[Federal Register Volume 88, Number 18 (Friday, January 27, 2023)]
[Proposed Rules]
[Pages 5440-5556]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2022-27644]
[[Page 5439]]
Vol. 88
Friday,
No. 18
January 27, 2023
Part II
Securities and Exchange Commission
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17 CFR Parts 240 and 242
Regulation Best Execution; Proposed Rule
Federal Register / Vol. 88 , No. 18 / Friday, January 27, 2023 /
Proposed Rules
[[Page 5440]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 240 and 242
[Release No. 34-96496; File No. S7-32-22]
RIN 3235-AN24
Regulation Best Execution
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule.
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SUMMARY: The Securities and Exchange Commission (``Commission'') is
proposing new rules under the Securities Exchange Act of 1934
(``Exchange Act'') relating to a broker-dealer's duty of best
execution. Proposed Regulation Best Execution would enhance the
existing regulatory framework concerning the duty of best execution by
requiring detailed policies and procedures for all broker-dealers and
more robust policies and procedures for broker-dealers engaging in
certain conflicted transactions with retail customers, as well as
related review and documentation requirements.
DATES: Comments should be received on or before March 31, 2023.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's internet comment form (https://www.sec.gov/regulatory-actions/how-to-submit-comments); or
Send an email to sec.gov">rule-comments@sec.gov. Please include
File Number S7-32-22 on the subject line.
Paper Comments
Send paper comments to Secretary, Securities and Exchange
Commission, 100 F Street NE, Washington, DC 20549-1090.
All submissions should refer to File Number S7-32-22. This file number
should be included on the subject line if email is used. To help the
Commission process and review your comments more efficiently, please
use only one method of submission. The Commission will post all
comments on the Commission's website (https://www.sec.gov/rules/proposed.shtml). Comments are also available for website viewing and
printing in the Commission's Public Reference Room, 100 F Street NE,
Washington, DC 20549, on official business days between the hours of 10
a.m. and 3 p.m. Operating conditions may limit access to the
Commission's Public Reference Room. All comments received will be
posted without change. Persons submitting comments are cautioned that
the Commission does not redact or edit personal identifying information
from comment submissions. You should submit only information that you
wish to make available publicly.
Studies, memoranda, or other substantive items may be added by the
Commission or staff to the comment file during this rulemaking. A
notification of the inclusion in the comment file of any materials will
be made available on the Commission's website. To ensure direct
electronic receipt of such notifications, sign up through the ``Stay
Connected'' option at www.sec.gov to receive notifications by email.
FOR FURTHER INFORMATION CONTACT: David Dimitrious, Senior Special
Counsel and Arisa Tinaves Kettig, Special Counsel at (202) 551-5500,
Office of Market Supervision, Division of Trading and Markets,
Securities and Exchange Commission, 100 F Street NE, Washington, DC
20549.
SUPPLEMENTARY INFORMATION: The Commission is proposing to add the
following new rules under the Exchange Act: (1) 17 CFR 242.1100 (Rule
1100 of Regulation Best Execution); (2) 17 CFR 242.1101 (Rule 1101 of
Regulation Best Execution); and (3) 17 CFR 242.1102 (Rule 1102 of
Regulation Best Execution). The Commission is also proposing to amend
17 CFR 240.17a-4 (Rule 17a-4 under the Exchange Act).
Table of Contents
I. Introduction
II. Duty of Best Execution
A. Current Regulatory Framework
B. Prior Commission Statements
C. FINRA and MSRB Best Execution Rules
III. Existing Order Handling Practices and Overview of Proposed
Regulation Best Execution
A. Existing Order Handling Practices
1. General Broker-Dealer Practices
2. Order Handling Conflicts of Interest
3. Crypto Asset Securities
B. Overview of Proposed Regulation Best Execution
IV. Discussion of Proposed Regulation Best Execution
A. Proposed Rule 1100--The Best Execution Standard
B. Proposed Rule 1101(a)--Best Execution Policies and Procedures
1. Proposed Rule 1101(a)(1)--Framework for Compliance With the
Best Execution Standard
2. Proposed Rule 1101(a)(2)--Best Market Determination
C. Proposed Rule 1101(b)--Policies and Procedures and
Documentation for Conflicted Transactions
1. Proposed Rules 1101(b)(1) and (2)--Policies and Procedures
for Conflicted Transactions
2. Proposed Rule 1101(b)(3)--Documentation for Conflicted
Transactions
3. Application of Proposed Rule 1101(b) to NMS Stock Market
Conflicts of Interest
4. Application of Proposed Rule 1101(b) to the Options Market
5. Application of Proposed Rule 1101(b) to the Corporate and
Municipal Bond Markets and Government Securities Markets
D. Proposed Rule 1101(c)--Regular Review of Execution Quality
E. Proposed Rule 1101(d)--Introducing Brokers
1. Definition of Introducing Broker and Executing Broker
2. Review of Executing Broker's Execution Quality
F. Proposed Rule 1102--Annual Report
G. Recordkeeping Requirements Under Rule 17a-4
V. Economic Analysis
A. Introduction
B. Baseline
1. Current Legal and Regulatory Framework
2. Best Execution Review Processes
3. Description of Markets and Broker-Dealer Order Handling and
Execution Practices
4. Broker-Dealer Services and Revenue
C. Economic Effects and Effects on Efficiency, Competition, and
Capital Formation
1. Benefits
2. Costs
3. Efficiency, Competition, and Capital Formation
D. Reasonable Alternatives
1. SEC Adopts FINRA Rule 5310 and MSRB Rule G-18 Best Execution
Rules
2. Require Order Execution Quality Disclosure for Other Asset
Classes
3. Utilize FINRA and MSRB Approach to Introducing Broker
4. Ban or Restrict Off-Exchange PFOF
5. Require Broker-Dealers To Utilize Best Execution Committees
6. Require Order-by-Order Documentation for Conflicted or All
Transactions
7. Staggered Compliance Dates
E. Request for Comments
VI. Paperwork Reduction Act
A. Summary of Collection of Information
1. Required Policies and Procedures and Related Obligations
2. Annual Report
B. Proposed Use of Information
1. Required Policies and Procedures and Related Obligations
2. Annual Report
C. Respondents
D. Total Initial and Annual Reporting and Recordkeeping Burdens
1. Required Policies and Procedures and Related Obligations
2. Annual Report
E. Total Paperwork Burden
F. Collection of Information Is Mandatory
G. Confidentiality of Responses to Collection of Information
H. Retention Period for Recordkeeping Requirements
I. Request for Comment
VII. Consideration of Impact on the Economy
[[Page 5441]]
VIII. Initial Regulatory Flexibility Act Analysis
A. Reasons for and Objectives of the Proposed Action
B. Legal Basis
C. Small Entities Subject to the Proposed Rule
D. Projected Compliance Requirements of the Proposed Rule for
Small Entities
1. Required Policies and Procedures and Related Obligations
2. Annual Report
E. Duplicative, Overlapping, or Conflicting Federal Rules
F. Significant Alternatives
1. Adopt FINRA Rule 5310 and MSRB Rule G-18 Concerning Best
Execution
2. Require Order Execution Quality Disclosure for Other Asset
Classes
3. Define ``Introducing Broker'' To Include Those Entities That
Qualify for Relief Under FINRA and MSRB Rules
4. Ban or Restrict Off-Exchange Payment for Order Flow
5. Require Broker-Dealers To Utilize Best Execution Committees
6. Require Order-by-Order Documentation for Conflicted or All
Transactions
7. Staggered Compliance Dates
G. General Request for Comment
Statutory Authority and Text of the Proposed Rule
I. Introduction
The duty of best execution requires a broker-dealer to execute
customers' trades at the most favorable terms reasonably available
under the circumstances,\1\ and customers benefit from broker-dealers'
robust considerations of execution opportunities that may provide
customers with the most favorable terms. Accordingly, promoting the
best execution of customer orders is of fundamental importance to
investors and the markets, and is an important aspect of investor
protection. The Financial Industry Regulatory Authority, Inc.
(``FINRA''), a national securities association, and the Municipal
Securities Rulemaking Board (``MSRB'') currently have rules and
guidance directly addressing the duty of best execution. The Commission
has made statements concerning the duty over the years, but has never
itself established a rule addressing best execution. While the
Commission believes the existing regulatory framework concerning the
duty of best execution has helped broker-dealers fulfill their duty to
their customers, the Commission believes this regulatory framework can
be made more effective. In particular, while FINRA and the MSRB have
established best execution rules and provided guidance on how broker-
dealers should achieve best execution in a variety of contexts, and
generally require broker-dealers to have procedures for compliance with
relevant laws and rules, the Commission believes it is appropriate to
propose its own comprehensive and detailed best execution requirements.
The Commission understands that, currently, broker-dealers' best
execution policies and procedures, and the documentation relating to
their best execution practices, may vary. However, as described in
section III.A below, the Commission believes that customers would
benefit from consistently robust best execution practices by broker-
dealers, and the execution of retail customer orders by broker-dealers
that have certain order handling conflicts of interest warrants
heightened attention by those broker-dealers.\2\
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\1\ See infra note 21 and accompanying text.
\2\ See infra Section V.A (describing the ``principal--agent''
problem that may exist between a broker-dealer and its customer and
how that can be exacerbated by other conflicts of interest).
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The Commission believes that having Commission rules providing a
policies and procedures-based best execution framework, along with
regular reviews and related documentation, would help broker-dealers
maintain consistently robust best execution practices and result in
vigorous efforts by broker-dealers to achieve best execution, including
in situations where broker-dealers have order handling conflicts of
interest with retail customers. The Commission also believes that
detailed policies and procedures, regular reviews, and related
documentations would allow broker-dealers to effectively assess their
best execution practices and assist the Commission and self-regulatory
organizations (``SROs'') to effectively examine and enforce broker-
dealers' compliance with the proposed rules.
Proposed Regulation Best Execution would establish through a
Commission rule a best execution standard for broker-dealers.\3\
Proposed Regulation Best Execution would also specifically require
broker-dealers to establish, maintain, and enforce written policies and
procedures reasonably designed to comply with that best execution
standard. Those policies and procedures would be required to address:
(1) how the broker-dealer will comply with the proposed standard of
best execution, including by identifying material potential liquidity
sources, incorporating material potential liquidity sources into its
order handling practices, and ensuring that the broker-dealer can
efficiently access each source, and (2) how the broker-dealer will
determine the best market for customer orders received, including by
assessing reasonably accessible and timely pricing information and
opportunities for price improvement.
