Blog: SEC Proposes New Regulation Best Execution — Brokers Must … – Mondaq

United States:

SEC Proposes New Regulation Best Execution — Brokers Must Achieve “Most Favorable Price” For Customers; Heightened Obligations For Conflicted Retail Transactions

07 March 2023

Goodwin Procter LLP

To print this article, all you need is to be registered or login on

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

  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
  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
  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
  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
    . 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
  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
  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,

Obtaining, identifying, and incorporating certain

  • 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

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

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

Areas for Closer Examination

Implications for Introducing

“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

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.

POPULAR ARTICLES ON: Corporate/Commercial Law from United States

Privileged Communications With Corporate Counsel

McLane Middleton, Professional Association

It might depend on what you are talking about. Important to keep in mind is that the corporation is the attorney’s client, not you. If your conversation is intended to help counsel provide…

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s