to FINRA, in the manner prescribed by FINRA, within the same time and in the same formats that such report is required to be made publicly available pursuant to Rule 606(a), and that:
      • erroneous or rejected submissions to FINRA are corrected and resubmitted;
      • hyperlinks in reports submitted to FINRA are operational;
      • reports made publicly available by firms are consistent with the reports submitted to FINRA; and
      • complete and current clearing firm information is submitted to FINRA (for introducing firms that incorporate by reference their clearing firm(s)’ Rule 606(a) Reports).
  • Due Diligence:
    • Identifying Execution Venues: Routing-only firm (i.e., a broker-dealer that re-routes but does not execute orders) confirming it is not inaccurately reported as an execution venue.
    • Third-Party Vendors: Assess the accuracy of public quarterly reports and customer-specific order disclosure reports provided by third-party vendors by, for example:
      • reviewing the content of reports; and
      • comparing order samples against third-party vendor-provided information; and confirming with the third-party vendor that all appropriate order information is being received (particularly when the firm has complex routing arrangements with execution venues).

Additional Resources

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1 In this situation, the routing firm and receiving firm may have different best execution obligations. See Supplementary Material .09 to FINRA Rule 5310 (Best Execution and Interpositioning).

2 See SEC Division of Market Regulation, Staff Legal Bulletin No. 13A, Frequently Asked Questions About Rule 11Ac1-6, FAQ #9.