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\3\ The proposed best execution standard is consistent with the
best execution standards set forth in FINRA and MSRB rules.
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In addition, for retail customer transactions that present
conflicts of interest, such as payment for order flow or
internalization, that could create incentives for a broker-dealer to be
less diligent in its search for better executions and potentially
result in broker-dealers not providing best execution to customer
orders, proposed Regulation Best Execution would require the broker-
dealer's policies and procedures to address how it will comply with the
best execution standard in light of such conflicts, including how it
would assess a broader range of markets than it would for non-
conflicted transactions. Proposed Regulation Best Execution would also
require broker-dealers to document their compliance with the best
execution standard and the basis for their determinations that best
execution would be achieved through conflicted transactions.
Proposed Regulation Best Execution would also require broker-
dealers to review the execution quality of their customer orders at
least quarterly, compare it with the execution quality that might have
been obtained from other markets, and revise their best execution
policies and procedures accordingly.
Proposed Regulation Best Execution would exempt from specified
requirements under the proposed rules an introducing broker (as defined
in the proposed rules) that establishes, maintains, and enforces
policies and procedures that require it to regularly review the
execution quality obtained from its executing broker, compares that
execution quality with the execution quality it might have obtained
from other executing brokers, and revises its order handling practices
accordingly.
Finally, proposed Regulation Best Execution would require broker-
dealers to review and assess the overall effectiveness of their best
execution policies and procedures, including their order handling
practices, on at least an annual basis, and prepare a report detailing
the results of such review and assessment that would be presented to
the broker-dealer's board of directors (or equivalent governing body).
The Commission recognizes 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, similar to
[[Page 5442]]
the Order Protection Rule,\4\ the Risk Management Controls for Brokers
or Dealers with Market Access Rule,\5\ and Regulation Systems
Compliance and Integrity.\6\ Under proposed Regulation Best Execution,
a broker-dealer's failure to achieve the most favorable price possible
under prevailing market conditions (``most favorable price'') for
customer orders would be part of the consideration of whether the
broker-dealer's policies and procedures are reasonably designed and
whether the broker-dealer is enforcing its policies and procedures. 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, because it may not be the result of a failure
by the broker-dealer to use reasonable diligence to ascertain the best
market and to buy or sell in such market so that the customer receives
the most favorable price.\7\ However, a failure to establish and
maintain reasonably designed policies and procedures applicable to all
customer orders, or a failure to enforce those policies and procedures,
would be a violation of the policies and procedures requirement under
proposed Regulation Best Execution.
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\4\ See 17 CFR 242.611.
\5\ See 17 CFR 240.15c3-5.
\6\ See 17 CFR 242.1001.
\7\ See also MSRB Rule G-18.01 (``A failure to have actually
obtained the most favorable price possible will not necessarily mean
that the dealer failed to use reasonable diligence.''). Whether a
broker-dealer has met the proposed best execution standard would
turn on an objective assessment of the facts and circumstances at
the time of the broker-dealer's transactions for or with the
customer (and not in hindsight).
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II. Duty of Best Execution
A. Current Regulatory Framework
A broker-dealer has a legal duty to seek best execution of customer
orders. The duty of best execution predates the Federal securities laws
and is derived from an implied representation that a broker-dealer
makes to its customers.\8\ The duty is established from ``common law
agency obligations of undivided loyalty and reasonable care that an
agent owes to [its] principal.'' \9\ This obligation requires that a
``broker-dealer seek to obtain for its customer orders the most
favorable terms reasonably available under the circumstances.'' \10\
While there is no Commission rule or standard addressing a broker-
dealer's duty of best execution, the duty is addressed in FINRA and
MSRB rules, as described in sections II.C and IV below.\11\
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\8\ See, e.g., Newton v. Merrill, Lynch, Pierce, Fenner & Smith,
Inc., 135 F.3d 266, 270 (3d Cir.), cert. denied, 525 U.S. 811
(1998).
\9\ See id.
\10\ See id. See also Securities Exchange Act Release No. 37619A
(Sept. 6, 1996), 61 FR 48290 (Sept. 12, 1996) (``Order Execution
Obligations Adopting Release''). A Report of the Special Study of
Securities Markets stated that, according to an NASD District
Business Conduct Committee in a 1952 proceeding, ``[t]he integrity
of the industry can be maintained only if the fundamental principle
that a customer should at all times get the best available price
which can reasonably be obtained for him is followed.'' See SEC,
Report of the Special Study of Securities Markets, H.R. Doc. No. 95,
88th Cong., 1st Sess. Pt. II, 624 (1963) (``Special Study''),
available at https://www.sechistorical.org/collection/papers/1960/1963_SSMkt_Chapter_07_2.pdf.
\11\ The Commission also oversees investment advisers, which
have a similar duty. As part of its duty of care, an investment
adviser has a duty to seek best execution of a client's transactions
where the adviser has responsibility to select broker-dealers to
execute client trades, and the Commission previously has described
the contours of that duty. See Commission Interpretation Regarding
Standard of Conduct for Investment Advisers, Advisers Act Release
No. 5248 (June 5, 2019), 84 FR 33669, 33674-75 (July 12, 2019). In
addition, the Commission has brought a variety of enforcement
actions against registered investment advisers in connection with
their alleged failure to satisfy their duty to seek best execution.
See, e.g., In the Matter of Aventura Capital Management, LLC,
Investment Advisers Act Release No. 6103 (Sept. 6, 2022) (settled
action); In the Matter of Madison Avenue Securities, LLC, Investment
Advisers Act Release No. 6036 (May 31, 2022) (settled action).
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The Commission is proposing Regulation Best Execution pursuant to,
among other provisions, sections 11A and 15 of the Exchange Act.\12\ In
section 11A, Congress identified key national market system objectives,
including the practicability of brokers executing investors' orders in
the best market.\13\ The Commission has rulemaking authority to further
the section 11A objectives.\14\ Separately, section 15 of the Exchange
Act provides authority for rules that are reasonably designed to
prevent fraudulent acts or practices. Specifically, section 15(c)(2)(A)
provides that no broker or dealer may make use of the mails or any
means or instrumentality of interstate commerce to effect any
transaction in, or to induce or attempt to induce the purchase or sale
of, any security (other than an exempted security \15\ or commercial
paper, bankers' acceptances, or commercial bills) otherwise than on a
national securities exchange of which it is a member, in connection
with which such broker or dealer engages in any fraudulent, deceptive,
or manipulative act or practice, or makes any fictitious quotation.\16\
Section 15(c)(2)(B) prohibits brokers, dealers, and municipal
securities dealers from engaging in such activity in ``any municipal
security.'' \17\ Section 15(c)(2)(C) prohibits government securities
brokers and government securities dealers from engaging in such
activity in any ``government security.'' \18\ Section 15(c)(2)(D)
authorizes the Commission to adopt rules that define, and prescribe
means reasonably designed to prevent, such acts and practices as are
fraudulent, deceptive, or manipulative and such quotations as are
fictitious.\19\ When a broker-dealer violates its duty of best
execution, it could be in violation of section 15(c) of the Exchange
Act.\20\
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\12\ 15 U.S.C. 78k-1; 15 U.S.C. 78o.
\13\ 15 U.S.C. 78k-1(a)(1)(C).
\14\ 15 U.S.C. 78k-1(a)(2).
\15\ See 15 U.S.C. 78c(a)(12) (defining the term ``exempted
security'' to include, among other things, government securities and
municipal securities, as defined in sections 3(a)(42) and 3(a)(29)
of the Exchange Act, respectively).
\16\ 15 U.S.C. 78o(c)(2)(A).
\17\ See 15 U.S.C. 78o(c)(2)(B). See also 15 U.S.C. 78c(a)(29)
(defining municipal securities).
\18\ See 15 U.S.C. 78o(c)(2)(C). See also 15 U.S.C. 78c(a)(42)
(defining government securities).
\19\ 15 U.S.C. 78o(c)(2)(D).
\20\ See, e.g., In the Matter of Knight Securities L.P.,
Securities Exchange Act Release No. 50867 (Dec. 16, 2004) (settled
action) (finding that the broker-dealer defrauded its institutional
customers by failing to provide best execution in violation of
section 15(c) of the Exchange Act).
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B. Prior Commission Statements
The Commission has made statements concerning the duty of best
execution in various contexts over the years. The following are some of
the statements that the Commission has made with respect to the duty of
best execution. The Commission solicits comment below, however, on
whether any of these prior statements should be revised in light of the
proposed rules.
The Commission has previously stated that the duty of best
execution requires a broker-dealer to execute customers' trades at the
most favorable terms reasonably available under the circumstances,
i.e., at the best reasonably available price.\21\ The Commission has
also recognized that price is a critical concern for investors.\22\ In
addition, the
[[Page 5443]]
Commission has described a non-exhaustive list of factors that may be
relevant to broker-dealers' best execution analysis. These factors
include the size of the order, speed of execution, clearing costs, the
trading characteristics of the security involved, the availability of
accurate information affecting choices as to the most favorable market
center for execution and the availability of technological aids to
process such information, and the cost and difficulty associated with
achieving an execution in a particular market center.\23\
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\21\ Securities Exchange Act Release No. 51808 (June 9, 2005),
70 FR 37496, 37538 (June 29, 2005) (``Regulation NMS Adopting
Release''). See also Geman v. SEC, 334 F.3d 1183, 1186 (10th Cir.
2003) (``[T]he duty of best execution requires that a broker-dealer
seek to obtain for its customer orders the most favorable terms
reasonably available under the circumstances.'') (quoting Newton,
supra note 8, 135 F.3d at 270); Kurz v. Fidelity Management &
Research Co., 556 F.3d 639, 640 (7th Cir. 2009) (describing the
``duty of best execution'' as ``getting the optimal combination of
price, speed, and liquidity for a securities trade'').
\22\ See Securities Exchange Act Release No. 43590 (Nov. 17,
2000), 65 FR 75414, 75418 (Dec. 1, 2000) (``Order Execution and
Routing Practice Release'') (``The Commission strongly believes,
however, that most investors care a great deal about the quality of
prices at which their orders are executed, and that an opportunity
for more vigorous competition among market participants to provide
the best quality of execution will enhance the efficiency of the
national market system.'').
\23\ See id., at 75422; Regulation NMS Adopting Release, supra
note 21, 70 FR 37538.
