The proposal would codify for the first time the federal-level
best execution standard for brokers and related obligations. New
Regulation Best Execution would result in a pivot from what has
been a principles-based approach to achieving and regulating best
execution, to a prescriptive, rules-based regime that heavily
emphasizes brokers’ policies and procedures. If adopted, the
regulation will reshape the landscape for order routing, execution,
and broker economics. Despite that, the Commission seems to rely on
significant conjecture to support the proposal, often referring to
“may,” “could,” and “might” when
describing concerns with existing practices and potential
ameliorative effects of the proposed requirements. This could prove
pivotal to the outcome of inevitable judicial challenges after
likely adoption in late 2023.

On December 14, 2022, the SEC proposed new Regulation Best Execution,
encompassing new Exchange Act Rules 1100, 1101, and 1102.
Regulation Best Execution would codify a federal best execution
standard pursuant to which broker-dealers must achieve the
“most favorable price” for customers. This means that
broker-dealers would be required to use reasonable diligence to
ascertain the best market for the 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. Regulation Best
Execution would also require broker-dealers to establish related
robust policies and procedures, particularly for firms engaging in
“conflicted transactions” with or for retail customers,
including principal trading, routing customer orders to affiliates,
and receiving payment for order flow (PFOF).

The operative words in the proposed best execution standard are
identical to those in FINRA Rule 5310. Nevertheless, and as the SEC
acknowledges, key aspects depart from the current best execution
regulatory regime and will require significant industry
adjustments. Introducing brokers, brokers with PFOF arrangements,
and executing brokers accustomed to internalizing retail order flow
or executing retail trades for affiliates will feel particularly
affected by this proposal.

Public comments are due by March 31, 2023.

Regulation Best Execution at a Glance

Regulation Best Execution would apply to transactions in
“securities” products (including equities, options,
corporate and municipal bonds, government securities, and
“crypto asset securities”) and would, among other
things:

1. Codify a federal rules-based best execution standard for
   brokers, dealers, government securities brokers, government
   securities dealers, and municipal securities dealers (proposed Rule
   1100 series) and establish exceptions similar to those available
   today.
2. Require broker-dealers to establish, maintain, and enforce
   written policies and procedures reasonably designed to comply with
   the best execution standard (proposed Rule 1101) while providing a
   limited exemption for introducing brokers (proposed Rule
   1101(d)).
3. Require enhanced policies and procedures for broker-dealers
   that engage in certain “conflicted transactions” for or
   with retail customers (proposed Rule 1101(b)).
4. Require broker-dealers to review the execution quality of their
   customer transactions at least quarterly (proposed Rule
   1101(c)).
5. Require broker-dealers to review their best execution policies
   and procedures at least annually and present a report detailing the
   results of such review to their boards of directors or equivalent
   governing bodies (proposed Rule 1102).

The term “market” is interpreted broadly for purposes
of existing requirements and would be broadly defined under
Regulation Best Execution as well, including other broker-dealers,
exchanges, alternative trading systems (ATSs), and other venues
that become known. The scope may also include a variety of
mechanisms operated by markets used by broker-dealers to transact
for or with customers (including auction mechanics and other
execution protocols).