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Over the years, the Commission has stated the need for broker-
dealers to continue to modernize their best execution practices. For
example, the Commission has stated that broker-dealer practices for
achieving best execution, including the data, technology, and types of
markets they access, must constantly be updated as markets evolve.\24\
In particular, the Commission has stated that the scope of the duty of
best execution must evolve as changes occur in the market that give
rise to improved executions for customer orders, including
opportunities to trade at more advantageous prices.\25\ As these
changes occur, a broker-dealer's procedures for seeking best execution
for its customer orders also must be modified to consider price
opportunities that become reasonably available.\26\ In doing so,
broker-dealers must take into account price improvement opportunities
\27\ and whether different markets may be more suitable for different
types of orders or particular securities.\28\
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\24\ See Regulation NMS Adopting Release, supra note 21, 70 FR
at 37538; Order Execution Obligations Adopting Release, supra note
10, 61 FR at 48322-23.
\25\ See Order Execution Obligations Adopting Release, supra
note 10, 61 FR 48323.
\26\ See id.; Regulation NMS Adopting Release, supra note 21, 70
FR 37516 (stating that broker-dealers must examine their procedures
for seeking best execution in light of market and technology changes
and modify those practices if necessary to enable their customers to
obtain the best reasonably available prices).
\27\ See Order Execution Obligations Adopting Release, supra
note 10, 61 FR 48323 n.357 (stating that price improvement means the
difference between execution price and the best quotes prevailing in
the market at the time the order arrived at the market or market
maker, and that any evaluation of price improvement opportunities
would have to consider not only the extent to which orders are
executed at prices better than the prevailing quotes, but also the
extent to which orders are executed at inferior prices).
\28\ See id.
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In addition, the Commission has expressed concerns regarding
interpositioning and the duty of best execution. Interpositioning can
occur when a broker-dealer places a third party between itself and the
best market for executing a customer trade in a manner that results in
a customer not receiving the best available market price.\29\
Interpositioning can violate the broker-dealer's duty of best execution
when it results in unnecessary transaction costs at the expense of the
customer.\30\
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\29\ See Edward Sinclair, et al., Securities Exchange Act
Release No. 9115, 1971 WL 120487 (Mar. 24, 1971) (Comm'n op.),
aff'd, 444 F2d. 399 (2d Cir. 1971) (order clerk in OTC department of
broker-dealer interposed a broker-dealer between his firm and best
available market price in return for split of profits with the
interposed broker); H.C. Keister & Co., et al., Securities Exchange
Act Release No. 7988, 1966 WL 84120 (Nov. 1, 1966) (Comm'n op.) (in
exchange for payments, trader for a large broker-dealer
interpositioned a small broker-dealer between its customers' orders
and the best available market prices); Synovus Securities, Inc.,
Securities Exchange Act Release No. 34313, 1994 WL 323096 (July 5,
1994) (settled order) (broker-dealer and its president placed
customer orders with person who was able to promptly sell the bonds
to or buy the bonds from other brokers at a profit and customers did
not get the best market price). See also SEC v. Ridenour, 913 F.2d
515 (8th Cir. 1990) (a bond salesman violated the antifraud
provisions based on his secret interpositioning of his personal
trading account between his customers' securities transactions and
the fair market price of the trades).
\30\ See Thomson & McKinnon, Securities Exchange Act Release No.
8310, 1968 WL 87637 (May 8, 1968) (Comm'n op.) (a National
Association of Securities Dealers (``NASD'') member firm interposed
broker-dealers between itself and the best available market, and the
added transaction cost was borne by its customers; the Commission
found that, ``[i]n view of the obligation of a broker to obtain the
most favorable price for his customer, where he interposes another
broker-dealer between himself and a third broker-dealer, he prima
facie has not met that obligation and he has the burden of showing
that the customer's total cost or proceeds of the transaction is the
most favorable obtainable under the circumstances'').
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The Commission has also discussed its views with respect to the
application of best execution to different order types. With regard to
the handling of limit orders, broker-dealers must take into account
material differences in execution quality, such as the likelihood of
execution among the various markets or market centers to which limit
orders may be routed.\31\ Broker-dealers are also subject to the duty
of best execution when executing customer orders at the beginning of
regular trading hours and should take into account alternative methods
when considering how to execute these orders.\32\
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\31\ See Order Execution Obligations Adopting Release, supra
note 10, 61 FR 48323.
\32\ See Order Execution and Routing Practice Release, supra
note 22, 65 FR 75422 (recognizing that customer orders in listed
securities were executed at one opening price in an auction whereas
customer orders in Nasdaq securities at the time traded at the
quoted bids and offers resulting in a liquidity premium for a large
number of orders that effectively cross each other at a single point
in time).
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Moreover, the Commission has recognized practical challenges
associated with the handling of a large volume of orders. In
particular, the Commission acknowledged in 1994 that although it may be
impractical for a broker-dealer that handles a heavy volume of orders
to make an individual determination regarding where to route each order
it receives, the broker-dealer must use due diligence to seek the best
execution possible given all facts and circumstances.\33\ At that time,
the Commission reasoned that, in such circumstances, the duty of best
execution requires a broker-dealer to periodically assess the quality
of competing markets to ensure that order flow is directed to the
markets providing the most beneficial terms for its customer
orders.\34\
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\33\ See Securities Exchange Act Release No. 34902 (Oct. 27,
1994), FR Document 94-27109 (Nov. 2, 1994) (``Payment for Order Flow
Release'').
\34\ See id. See also Regulation NMS Adopting Release, supra
note 21, 70 FR 37516.
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The Commission has further identified the types of data needed by
broker-dealers to fulfill their duty of best execution. For example,
quotation information contained in the public quotation system must be
considered in seeking best execution of customer orders.\35\ In
adopting Rules 605 and 606 of Regulation NMS,\36\ the Commission
recognized that the reports required of market centers would provide
statistical disclosures regarding certain factors, such as execution
price and speed of execution, relevant to a broker-dealer's order
routing decision and that these public disclosures of execution quality
should help broker-dealers fulfill their duty of best execution.\37\
More recently, the Commission stated that broker-dealers should
consider the availability of consolidated market data, including the
various elements of data content and the timeliness, accuracy, and
reliability of the data in developing and maintaining their best
execution
[[Page 5444]]
policies and procedures.\38\ However, recognizing that best execution
analysis varies depending upon the characteristics of customers and
orders handled and the large array of potential scenarios, the
Commission stated that it cannot specify the data elements that may be
relevant to every specific situation.\39\
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\35\ See Order Execution Obligations Adopting Release, supra
note 10, 61 FR 48324.
\36\ See 17 CFR 242.605, 242.606.
\37\ See Order Execution and Routing Practice Release, supra
note 22, 65 FR 75413. The Commission further stated that the rules
were designed to generate uniform, general purpose statistics that
will prompt more vigorous competition on execution quality. The
information provided by these reports is not, by itself, sufficient
to support conclusions regarding the provision of best execution,
and any such conclusions would require a more in-depth analysis of
the broker-dealer's order routing practices than will be available
from the disclosures required by the rules. See id. at 75420.
\38\ See Securities Exchange Act Release No. 90610 (Dec. 9,
2020), 86 FR 18596, 18605-06 (Apr. 9, 2021) (``MDI Adopting
Release''). The Commission stated that it was not establishing
minimum data elements needed to achieve best execution nor mandating
consumption of the expanded data content. The Commission also
acknowledged that different market participants and different
trading applications have different market data needs. See id.
(citing Securities Exchange Act Release No. 88216 (Feb. 14, 2020),
85 FR 16726, 16734, 16755 (Mar. 24, 2020) (``Market Data
Infrastructure Proposing Release'')).
\39\ See MDI Adopting Release, supra note 38, 86 FR at 18606.
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The Commission has also stated the importance of price improvement
opportunities in the context of listed and over-the-counter (``OTC'')
equities.\40\ 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.\41\
Rather, broker-dealers handling small orders in listed and OTC equities
should look for price improvement opportunities when executing these
orders.\42\ And the expectation of price improvement for customer
orders is particularly important when broker-dealers receive payments
in return for routing their customer orders.\43\
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\40\ See Order Execution Obligations Adopting Release, supra
note 10, 61 FR at 48323. See also id. at 48323 n.357.
\41\ See id. at 48323.
\42\ See id.
\43\ See Payment for Order Flow Release, supra note 33, 59 FR at
55008. See also 17 CFR 240.10b-10(d)(8) (defining ``payment for
order flow'' as any monetary payment, service, property, or other
benefit that results in remuneration, compensation, or consideration
to a broker or dealer from any broker or dealer, national securities
exchange, registered securities association, or exchange member in
return for the routing of customer orders by such broker or dealer
to any broker or dealer, national securities exchange, registered
securities association, or exchange member for execution, including
but not limited to: research, clearance, custody, products or
services; reciprocal agreements for the provision of order flow;
adjustment of a broker or dealer's unfavorable trading errors;
offers to participate as underwriter in public offerings; stock
loans or shared interest accrued thereon; discounts, rebates, or any
other reductions of or credits against any fee to, or expense or
other financial obligation of, the broker or dealer routing a
customer order that exceeds that fee, expense or financial
obligation). Retail broker-dealers receiving cash payments from
wholesale market makers in return for routing their customers'
orders to the market maker for execution is a common example of
payment for order flow. See Memorandum to the SEC Equity Market
Structure Advisory Committee from the SEC Division of Trading and
Markets, Certain Issues Affecting Customers in the Current Equity
Market Structure 5-6 (Jan. 26, 2016). Staff reports, Investor
Bulletins, and other staff documents (including those cited herein)
represent the views of Commission staff and are not a rule,
regulation, or statement of the Commission. The Commission has
neither approved nor disapproved the content of these staff
documents and, like all staff statements, they have no legal force
or effect, do not alter or amend applicable law, and create no new
or additional obligations for any person.
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C. FINRA and MSRB Best Execution Rules
FINRA, an SRO,\44\ has a best execution rule (Rule 5310) and has
issued interpretive regulatory notices concerning its members' duty to
provide best execution to customer orders.\45\ FINRA Rule 5310 states
that, ``[i]n any transaction for or with a customer or customer of
another broker-dealer, a member and persons associated with a member
must 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.'' Over the years, FINRA and its predecessor, the
NASD, have modified the rule and issued interpretations to account for
changes in market practices and market structure, and to account for
new technologies and new data available to broker-dealers that handle
and execute customer orders.\46\
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\44\ While the MSRB is an SRO for only certain purposes of the
Exchange Act, see Exchange Act section 3(a)(26), 15 U.S.C.
78c(a)(26), MSRB rules are rules of an SRO, see Exchange Act section
3(a)(28), 15 U.S.C. 78c(a)(28). FINRA and the MSRB are both referred
to herein as SROs.
\45\ For ease of discussion and consistency, this release refers
to FINRA members as broker-dealers when discussing the FINRA rules
that are applicable to FINRA members.
\46\ See, e.g., FINRA Regulatory Notices 21-23 (June 23, 2021),
21-12 (Mar. 18, 2021), 18-29 (Sept. 12, 2018), 15-46 (Nov. 2015),
and 09-58 (Oct. 2009); NASD Notices to Members 01-22 (Apr. 2001),
00-42 (June 2000), and 99-12 (Feb. 1999).
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Modeled on FINRA Rule 5310,\47\ MSRB Rule G-18 is the best
execution rule for transactions in municipal securities \48\ and
similarly requires broker-dealers to ``use reasonable diligence to
ascertain the best market for the subject security and to buy or sell
in that market so that the resultant price to the customer is as
favorable as possible under prevailing market conditions.''
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\47\ In proposing Rule G-18, the MSRB stated that a best
execution rule should be generally harmonized with FINRA Rule 5310
for purposes of regulatory efficiency, but appropriately tailored to
the characteristics of the municipal securities markets. See
Securities Exchange Act Release No. 73764 (Dec. 5, 2014), 79 FR
73658 (Dec. 11, 2014) (``MSRB Best Execution Approval Order'').
While proposed Regulation Best Execution does not include different
requirements for markets with different characteristics, proposed
Regulation Best Execution is designed to enable broker-dealers to
tailor their compliance based on the different characteristics of
the markets.
\48\ MSRB Rule G-18 applies to brokers, dealers, and municipal
securities dealers. For ease of discussion and consistency, when
discussing the MSRB rule, the release refers to these entities
collectively as broker-dealers. Furthermore, the term ``municipal
securities'' throughout this release is referred to as either
``municipal bonds'' or ``municipal securities.''
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The Commission describes the elements in FINRA Rule 5310 and MSRB
Rule G-18, as well as the differences between those rules and the
proposed rules, in section IV below.
III. Existing Order Handling Practices and Overview of Proposed
Regulation Best Execution
A. Existing Order Handling Practices
1. General Broker-Dealer Practices
In the past few decades, there has been a proliferation of markets
and increasingly accessible prices across asset classes. For example,
broker-dealers have numerous execution venues from which to choose in
the NMS stock market. These include 16 registered equities exchanges,
an increase from 11 registered equities exchanges approximately 12
years ago.\49\ In the options markets, the number of options exchanges
continues to increase, with 6 new options exchanges in the last 10
years and 16 registered options exchanges operating today. In the
corporate and municipal bond markets and government securities markets,
traditional OTC voice trading protocols and customer liquidity
provision by principal trading desks of broker-dealers are being
supplemented by other methods of execution that are both electronic and
multilateral in nature. As of October 31, 2022, there are 21 corporate
bond alternative trading systems (``ATSs''), 7 municipal securities
ATSs, and 14 government securities ATSs, each operating pursuant to a
Form ATS currently on file with the Commission.
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\49\ See Securities Exchange Act Release No. 61358 (Jan. 14,
2010), 75 FR 3594 (Jan. 21, 2010) (``Concept Release on Equity
Market Structure'').
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The Commission believes that customers would benefit from broker-
dealers' robust considerations of liquidity sources and price
improvement opportunities, which may provide customers with the most
favorable prices. In the NMS stock market, for example, broker-dealers
that primarily service the accounts of individual investors (``retail
broker-dealers'') route more than 90% of their customers' marketable
orders to a small group of off-exchange dealers, known as
wholesalers,\50\ and the Commission
[[Page 5445]]
believes 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.
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\50\ See Table 8, infra section V.B.3.(a).i.d..
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For NMS stock orders that receive price improvement from
wholesalers, approximately 18.6% of those shares receive an amount of
price improvement of less than 0.1 cent per share when executed by the
wholesaler.\51\ Moreover, for stocks priced higher than $30, between
approximately 46-63% of shares executed by wholesalers received price
improvement that was less favorable than the midpoint of the prevailing
national best bid and offer (``NBBO'') at the time the wholesaler
received the order.\52\ For stocks priced higher than $30, it appears
that for between 60-93% of the shares executed by the wholesaler in a
principal capacity at a price less favorable than the NBBO midpoint
there was midpoint liquidity that was available on exchanges and ATSs
at the time the wholesaler executed the order.\53\ Retail broker-
dealers often do not route customer orders to execute against midpoint
liquidity that may be present on other markets prior to routing for
execution by wholesalers.\54\ While a retail broker-dealer's decision
to route orders to a wholesaler that provides price improvement may
indeed be consistent with its duty of best execution in many cases,\55\
the Commission believes 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.
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\51\ See Table 8, infra section V.B.3.(a).i.d.
\52\ The percentage ranges are based on stock prices, the
liquidity of the stock, whether or not the stock was in the S&P 500
Index, and whether or not the stock is an exchange-traded fund
(``ETF''). See Table 8, infra section V.B.3.(a).i.d (analysis
showing that depending on the type of NMS stock, its price, and
liquidity, between 46% and 73% of retail marketable order shares are
internalized by a wholesaler at a price worse than the NBBO
midpoint).
\53\ See Table 8, infra section V.B.3.(a).i.d (analysis showing
that, depending on the type of NMS stock, its price, and its
liquidity, between 40% and 93% of the shares in marketable retail
orders that wholesalers internalize at prices less favorable than
the NBBO midpoint had midpoint liquidity available at a better price
on an exchange or ATS).
\54\ See Table 3, infra section V.B.3.(a).i.d (according to
Table 3, retail brokers appear to outsource handling of over 87% of
customer orders and over 90% of customer marketable orders to
wholesalers).
\55\ For example, wholesalers appear to provide customers with
executions in NMS stocks at the midpoint or better (based on the
NBBO at the time the wholesaler received the order) for almost 46%
of the customer orders executed by the wholesaler in a principal
capacity. See Table 7, infra section V.B.3.(a).i.d . But see supra
note 53 and accompanying text (describing that for stocks priced
higher than $30, it appears that between 60-93% of the shares
executed by the wholesaler in a principal capacity at a price less
favorable than the NBBO midpoint had liquidity available at the NBBO
midpoint on an exchange or ATS).
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Similar considerations are present with the order handling and
routing practices of wholesalers in the NMS stock market.\56\ While the
prices that wholesalers provide to a customer may often justify the
determination by the wholesaler that it is the best market for the
customer order, the specific amount of price improvement for orders
that are executed internally is largely within the discretion of the
wholesaler. The wholesaler typically first determines whether or not it
desires to transact with a particular customer order in a principal
capacity. Should it choose to do so, the wholesaler determines what
amount of price improvement it will provide for the order, and the data
described above shows that wholesalers often do not execute customer
orders at the NBBO midpoint. When the wholesaler has determined that it
does not want to transact with a customer order in a principal
capacity, the wholesaler may attempt to route such order to other
markets.
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\56\ Wholesalers owe a duty of best execution to the customers
of retail broker-dealers under FINRA Rule 5310. See FINRA Rule
5310(a) (applying its best execution requirements to any transaction
for or with a customer or a customer of another broker-dealer).
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As discussed in section III.A.2, the Commission believes that
customers would benefit from robust considerations by broker-dealers of
liquidity sources and price improvement opportunities in the options
market, particularly with respect to transactions that involve order
handling conflicts of interest.
The corporate and municipal bond markets and the government
securities markets are different from the NMS stock market in
substantial ways that can impact how a broker-dealer fulfills its duty
of best execution. For example, market participants do not have the
same level of price transparency in these markets as they do in the NMS
stock market. While the corporate and municipal bond markets
disseminate post-trade price information, this information often is not
available immediately upon execution of a bond transaction as FINRA and
MSRB rules permit a trade to be reported within 15 minutes of the
transaction.\57\ In the government securities market, there is no real-
time public dissemination of post-trade price information. Despite the
increase in electronic trading and the use of ATSs, these markets are
decentralized with most trading occurring through broker-dealers that
make markets in securities they have underwritten or hold in
inventory.\58\ There is virtually no exchange trading of these
bonds.\59\ Generally, trades occur both by voice and through the use of
electronic systems that provide trading facilities and communication
protocols with varying degrees of execution functionality and access to
pre-trade pricing information.\60\ However, market participants in the
corporate and municipal bond markets and the government securities
markets are increasingly utilizing technology to trade these
securities, and electronic trading is growing.\61\ The lower level of
price transparency in, and the decentralized nature of, the corporate
and municipal bond and government securities markets make it more
difficult for customers to evaluate their transactions and highlights
the importance of robust best execution considerations by broker-
dealers in these markets.
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\57\ However, both FINRA and the MSRB recently solicited comment
about shortening the applicable transaction reporting window to one
minute. See FINRA Regulatory Notice 22-17 (Aug. 2, 2022); MSRB
Notice 2022-07 (Aug. 2, 2022).
\58\ See, e.g., Maureen O'Hara & Xing (Alex) Zhou, Anatomy of a
Liquidity Crisis: Corporate Bonds in the COVID-19 Crisis, 142 J.
Fin. Econ. 46 (2021).
\59\ A small percentage of corporate bonds are exchange-traded
on trading systems such as NYSE Bonds and the Nasdaq Bond Exchange.
See generally, https://www.nyse.com/markets/bonds and https://www.nasdaq.com/solutions/nasdaq-bond-exchange. Trading volume in
exchange-traded bonds was reported to be around $19 billion as of
January 2020. See Securities Exchange Act Release No. 94062 (Jan.
26, 2022), 87 FR 15496 (Mar. 18, 2022) (``Government Securities ATS
Proposing Release''), at 15604 n.863 (citing Eric Uhlfelder, A
Forgotten Investment Worth Considering: Exchange-Traded Bonds, Wall
St. J. (Jan. 5, 2020), https://www.wsj.com/articles/a-forgotten-investment-worth-considering-exchange-traded-bonds-11578279781).
\60\ See Government Securities ATS Proposing Release, supra note
59, 87 FR 15606.
\61\ For example, according to one industry group, approximately
32% of investment-grade and 23% of high-yield corporate bond daily
dollar volumes are executed electronically. See id., at 15606 n.890.