Top 10 Observations and Takeaways

1. The Commission noted in the proposal that “a
   broker-dealer’s failure to achieve the most favorable price for
   customer orders would not necessarily be a violation of the
   proposed best execution standard.” However, Regulation Best
   Execution appears to focus on price as the alpha and omega
   considerations for firms, seemingly regardless of other order
   routing and order execution variables available for consideration.
   The Commission devotes significant discussion in the proposal to
   how broker-dealers should scour markets for the best available
   price, yet substantially less time helping broker-dealers
   understand how to identify and weigh other best execution factors
   (like trading characteristics of the security, size of orders,
   likelihood of execution, and accessibility of the market).
2. When it comes to price, it seems like the SEC expects firms to
   achieve executions for their customers at the midpoint of the NBBO
   (the proposal mentions midpoint 173 times). By way of example, the
   Commission notes its belief “that customers would benefit from
   robust considerations by retail broker-dealers regarding, for
   example, the possibility of available liquidity priced at the
   midpoint of the NBBO at other markets.” The SEC does not,
   however, explicitly say that firms should route orders to exchanges
   to hit midpoint liquidity prior to routing for execution by
   wholesalers. Nevertheless, the proposal feels slanted in that
   direction (especially when read in tandem with the retail order
   auction exposure rulemaking proposed by the Commission on the same
   day). Transparency from the Commission here is critical, if that is
   what the agency ultimately desires or expects.
3. Brokers engaged in conflicted transactions with or for retail
   investors may need to scour small, opaque markets with thin and
   unreliable liquidity to find what is akin to super best
   execution. The Commission noted in the proposal “that
   customers would benefit from considerations by these retail
   broker-dealers of whether other markets may provide customer
   orders, or a portion of those orders, with potentially better
   executions than wholesalers.” Unfortunately, the Commission
   does not sufficiently explain the proverbial line between regular
   and super best execution price checks. Query, for example, whether
   the Commission has in mind a specific number and sequencing of
   markets to be assessed and, even if those “better”
   executions are possible, at what cost (pun intended). The
   Commission itself even refers to “reasonably balancing the
   likelihood of obtaining better prices with the risk that delay
   could result in a worse price.”
4. On the one hand, the Commission acknowledged “the
   importance of providing a broker-dealer flexibility to exercise its
   expertise and judgment when executing customer orders, and proposed
   Regulation Best Execution primarily would be a policies and
   procedures-based rule.” At the same time, the SEC refers to
   its belief “that the receipt of [PFOF] continues to warrant
   heightened attention by broker-dealers.” It was never a
   realistic outcome for the SEC to impose an outright ban on PFOF.
   Nevertheless, the proposal contains a consistent and recurring
   theme that, in our view, the Commission thinks (really, hopes) that
   the proposed super best execution obligation will cause most
   retail-focused firms to cease accepting these payments. The SEC
   does note, however, that passing PFOF along to customers would
   suffice to de-conflict a transaction.
5. In determining the best market for customer orders received,
   brokers will need to consider reasonably accessible and timely
   pricing information and opportunities for price improvement. The
   Commission notes in the proposal that it “has also stated the
   importance of price improvement opportunities in the context of
   listed and [OTC] equities. Simply routing customer order flow for
   automated executions or internalizing customer orders on an
   automated basis at the best bid or offer would not necessarily
   satisfy a broker-dealer’s duty of best execution for small
   orders in listed and OTC equities. Rather, broker-dealers handling
   small orders in listed and OTC equities should look for price
   improvement opportunities when executing these orders. And the
   expectation of price improvement for customer orders is
   particularly important when broker-dealers receive payments in
   return for routing their customer orders.”
6. The conflicted transaction regime would only apply to
   “retail customers,” which the SEC defines more broadly
   than under legacy FINRA rules and, curiously, even compared to
   Regulation Best Interest. The Commission should just use a
   single core definition of retail customer and scope it to apply to
   recommended transactions for best interest and more
   broadly for best execution. In particular, and
   unlike Regulation Best Interest, retail customers for best
   execution purposes would encompass accounts held in legal
   form on behalf of a natural person or a “group of related
   family members,” which the SEC intends to cover the
   “types of arrangements that may be set up to benefit family
   groups, including individual retirement accounts, corporations, and
   limited liability companies for the benefit of related family
   members.” The SEC tries to explain the rationale for the
   diverging best interest and best execution
   scopes, stating that “[p]roposed Rule 1101(b) does not
   incorporate all of the definition of ‘retail customer’ in
   Regulation Best Interest because that definition is limited to
   scenarios where a person receives and uses a recommendation. In
   contrast, proposed Rule 1101(b) and the proposed standard of best
   execution are not limited to scenarios where a person receives and
   uses a recommendation.” The proposed new definition
   is similar to that under Regulation Best Interest
   in that it captures individuals with $50 million of assets or more,
   which is the threshold FINRA uses to define institutional
   account.
7. It was only a few years ago that the SEC was trying to encourage innovation to improve
   secondary market quality for thinly traded securities, which is
   retail-heavy. Instead, the market for thinly-traded securities has
   contracted significantly since the SEC amended Exchange Act Rule
   15c2-11 in September 2020 by limiting the ability for brokers to
   quote and publish on these names. The Regulation Best Interest
   proposal is lean on discussion around OTC trading. Nevertheless,
   the potential intersection of these rules would make it virtually
   impossible for brokers to satisfy the regular best execution
   standard, let alone super best execution for conflicted retail
   transactions. This will have the likely effect of eliminating
   retail investor access beyond the top 3,000 names.
8. Regulation Best Execution would impose the new requirements on
   introducing brokers that, until now, have complied with their best
   execution obligations by performing “regular and
   rigorous” reviews of execution quality (EQ) reports and other
   statistics from executing and clearing brokers with which they have
   contracted. The Rule 605 amendments proposed by the Commission on
   the same day as Regulation Best Execution would enhance broker
   disclosure of order execution information and seem designed to help
   in this regard. Given the rigorous requirement to review EQ and
   adjust order-handling practices based on that review, it is not
   clear why it is necessary also to narrow the definition of
   introducing broker to exclude, for example, those that execute
   through an affiliated broker. If their EQ review indicates that
   they can obtain better execution from another broker, they would
   implicitly be required to switch to the other broker.
9. SEC staff will need to eventually provide significant guidance
   to the industry regarding how the proposed duty of best execution
   will be affected by age-old variables and pain points like access
   to and utilization of data feeds (including the use of proprietary
   exchange feeds versus the SIPs), exchange and ATS access fees, and
   the speed and means of access to quotes and latency considerations.
   This is particularly true regarding determining what is
   “reasonably accessible information” and whether brokers
   can “efficiently access each material potential liquidity
   source.”
10. The Regulation Best Execution proposal is one of three other significant “market
    structure” proposals announced on the same day in December
    2022. These include an “Order Competition Rule” (new
    Exchange Act Rule 616, including requiring certain retail equity
    orders to be exposed in auctions before being internalized);
    amendments to Exchange Act Rule 605 (enhancing broker disclosure of
    order execution information); and amendments to Exchange Act Rules
    610 and 612 (amending minimum pricing increments and exchange
    access fee caps and enhancing the transparency of better-priced
    orders). The Commission is already facing significant criticism for
    proposing all four of these at the same time, particularly given
    that each warrants careful consideration without effects from
    exogenous factors, like the adoption of the other proposals, that
    will certainly ensue. For example, beyond the proposed new retail
    order auction proposal, what does the agency expect from brokers
    regarding “order exposure opportunities that may result in the
    most favorable price”? Also, how will the anticipated new
    minimum tick sizes affect brokers’ consideration of pricing
    when making their order routing decisions? Finally, will the
    enhanced 605 reports yield the information the SEC anticipates they
    will and will firms be expected to ingest and factor those into
    their routing decisions immediately?