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Commission analysis shows significant differences in the
variability of execution prices among interdealer trades \62\ compared
to the variability of execution prices among customer trades in the
same bonds on the same trading day. For example, in the corporate bond
market, the dispersion, or standard deviation, of customer execution
prices for transactions under $100,000 was almost 3 times more than
that of interdealer execution prices.\63\
[[Page 5446]]
Similarly, in the municipal bond market, the dispersion of customer
execution prices for transactions under $100,000 was more than 4 times
greater than that of interdealer trades.\64\ And in the government
securities market, the dispersion of customer execution prices for
transactions under $100,000 was almost 40 percent greater than that of
interdealer trades.\65\ The variability of prices for customer
transactions suggests that some customers may be paying or receiving
worse prices than other customers in the same security on the same day
because their broker-dealers may not be evaluating as many markets for
those transactions as other broker-dealers. While it is possible that
some of the variability of prices paid by customers may be attributable
to variations in broker-dealer compensation as reflected in the markups
or markdowns charged by broker-dealers when they transact with
customers in a principal capacity, the Commission does not believe that
this is the only reason for customer price dispersion in the same bonds
on the same day.\66\ For example, Commission analysis shows that in the
corporate bond market, for trades that were reported by the broker-
dealer as not involving any collection of commissions, markups or
markdowns, the dispersion of customer execution prices was still 65%
greater than that of interdealer trades.\67\ Because the variability in
the customer execution prices suggests that some broker-dealers may not
be exercising as much diligence in identifying the best market for
customer orders, the Commission believes that customers would benefit
from consistently robust best execution considerations by broker-
dealers, including considerations of the various markets that may
provide their customers with the most favorable prices.
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\62\ It is well-established that interdealer prices can reflect
the prevailing market value for a bond. See, e.g., FINRA Rule 2121.
\63\ See Table 17, infra section V.B.3.b.i.
\64\ See Table 17, infra section V.B.3.b.i and V.B.3.b.ii.
\65\ See Table 17, infra section V.B.31.b.i and V.B.3.b.iii .
\66\ See, e.g., John M. Griffin, Nicholas Hirschey, and Samuel
Kruger, Do Municipal Bond Dealers Give their Customers `Fair and
Reasonable' Pricing? J. Fin., Forthcoming (Aug. 4, 2022) (``Instead
of delivering uniform pricing, dealer transactions with customers
take place at highly variable markups relative to both reoffering
prices and dealer costs. On the same day, customers frequently buy
the same bond at different prices from different dealers, and prices
even vary across different customers purchasing the same bond from
the same dealer on the same day. These price differences are not
explained by trade characteristics or by dealer costs. Some dealers
provide customers with low and consistent markups, but this does not
appear to be the industry norm. Pricing at quarter or eighth price
or yield increments is common and is seemingly a method to deliver
higher markups.'').
\67\ See infra note 478.
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2. Order Handling Conflicts of Interest
The Commission also believes that execution of retail customer
orders by broker-dealers that have order handling conflicts of interest
warrants heightened attention by those broker-dealers. These order
handling conflicts of interest include payment for order flow,
principal trading, and routing customer orders to affiliates.
Payment for order flow \68\ creates a conflict of interest because
it creates an incentive for a broker-dealer to send customer orders to
a market, such as a wholesaler or an exchange, which agrees to pay the
broker-dealer for sending its customer orders.\69\ Payment for order
flow may harm customers because the broker-dealer may be making order
handling decisions to benefit itself at the expense of its
customer.\70\ Because payment for order flow is a form of economic
inducement that has the potential to influence the way a broker-dealer
handles customer orders, the Commission has stated that such
arrangements must be considered as part of a broker-dealer's best
execution assessment.\71\
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\68\ When discussing payment for order flow in the context of
the proposed rules, the Commission uses the term as defined in
Exchange Act Rule 10b-10(d)(8). This definition includes payment for
order flow from wholesalers to retail broker-dealers, as well as
exchange rebates that are paid to broker-dealers in return for
sending orders to the exchange. See 17 CFR 240.10b-10 (defining
payment for order flow and requiring a broker-dealer to disclose to
the customer whether payment for order flow is received by the
broker-dealer for the customer transaction and the fact that the
source and nature of the compensation received in connection with
the particular transaction will be furnished upon written request of
the customer).
\69\ See, e.g., Payment for Order Flow Release, supra note 33,
FR Doc No: 94-27109; FINRA Regulatory Notice 21-23; Robinhood
Financial, LLC, Letter of Acceptance, Waiver and Consent (FINRA Case
No. 2017056224001) (Dec. 2019) (``Robinhood FINRA'') (describing
violations of FINRA's best execution rule where the firm routed its
customers' orders to four broker-dealers that all paid for order
flow and ``did not exercise reasonable diligence to ascertain
whether these four broker-dealers provided the best market for the
subject securities to ensure its customers received the best
execution quality from these as compared to other execution
venues''); In the Matter of Robinhood Financial, LLC, Securities
Exchange Act Release No. 90694 (Dec. 17, 2020) (settled action)
(``Robinhood SEC''). Broker-dealers that accept payment for order
flow must disclose certain information concerning the payments
publicly. See 17 CFR 242.606(a)(1)(iv) (requiring a description of
any arrangement for payment for order flow and any profit-sharing
relationship and a description of any terms of such arrangements,
written or oral, that may influence a broker-dealer's order routing
decision).
\70\ See, e.g., Robinhood FINRA, supra note 69; Robinhood SEC,
supra note 69 (finding that the retail broker-dealer explicitly
offered to accept less price improvement for its customers than what
the wholesalers were offering, in exchange for receiving a higher
rate of payment for order flow for itself).
\71\ See Payment for Order Flow Release, supra note 33, FR Doc
No: 94-27109.
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While the Commission has stated that a broker-dealer's receipt of
payment for order flow is not a violation of its duty of best execution
as long as it periodically assesses the quality of the markets to which
it routes order flow, a broker-dealer must not allow payment for order
flow to interfere with its efforts to obtain best execution.\72\
Likewise, FINRA has stated that broker-dealers may not negotiate the
terms of order routing arrangements for customer orders in a manner
that reduces the price improvement opportunities that, absent payment
for order flow, otherwise would be available to those customer
orders.\73\ FINRA has also stated that obtaining price improvement is a
heightened consideration when a broker-dealer receives payment for
order flow and it is especially important to determine that customers
are receiving the best price and execution quality opportunities
notwithstanding the payment for order flow.\74\ Accordingly, the
Commission believes that the receipt of payment for customer order flow
continues to warrant heightened attention by broker-dealers.\75\
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\72\ See id.
\73\ See FINRA Regulatory Notice 21-23 (June 23, 2021).
\74\ See id., at 3-4. FINRA has also stated that ``inducements
such as payment for order flow and internalization may not be taken
into account in analyzing market quality.'' See id. at 4.
\75\ Commission staff, in a recent report, stated that
wholesaler payment for order flow to retail broker-dealers is
``individually negotiated prior to trading between the retail
broker-dealer and the [wholesaler], and the rates and amounts can
vary substantially depending on the broker-dealer and its customer
order flow. [Wholesalers] may give the retail broker the choice of
how to allocate those funds--either by applying some or all of that
payment to improve the prices of its customers' orders or by
allowing the retail broker-dealer to keep part of the payment for
itself.'' Commission staff stated that these payments can create a
conflict of interest for the retail broker-dealer. See Staff Report
on Equity and Options Market Structure Conditions in Early 2021
(Oct. 14, 2021), available at https://www.sec.gov/files/staff-report-equity-options-market-struction-conditions-early-2021.pdf.
Additionally, Rule 606(a) of Regulation NMS requires broker-dealers
to make publicly available on a quarterly basis certain aggregated
order routing disclosures for held orders that provide, among other
things, detailed disclosure of payments received from or paid to
certain trading centers, as well as a discussion of the material
aspects of broker-dealers' relationships with those trading centers,
including a description of any arrangements for payment for order
flow and any profit-sharing relationships and a description of any
terms of such arrangements, written or oral, that may influence
broker-dealers' order routing decisions. See 17 CFR 242.606(a).
---------------------------------------------------------------------------
A significant portion of retail orders in the NMS stock and listed
options market is routed in return for payment
[[Page 5447]]
for order flow. In the first quarter of 2022, wholesalers paid more
than $796 million dollars to retail broker-dealers for order flow in
NMS stocks and listed options.\76\ Listed options represented
approximately 70% of the total payment for order flow with more than
$561 million paid to retail broker-dealers by wholesalers.\77\ Payment
for order flow creates an incentive for the retail broker-dealer to
adopt order handling and execution practices that may not result in
best execution for their customers.\78\ For example, as discussed more
fully in section V, analysis in the NMS stock market appears to show
that payment for order flow can harm customer execution quality. More
specifically, the orders of broker-dealers that receive more payment
for order flow from wholesalers are internalized by wholesalers with
(1) higher effective spreads, (2) higher execution quality ratios, and
(3) slightly smaller price improvement when compared with the orders of
broker-dealers that do not receive payment for order flow and that are
internalized by wholesalers.\79\ In the context of exchange rebates in
the options market, one study finds that some brokers seemingly route
non-marketable orders to exchanges that offer large liquidity rebates
to maximize the value of order flow and suggests that broker-dealers
can enhance non-marketable limit order execution quality by routing
those orders to exchanges that do not offer liquidity rebates to non-
marketable limit orders.\80\
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\76\ See Table 12, infra section V.B.3.(a).iii.a.
\77\ See id. See also Thomas Ernst & Chester S. Spatt, Payment
for Order Flow and Asset Choice, 40 (NBER Working Paper No. w29883,
May 2022), https://ssrn.com/abstract=4068065 (retrieved from
Elsevier database) (finding that approximately 65% of all payment
for order flow is attributable to the options market). In addition
to payment for order flow paid by wholesalers to retail broker-
dealers, some exchanges administer ``marketing fee'' programs
pursuant to rules filed with the Commission, that result in payment
for order flow directed by exchange market makers to order flow
providers, which can include retail broker-dealers. See, e.g.,
Nasdaq Phlx LLC Options 7, Section 4; Miami International Securities
Exchange LLC Fee Schedule Section (1)(a)(xi); NYSE American LLC
Options Fee Schedule Section I.A. Under these programs, the
exchanges assess fees on market makers who then typically direct the
disbursement of some or all of the marketing fees to selected market
participants in return for retail order flow directed to the market
makers from the broker-dealer recipients of the marketing fees. If
the directed market maker is quoting at the NBBO when the order is
received, exchange rules typically guarantee the market maker a
certain allocation of the incoming directed order, typically
determined by the number of other market makers quoting at the NBBO
at the time the order is received. See, e.g., PHLX Options 3,
Section 10(a)(1)(C) (describing the directed market maker priority).
\78\ The Commission and FINRA settled claims against a retail
broker-dealer for, among other things, failing to provide best
execution to customer orders for which it received payment for order
flow. See supra note 69. The inherent trade-off between payment for
order flow for a retail broker-dealer and price improvement for
their customers was discussed in the Commission's settled
enforcement action against the retail broker. See Robinhood SEC,
supra note 69. The Commission found that the retail broker-dealer
had negotiated with a number of wholesalers about potentially
routing customer orders to those firms and that, in the course of
those negotiations, certain of the wholesalers told the retail
broker-dealer that there was a trade-off between payment for order
flow on the one hand and price improvement on the other. See id. The
Commission also found that the retail broker-dealer explicitly
offered to accept less price improvement for its customers than what
the wholesalers were offering, in exchange for receiving a higher
rate of payment for order flow for itself. See id. Subsequently, the
retail broker-dealer conducted a more extensive internal analysis,
which showed that its execution quality and price improvement
metrics were substantially worse than other retail broker-dealers in
many respects, including the percentage of orders that received
price improvement and the amount of price improvement, measured on a
per order, per share, and per dollar traded basis. See id.
\79\ See Table 16, infra section V.B.3.b..iii.b.
\80\ See Robert Battalio et al., Do (Should) Brokers Route Limit
Orders to Options Exchanges That Purchase Order Flow?, 56 J. Fin. &
Quantitative Analysis 183 (2020).
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The Commission has also acknowledged that the opportunity for a
broker-dealer to trade with a customer order as principal is an order
routing inducement that could interfere with the broker-dealer's duty
of best execution.\81\ Internalizing customer orders may create a
conflict of interest because broker-dealers do so for the opportunity
to capture the spread,\82\ and may thereby provide broker-dealers an
incentive to trade with orders as principal. In the NMS stock market
and listed options market, principal trading with retail customers is a
common practice. As stated above in section III.A.1, a significant
portion of retail customer orders are routed to wholesalers for
handling and execution. Once the wholesaler receives retail customer
orders for handling and execution, it often trades with those customer
orders as principal. Wholesalers internalize over 90% of the dollar
value of the marketable order flow retail broker-dealers send them.\83\
The Commission believes that the incentive to trade in a principal
capacity at a price most advantageous for the wholesaler itself rather
than the customer warrants heightened attention by the wholesaler.
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\81\ See Order Execution Obligations Adopting Release, supra
note 10, 61 FR 48323.
\82\ See Internalized/Affiliate Practices, Payment for Order
Flow and Order Routing Practices, Securities Exchange Act Release
No. 34903 (Oct. 27, 1994), 59 FR 55014, 55014 (Nov. 2, 1994)
(recognizing several commenters who described this conflict of
interest).
\83\ See Table 7, infra Section V.B.3.a.i.d.
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Principal trading in the listed options market is also common.
Options exchange trading and priority rules, which must be filed with
the Commission under section 19(b) of the Exchange Act \84\ and Rule
19b-4 thereunder,\85\ provide wholesalers with a number of methods to
internalize customer orders. For example, the wholesaler or an
affiliate is often either a specialist or directed market maker on one
or more of the options exchanges. Exchange rules typically provide the
specialist or directed market maker with the right to trade with a
certain portion of incoming order flow regardless of whether other
market participants may also be quoting at the same price as the
specialist or directed market maker.\86\ These ``allocation
guarantees'' effectively allow the wholesaler to internalize a minimum
amount of the customer orders by routing the customer orders to
exchanges where the wholesaler or its affiliate is designated as a
specialist or directed market maker. Similarly, many options exchanges
provide small order guarantees that permit the specialist (which
potentially can be an affiliate of the wholesaler) to trade with 100%
of all orders sent to the exchange for five contracts or less.\87\
Moreover, options exchanges' two-sided auctions (``price improvement
auctions'') allow a wholesaler to internalize a customer order by
submitting a proposed transaction between the wholesaler and a customer
at a specified price.\88\ Other market participants are permitted to
compete with the wholesaler for the opportunity to trade with the
customer order. These price improvement auctions, however, generally
afford the wholesaler with certain advantages over other market
participants that may be interested in competing for the right to trade
with a customer order.\89\ The Commission estimates that wholesalers in
the listed options market generally internalize approximately 31% of
the executed
[[Page 5448]]
orders routed to option exchanges, with approximately 73% of orders
routed to price improvement auctions being internalized and
approximately 17% of orders routed to the limit order book being
internalized.\90\ The Commission believes that the incentive to trade
in a principal capacity at a price most advantageous for the wholesaler
itself rather than the customer warrants heightened attention by the
wholesaler.
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\84\ 15 U.S.C. 78s(b).
\85\ 17 CFR 240.19b-4.
\86\ See, e.g., BOX Exchange LLC Rule 7135(c); Miami
International Securities Exchange LLC Rule 514(g)-(i); Nasdaq Phlx
LLC Options 3, Section 10(a)(1); Nasdaq ISE, LLC Options 3, Section
10(c)(1); NYSE American LLC Rule 964NY(b)(2).
\87\ See, e.g., Nasdaq ISE, LLC Options 3, Section 10(c)(1)(D);
Nasdaq Phlx LLC Options 3, Section 10(a)(1)(D); BOX Exchange LLC
Rule 7135(c)(2)(iii); NYSE American LLC Rule 964NY(b)(2)(C)(iv).
\88\ Customer orders that are submitted into price improvement
auctions are guaranteed complete execution at a minimum execution
price and are electronically auctioned for price improvement. See,
e.g., Nasdaq ISE, LLC Options 3, Section 13; Nasdaq Phlx LLC Options
3, Section 13; Miami International Securities Exchange LLC Rule
515A; BOX Exchange LLC Rule 7150; NYSE American LLC Rule 971.1NY;
Cboe Exchange, Inc. Rule 5.37.
\89\ See infra notes 137-140 and accompanying text.
\90\ See infra Section V.B.3.a.ii.
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Finally, the practice of routing customer orders to affiliates
raises a conflict of interest for the broker-dealer. When a broker-
dealer chooses to route customer orders to an affiliate, it may do so
because of financial incentives, and these incentives can vary
depending on the business model or business lines of the broker-dealer.
For example, broker-dealers may have conflicts of interest to the
extent that they operate or are affiliated with an entity that operates
a trading venue, such as an ATS, because the broker-dealer or its
affiliate receives financial benefits when the broker-dealer operator
chooses to route customer orders to its ATS for execution (e.g., by
routing an order to its ATS, a broker-dealer operator that does not
pass through trading fees to its customers may be able to avoid paying
fees that it otherwise would have to pay when routing and executing
orders on unaffiliated trading venues).\91\ A broker-dealer operator
also benefits by routing to its ATS because it creates higher volume on
the ATS, which can attract additional order flow to the ATS, ultimately
increasing the ATS' market share and associated revenue.\92\ Another
example of affiliate routing conflicts of interest relates to a
financial services firm that may have an organizational structure that
separates its retail facing business from its order handling and
execution business. The retail broker-dealer that receives a customer
order may have a financial incentive to send the customer order to its
affiliated executing broker-dealer because the affiliated executing
broker-dealer may wish to trade as principal with the customer order.
While an affiliated executing broker-dealer could provide best
execution for customer orders, the incentive to send customer orders to
an affiliate may influence the broker-dealer to route the customer
order in a manner that maximizes the broker-dealer's interest, rather
than route the customer order to another market consistent with its
duty of best execution.\93\ Accordingly, the Commission believes that
the impact of this practice on customer orders continues to warrant
heightened attention by broker-dealers.
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\91\ See Amber Anand et al., Institutional Order Handling and
Broker-Affiliated Trading Venues, 34 Rev. Fin. Stud. 3364, 3366
(July 2021) (``Anand'') (recognizing the conflict between obtaining
the best outcome for the customer and maximizing the broker-dealer's
revenue due to avoiding a fee that is typically borne by the broker-
dealer). This study found that ``institutional brokers who route
more orders to affiliated [ATSs] are associated with lower execution
quality (i.e., lower fill rates and higher implementation shortfall
costs).'' Id. See also Regulation of NMS Stock Alternative Trading
Systems, Securities Exchange Act Release No. 83663 (July 18, 2018),
83 FR 38768, 38775, 38834 (Aug. 7, 2018).
\92\ See Anand, supra note 91, at 3366.
\93\ Recently, FINRA has entered into settlements with broker-
dealers for best execution violations of FINRA rules involving
affiliated routing practices. In one case, FINRA found that the
broker-dealer ``failed to consider whether alternate routing
arrangements could have provided price improvement opportunities and
better speed of execution'' for customer orders despite its
consideration of certain execution quality factors for orders routed
to an affiliated ATS. FINRA also stated that ``although [the firm]
reviewed fill rates in [its affiliated ATS] during the relevant
period, the firm failed to consider alternate routing arrangements
when the firm showed that fill rates in [its affiliated ATS] were
inferior to fill rates at some competing execution venues.'' FINRA
found that this practice violated FINRA's best execution rule. See
Barclays Capital Inc., Letter of Acceptance, Waiver, and Consent No.
2014041808601 (Oct. 4, 2022), available at https://www.finra.org/sites/default/files/2022-10/Barclays-Capital-AWC-100522.pdf. In
another case, FINRA found that the broker-dealer routinely routed
institutional customer orders to its affiliated ATS prior to routing
such orders to exchanges or to other ATSs. According to FINRA's
findings, the broker-dealer routed to its affiliated ATS despite
having evidence that (1) orders that were sent to the affiliated ATS
had lower fill rates as compared to orders sent directly to
exchanges, and (2) other ATSs consistently ranked higher in the
firm's rankings for execution quality than the affiliated ATS. FINRA
found that this affiliated routing practice violated FINRA's best
execution rule 5310. See Deutsche Bank Securities Inc., Letter of
Acceptance, Waiver, and Consent No. 2014041813501 (Mar. 7, 2022),
available at https://www.finra.org/sites/default/files/2022-03/deutsche-bank-awc-030722.pdf.