Required Policies and Procedures and Related Obligations

Regulation Best Execution would require broker-dealers to
establish, maintain, and enforce written policies and procedures
reasonably designed to comply with the best execution standard,
including:

Obtaining, identifying, and incorporating certain
information

• Obtaining and assessing reasonably accessible information,
  including information about price, volume, and EQ, concerning the
  markets trading the relevant securities;
• Identifying markets that may be reasonably likely to provide
  the most favorable prices for customer orders (so-called
  “material potential liquidity sources”); and
• Incorporating material potential liquidity sources into their
  order handling practices, and ensuring that the firm can
  efficiently access each such material potential liquidity
  source.

Assessing and determining the best market and making
customer order routing or execution decisions

• Assessing reasonably accessible and timely information with
  respect to the best displayed prices, opportunities for price
  improvement, including midpoint executions, and order exposure
  opportunities that may result in the most favorable price;
• Assessing the attributes of customer orders and considering the
  trading characteristics of the security, the size of the order, the
  likelihood of execution, the accessibility of the market, and any
  customer instructions in selecting the market most likely to
  provide the most favorable price; and
• In determining the number and sequencing of markets to be
  assessed, reasonably balancing the likelihood of obtaining better
  prices with the risk that delay could result in a worse price.

A “conflicted transaction” would be any transaction
for or with a retail customer where a broker-dealer (1) executes an
order as principal, including riskless principal, (2) routes an
order to or receives an order from an affiliate for execution, or
(3) provides or receives PFOF. Required policies and procedures
would need to specifically document compliance with the best
execution standard for conflicted retail transactions in light of
any PFOF, including:

• Obtaining and assessing enhanced information,
  including additional information about price, volume, and EQ, in
  identifying a broader range of markets beyond those identified as
  material potential liquidity sources;
• Evaluating a broader range of markets, beyond those
  identified as material potential liquidity sources, that might
  provide the most favorable price for customer orders, including a
  broader range of order exposure opportunities and markets that may
  be smaller or less accessible than those identified as material
  potential liquidity sources;
• Documenting compliance with the best execution
  standard (in accordance with written procedures), including all
  efforts to enforce the firm’s best execution policies and
  procedures for conflicted transactions and the basis and
  information relied on for its compliance determinations; and
• Documenting any PFOF arrangement, whether written or
  oral, including the parties, all qualitative and quantitative
  terms, and the date and terms of any changes.

Regulation Best Execution would require that broker-dealers, at
least quarterly:

• Review the EQ of their transactions for or with
  customers or customers of another broker-dealer, and how such EQ
  compares with the EQ the broker-dealer might have obtained from
  other markets;
• Revise their best execution policies and procedures,
  including order handling practices, accordingly; and
• Document the results of this review.

Introducing brokers that route customer orders to an executing
broker would not need to comply with the requirements above if
they:

• Establish, maintain, and enforce policies and procedures
  for regularly reviewing the EQ obtained from the executing
  broker;
• Compare it with the EQ the introducing broker might
  have obtained from other executing brokers;
• Revise their order handling practices accordingly;
  and
• Document the results of their review.