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3. Crypto Asset Securities
As discussed in section II.A above, a broker-dealer has a legal
duty to seek best execution of customer orders in securities. Proposed
Regulation Best Execution would apply to all securities, including any
digital asset that is a security or a government security under the
Federal securities laws. The term ``digital asset'' refers to 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.'' \94\
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\94\ See Custody of Digital Asset Securities by Special Purpose
Broker-Dealers, Securities Exchange Act Release No. 90788 (Dec. 23,
2020), 86 FR 11627, 11627 n.1 (Feb. 26, 2021) (``Crypto Asset
Securities Custody Release''). A digital asset may or may not meet
the definition of a ``security'' under the Federal securities laws.
See, e.g., Report of Investigation Pursuant to Section 21(a) of the
Securities Exchange Act of 1934: The DAO, Securities Exchange Act
Release No. 81207 (July 25, 2017) (``DAO 21(a) Report''), available
at https://www.sec.gov/litigation/investreport/34-81207.pdf. See
also SEC v. W.J. Howey Co., 328 U.S. 293 (1946). To the extent
digital assets rely on cryptographic protocols, these types of
assets also are commonly referred to as ``crypto assets'' and
``digital asset securities'' can be referred to as ``crypto asset
securities.'' For purposes of this release, the Commission does not
distinguish between the terms ``digital asset securities'' and
``crypto asset securities.''
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Unlike securities that are not issued or transferred using
distributed ledger technology, the Commission has limited information
about the order handling and best execution practices of broker-dealers
that engage in transactions for or with customers in crypto asset
securities.\95\ This information limitation is, in part, due to the
fact that only a small portion of crypto asset security trading
activity is occurring within entities that are registered with the
Commission and any of the SROs. For example, there are currently no
special purpose broker-dealers authorized to maintain custody of crypto
asset securities.\96\ Similarly, only a limited
[[Page 5449]]
amount of crypto asset security volume is executed on trading venues
under the Commission's ATS framework.\97\ This information limitation
is also, in part, due to the significant trading activity in crypto
asset securities that may be occurring in non-compliance with the
Federal securities laws.\98\
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\95\ See, e.g., Fin. Stability Oversight Council, Report on
Digital Asset Financial Stability Risks and Regulation 119 (2022)
(``FSOC Report''), available at https://home.treasury.gov/system/files/261/FSOC-Digital-Assets-Report-2022.pdf (``The crypto-asset
ecosystem is characterized by opacity that creates challenges for
the assessment of financial stability risks.''); U.S. Dep't of the
Treasury, Crypto-Assets: Implications for Consumers, Investors, and
Businesses 12 (Sept. 2022) (``Crypto-Assets Treasury Report''),
available at https://home.treasury.gov/system/files/136/CryptoAsset_EO5.pdf (finding that data pertaining to ``off-chain
activity'' is limited and subject to voluntary disclosure by trading
platforms and protocols, with protocols either not complying with or
not subject to obligations ``to report accurate trade information
periodically to regulators or to ensure the quality, consistency,
and reliability of their public trade data''); Fin. Stability Bd.,
Assessment of Risks to Financial Stability from Crypto-assets 18-19
(Feb. 16, 2022) (``FSB Report''), available at https://www.fsb.org/wp-content/uploads/P160222.pdf (finding that the difficulty in
aggregating and analyzing available data in the digital asset space
``limits the amount of insight that can be gained with regard to the
[digital asset] market structure and functioning,'' including who
the market participants are and where the market's holdings are
concentrated, which, among other things, limits regulators' ability
to inform policy and supervision); Raphael Auer et al., Banking in
the Shadow of Bitcoin? The Institutional Adoption of
Cryptocurrencies 4, 9 (Bank for Int'l Settlements, Working Paper No.
1013, May 2022), available at https://www.bis.org/publ/work1013.pdf
(stating that data gaps, which can be caused by limited disclosure
requirements, risk undermining the ability for holistic oversight
and regulation of cryptocurrencies); Int'l Monetary Fund, The Crypto
Ecosystem and Financial Stability Challenges, in Global Financial
Stability Report 41, 47 (Oct. 2021), available at https://www.imf.org/-/media/Files/Publications/GFSR/2021/October/English/ch2.ashx (finding that digital asset service providers provide
limited, fragmented, and, in some cases, unreliable data, as the
information is provided voluntarily without standardization and, in
some cases, with an incentive to manipulate the data provided).
\96\ For background on Rule 15c3-3, 17 CFR 240.15c3-3, as it
relates to digital asset securities, see U.S. Sec. & Exch. Comm'n,
Joint Staff Statement on Broker-Dealer Custody of Digital Asset
Securities (July 8, 2019), https://www.sec.gov/news/public-statement/joint-staff-statement-broker-dealer-custody-digital-asset-securities; Fin. Indus. Regul. Auth., SEC Staff No-Action Letter,
ATS Role in the Settlement of Digital Asset Security Trades (Sept.
25, 2020), available at https://www.sec.gov/divisions/marketreg/mr-noaction/2020/finra-ats-role-in-settlement-of-digital-asset-security-trades-09252020.pdf. To date, five offerings of crypto
asset securities have been registered or qualified under the
Securities Act of 1933, and five classes of crypto asset securities
have been registered under the Exchange Act. The Commission issued a
statement describing its position that, for a period of five years,
special purpose broker-dealers operating under the circumstances set
forth in the statement will not be subject to a Commission
enforcement action on the basis that the broker-dealer deems itself
to have obtained and maintained physical possession or control of
customer fully paid and excess margin digital asset securities for
purposes of Rule 15c3-3(b)(1) under the Exchange Act. See Crypto
Asset Securities Custody Release, supra note 94. To date, no such
special purpose broker-dealer registration applications have been
granted by FINRA.
\97\ ATSs that do not trade NMS stocks file with the Commission
a Form ATS notice, which the Commission does not approve. Form ATS
requires, among other things, that ATSs provide information about:
classes of subscribers and differences in access to the services
offered by the ATS to different groups or classes of subscribers;
securities the ATS expects to trade; any entity other than the ATS
involved in its operations; the manner in which the system operates;
how subscribers access the trading system; procedures governing
entry of trading interest and execution; and trade reporting,
clearance, and settlement of trades on the ATS. In addition, all
ATSs must file quarterly reports on Form ATS-R with the Commission.
Form ATS-R requires, among other things, volume information for
specified categories of securities, a list of all securities traded
in the ATS during the quarter, and a list of all subscribers that
were participants. To the extent that an ATS trades crypto asset
securities, the ATS must disclose information regarding its crypto
asset securities activities as required by Form ATS and Form ATS-R.
Form ATS and Form ATS-R are deemed confidential when filed with the
Commission. Based on information provided on these forms, a limited
number of ATSs have noticed on Form ATS their intention to trade
certain crypto asset securities and a subset of those ATSs have
reported transactions in crypto asset securities on their Form ATS-
R.
\98\ See also FSOC Report, supra note 95, at 5, 87, 94, 97
(emphasizing the importance of the existing financial regulatory
structure while stating that certain digital asset platforms may be
listing securities while not in compliance with exchange, broker-
dealer, or other registration requirements, which may impose
additional risk on banks and investors and result in ``serious
consumer and investor protection issues''); Crypto-Assets Treasury
Report, supra note 95, at 26, 29, 39, 40 (stating that issuers and
platforms in the digital asset ecosystem may be acting in non-
compliance with statutes and regulations governing traditional
capital markets, with market participants that actively dispute the
application of existing laws and regulations, creating risks to
investors from non-compliance with, in particular, extensive
disclosure requirements and market conduct standards); FSB Report,
supra note 95, at 4, 8, 18 (stating that some trading activity in
crypto assets may be failing to comply with applicable laws and
regulations, while failing to provide basic investor protections due
to their operation outside of or in non-compliance with regulatory
frameworks, thereby failing to provide the ``market integrity,
investor protection or transparency seen in appropriately regulated
and supervised financial markets'').
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The Commission believes that it is appropriate for a broker-dealer
that engages in transactions for or with customers or customers of
another broker-dealer in crypto asset securities to be subject to
proposed Regulation Best Execution. As discussed in section I above,
the duty of best execution is of fundamental importance to investors
and the markets, including investors in, and the market for, crypto
asset securities. For example, a customer transacting in crypto asset
securities should receive the protections afforded by the requirement
that broker-dealers exercise reasonable diligence to ascertain the best
market for the crypto asset securities and buy and sell in such market
so that the price to the customer is as favorable as possible under
prevailing market conditions. In doing so, broker-dealers should be
taking steps to ensure that they are evaluating the range of markets
that trade crypto asset securities and appropriately identifying those
markets that may be likely to provide customers with the most favorable
prices.
B. Overview of Proposed Regulation Best Execution
The Commission believes that proposed Regulation Best Execution
would further the Congressional goal set forth in Exchange Act Section
11A(a)(1)(C)(iv) regarding executing investors' orders in the best
market and reinforce broker-dealer obligations concerning the duty of
best execution. In particular, proposed Regulation Best Execution would
identify specific factors that must be addressed by a broker-dealer's
policies and procedures on best execution, impose additional
requirements for conflicted transactions, and impose best execution-
specific review and documentation requirements, all of which should
better protect investors by promoting consistently robust order
handling and execution practices.\99\
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\99\ See section IV for discussions of the differences between
the proposed rules and the existing FINRA and MSRB rules on best
execution. As discussed in detail in section IV, proposed Regulation
Best Execution is consistent with the FINRA and MSRB best execution
rules in some respects and, in some other respects, goes beyond
those rules imposing additional and/or more specific requirements.
---------------------------------------------------------------------------
Proposed Rule 1100 would set forth the standard of best execution,
requiring a broker-dealer to use reasonable diligence to ascertain the
best market for a 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. Proposed Rule 1101 would require a
broker-dealer to establish, maintain, and enforce written policies and
procedures that address specific elements that are designed to promote
the best execution of customer orders, and comply with certain
execution quality review and documentation requirements.
More specifically, proposed Rule 1101(a)(1) would require that a
broker-dealer's policies and procedures address how it will comply with
the best execution standard in proposed Rule 1100. In particular, a
broker-dealer's policies and procedures would be required to address
how it will: (1) obtain and assess reasonably accessible information
concerning the markets trading the relevant securities; (2) identify
markets that may be reasonably likely to provide the most favorable
prices for customer orders (``material potential liquidity sources'');
and (3) incorporate the material potential liquidity sources into its
order handling practices and ensure efficient access to each such
material potential liquidity source. The Commission believes this
aspect of the proposal would promote consistently robust order handling
practices by requiring each broker-dealer to establish a detailed
framework to achieve best execution, which involves an analysis of
relevant information, an evaluation of the range of liquidity sources,
and the identification of and ability to efficiently access liquidity
sources.