Areas for Closer Examination

Implications for Introducing
Brokers

“Introducing broker” would mean a broker-dealer that
(1) does not carry customer accounts and does not hold customer
funds or securities, (2) has entered into an arrangement with an
unaffiliated executing broker-dealer that has agreed to handle and
execute on an agency basis all of the introducing broker’s
customer orders, and (3) has not accepted any monetary payment,
service, property, or other benefit that results in remuneration,
compensation, or consideration from the executing broker in return
for the routing of the introducing broker’s customer orders to
the executing broker.

• We expect the Commission to clarify that a single introducing
  broker is able to use multiple unaffiliated executing brokers to
  handle orders on an agency basis (despite the text suggesting
  otherwise). Examples of “other benefits” introducing
  brokers could not receive from executing brokers include research,
  clearance, or custody products or services; reciprocal agreements
  for the provision of order flow; adjustment of a broker-dealers
  unfavorable trading errors; offers to participate as underwriter in
  public offerings; stock loans or shared interest accrued thereon;
  and discounts, rebates, or any other reductions of or credits
  against any fee to, or expense or other financial obligation of,
  the broker-dealer routing a customer order that exceeds that fee,
  expense, or financial obligation.
• Proposed Rule 1101(d) would exempt an introducing broker that
  routes customer orders to an executing broker from separately
  complying with proposed Rules 1101(a), (b), and (c) if the
  introducing broker establishes, maintains, and enforces policies
  and procedures that require the introducing broker to regularly
  review the EQ obtained from its executing broker, compare it with
  the execution quality it could have obtained from other executing
  brokers, and revise its routing practices accordingly. This would
  provide a tailored exemption from certain provisions of proposed
  Regulation Best Execution for firms that do not make decisions or
  exercise discretion regarding the manner in which their customer
  orders are handled and executed (other than the determination to
  engage the executing broker). The Commission points out that this
  exemption would be provided to a narrower group of firms compared
  to similar exemptions provided by FINRA and the MSRB, and would
  require additional specific policies and procedures that are not
  required under the FINRA and MSRB rules.
• A broker-dealer that effects any transaction for or with a
  customer or a customer of another broker or dealer must at least
  annually review and assess the design and overall effectiveness of
  its best execution policies and procedures, including its order
  handling practices, conduct the review and assessment in accordance
  with written procedures, and document the review and assessment.
  The broker-dealer must also prepare a written report detailing the
  results of the review and assessment, including a description of
  all deficiencies found and any plan to address deficiencies, and
  present the report to the firm’s board of directors (or
  equivalent governing body).
• The SEC excludes two principal trading scenarios from its new
  introducing broker prohibitions: (i) fractional share trading in
  NMS stocks; and (ii) riskless principal trading in corporate and
  municipal bonds and government securities. In both scenarios, the
  SEC believes that current market practice necessitates these
  exemptions. We think it is a given that the industry will identify
  others that warrant similar carve-outs.

Exemptions for Institutional-Only Broker-Dealers

Proposed Rule 1100 would exempt from the best execution standard
broker-dealers with business limited to (i) quoting a price for a
security where another broker-dealer routes a customer order for
execution against that quote; and (ii) transacting with
institutional customers that exercise independent judgment and
execute an order against the broker-dealer’s quotation. The
first exemption is included in FINRA’s existing best execution
rule. The second may be consistent with FINRA’s best execution
rule, but is not expressly discussed therein. Proposed Regulation
Best Execution does not define the term “institutional
customer” for purposes of this exemption but asks commenters
if a definition is appropriate.

Coverage for Digital Asset Securities

Regulation Best Execution would apply to crypto assets that
qualify as securities or government securities. The SEC notes in
the proposal multiple times that it “has limited information
about the order handling and best execution practices” of
participants in the crypto asset market. The SEC nevertheless
concludes that despite its own inability to assess execution
quality in the crypto markets, broker-dealers facilitating
transactions in crypto asset securities must assess execution
quality and fully comply with Regulation Best Execution. It is
unclear, however, how the SEC expects digital asset security
broker-dealers to do what the SEC itself cannot. The SEC refers to
“digital asset” as an asset that is issued and/or
transferred using distributed ledger or blockchain technology
(“distributed ledger technology”), including, but not
limited to, so-called “virtual currencies,”
“coins,” and “tokens.”

Next Steps

Despite being quite long (440 pages), the proposal is short on
details and definitions and would benefit from clear statements of
SEC expectations. We expect continued robust comment and criticism
up to and after the March 31, 2023 comment deadline. Even though
the SEC remains in full remote work status, engagement with the
Chairman and Commissioners, their staffs, and staff in the Division
of Trading and Markets should remain a high priority for industry
stakeholders.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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