Proposed Rule 1101(a)(2) would require a broker-dealer's policies
and procedures to address how it will determine the best market and
make routing and execution decisions for the customer orders that it
receives. In particular, a broker-dealer's policies and procedures
would be required to address how it will: (1) assess reasonably
accessible and timely information, including information with respect
to the best displayed prices, opportunities for price improvement, and
order exposure opportunities that may result in the most favorable
price; (2) assess the attributes of customer orders and consider the
trading characteristics of the security, the size of the orders, the
likelihood of execution, and the accessibility of the market, and any
customer instructions in selecting the market most likely to provide
the most favorable price; and (3) reasonably
[[Page 5450]]
balance the likelihood of obtaining a better price with the risk that
delay could result in a worse price when determining the number and
sequencing of markets to be assessed. These considerations have been
recognized as relevant for a broker-dealer's duty of best
execution.\100\
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\100\ See, e.g., supra notes 21-23 and accompanying text; FINRA
Rules 5310(a)(1) and 5310.09(b)(1).
---------------------------------------------------------------------------
As discussed in section IV.B below, the factors that must be
included in a broker-dealer's policies and procedures under proposed
Rule 1101(a) are generally consistent with the factors that FINRA and
the MSRB have identified as relevant to a broker-dealer's best
execution determinations. The Commission understands that, currently,
some broker-dealers incorporate various best execution factors from the
FINRA and MSRB best execution rules in their policies and procedures.
However, by requiring broker-dealers' best execution policies and
procedures to explicitly address these factors, proposed Rule 1101(a)
would help ensure that broker-dealers have established processes in
place for considering these factors and that broker-dealers follow
these processes when transacting for or with customers, which should
promote consistently robust order handling practices among broker-
dealers.\101\
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\101\ Moreover, requiring broker-dealers' best execution
policies and procedures to address factors similar to those that
FINRA and the MSRB have already identified as relevant to best
execution determinations would mitigate compliance costs associated
with the proposed rules.
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Proposed Rule 1101(b) would require broker-dealers that have
certain conflicts of interest to establish additional policies and
procedures to better position them to meet the best execution standard
in these circumstances. In particular, a broker-dealer's policies and
procedures for conflicted transactions would be required to address how
it will: (1) obtain and assess information beyond that required by
proposed Rule 1101(a)(1)(i) in identifying a broader range of markets
beyond the material potential liquidity sources; and (2) evaluate a
broader range of markets beyond the material potential liquidity
sources. Proposed Rule 1101(b) would also require broker-dealers to
document their compliance with the best execution standard for
conflicted transactions, including all efforts taken to enforce their
policies and procedures, and their basis and information relied on for
determining that their conflicted transactions would comply with the
proposed best execution standard. Such documentation would be required
to be done in accordance with written procedures. Proposed Rule 1101(b)
would also require broker-dealers to document any arrangements
concerning payment for order flow.\102\ These requirements for
conflicted transactions would be in addition to the current FINRA and
MSRB best execution rules, although the Commission understands that
some broker-dealers currently preserve information that allows them to
support their best execution determinations (e.g., information to
recreate the pricing information that was available at the time an
order was received). The Commission believes that these requirements
would encourage broker-dealers to exercise additional diligence with
respect to conflicted transactions in light of the incentives to handle
conflicted transactions in a manner that prioritizes their own
interests over their customers' interests, and are part of the
Commission's ongoing efforts to protect investors when conflicts of
interest exist.
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\102\ See infra section IV.C.2 (discussing the proposed
requirement to document payment for order flow arrangements).
---------------------------------------------------------------------------
Proposed Rule 1101(c) would require broker-dealers to review the
execution quality of customer orders at least quarterly, and how such
execution quality compares with the execution quality that might have
been obtained from other markets, and revise their best execution
policies and procedures, including order handling practices,
accordingly. The Commission understands that, currently, broker-
dealers' reviews of execution quality vary in rigor,\103\ and the
Commission preliminarily believes that the proposed review requirement
would further ensure that broker-dealers evaluate the effectiveness of
their current order handling practices and enable broker-dealers to
make informed judgments regarding whether their policies and procedures
or practices need to be modified. This review requirement would also
apply to a broader range of broker-dealers than FINRA's rule that
governs the review of execution quality,\104\ and would be in addition
to the current MSRB best execution rule.
---------------------------------------------------------------------------
\103\ See infra note 210 (discussing FINRA exam findings
relating to execution quality reviews).
\104\ See infra section IV.D (discussing the proposed execution
quality review requirement, including the scope of the proposed
requirement).
---------------------------------------------------------------------------
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), so long as the introducing
broker establishes, maintains, and enforces policies and procedures
that require the introducing broker to regularly review the execution
quality obtained from its executing broker, compare it with the
execution quality it might have obtained from other executing brokers,
and revise its routing practices accordingly. This provision would
provide a tailored exemption from certain provisions of proposed
Regulation Best Execution for broker-dealers that do not make decisions
or exercise discretion regarding the manner in which their customer
orders are handled and executed, beyond their determinations to engage
the services of executing brokers. This exemption would be provided to
a narrower group of broker-dealers than 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.\105\
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\105\ See infra section IV.E (describing the applicability of
the proposed exemption under proposed Rule 1101(d)).
---------------------------------------------------------------------------
Proposed Rule 1102 would require each broker-dealer to review and
assess the design and overall effectiveness of their best execution
policies and procedures, including their order handling practices, on
at least an annual basis, and document such review and assessment in an
annual report that would be provided to the broker-dealer's governing
body. The Commission understands that, currently, broker-dealers
periodically review their policies and procedures (including those
related to best execution), although the frequency of review may
vary.\106\ However, proposed Rule 1102 would require the broker-dealer
to review and assess the policies and procedures it established under
proposed Regulation Best Execution, and the Commission believes that
these requirements would help ensure the effectiveness of broker-
dealers' best execution policies and procedures that are adopted
pursuant to the proposed rules.
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\106\ See infra notes 222, 223, and 224 and accompanying text
(describing the minimum frequency standards for review of execution
quality under the FINRA and MSRB rules and how broker-dealers may
need to review execution quality more frequently than the minimum
requirements depending on the circumstances).
---------------------------------------------------------------------------
Finally, the Commission is proposing to amend Rule 17a-4 under the
Exchange Act\107\ to include record preservation requirements for
records made under proposed Regulation Best Execution.
---------------------------------------------------------------------------
\107\ 17 CFR 240.17a-4.
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The Commission believes that proposed Regulation Best Execution
would also enhance its oversight of
[[Page 5451]]
broker-dealers through the broker-dealers' best execution policies and
procedures required by the proposal, as well as broker-dealers'
documentation of their compliance with proposed Regulation Best
Execution.\108\
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\108\ The Commission believes that Proposed Regulation Best
Execution will also provide certain investor protection benefits. As
discussed in Section V below, by having its own rule, the Commission
will be able to seek certain remedies and other sanctions for
violations of the Commission rule best execution violations that are
not necessarily available under the current regulatory framework. In
general, a best execution rule promulgated pursuant to the Exchange
Act will expand and enhance the Commission's flexibility when
pursuing best execution violations and produce efficiencies
resulting from that greater flexibility.
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Request for Comment
The Commission requests comment on its understanding of broker-
dealers' current best execution practices, and in particular:
1. Do commenters agree with the Commission's understanding that
some broker-dealers currently incorporate various best execution
factors from the FINRA and MSRB best execution rules in their policies
and procedures? Please explain whether, and the extent to which,
broker-dealers currently incorporate those factors in their policies
and procedures. For example, do broker-dealers currently incorporate
all of the best execution factors from the FINRA and MSRB rules in
their policies and procedures?
2. Do commenters agree with the Commission's understanding that
some broker-dealers currently preserve information that allows them to
support their best execution determinations, such as information to
recreate the pricing information that was available at the time of an
execution? Please explain whether broker-dealers currently preserve
information that allows them to support their best execution
determinations, and if so, the type of information that they preserve.
3. Do commenters agree with the Commission's understanding that,
currently, broker-dealers' reviews of execution quality vary in rigor?
Please explain how broker-dealers currently conduct execution quality
reviews of customer orders.
4. Do commenters agree with the Commission's understanding that,
currently, broker-dealers periodically review their best execution
policies and procedures, but with varying frequency? Please describe
how frequently broker-dealers currently review their best execution
policies and procedures.
IV. Discussion of Proposed Regulation Best Execution
As discussed in this section IV below, the Commission is proposing
Regulation Best Execution, which is consistent with the FINRA and MSRB
best execution rules in many respects and is different from those rules
in some respects. Proposed Regulation Best Execution would not affect a
broker-dealer's obligation to comply with the FINRA or MSRB best
execution rule. Accordingly, a broker-dealer would be required to
comply with proposed Regulation Best Execution, in addition to their
existing obligations to comply with the FINRA and MSRB best execution
rules, as applicable.\109\
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\109\ For example, where proposed Regulation Best Execution
would impose additional or more specific requirements as compared to
the FINRA or MSRB rules, a broker-dealer would be required to comply
with the additional or more specific requirements under the proposed
rules. See, e.g., infra section IV.A (discussing the application of
proposed Rule 1100 to transactions with sophisticated municipal
market professionals, which are exempted from the MSRB's best
execution rule). Similarly, where FINRA or the MSRB impose more
specific requirement than proposed Regulation Best Execution, a
broker-dealer would be required to continue to comply with those
requirements of FINRA and the MSRB. See, e.g., infra note 223 and
accompanying text (discussing the requirement under FINRA Rule 5310
for broker-dealers to conduct at least a quarterly review of
execution quality).
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A. Proposed Rule 1100--The Best Execution Standard
Proposed Rule 1100 would set forth the best execution standard for
broker-dealers.\110\ Specifically, proposed Rule 1100 states that, in
any transaction for or with a customer, or a customer of another
broker-dealer, a broker-dealer, or a natural person who is an
associated person of a broker-dealer,\111\ must 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.\112\
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\110\ For purposes of this release and proposed Regulation Best
Execution, ``broker-dealer'' refers to a broker, dealer, government
securities broker, government securities dealer, and municipal
securities dealer, unless specifically indicated otherwise.
\111\ Section 3(a)(18) of the Exchange Act defines ``person
associated with a broker or dealer'' to mean any partner, officer,
director, or branch manager of the broker or dealer (or any person
occupying a similar status or performing similar functions), any
person directly or indirectly controlling, controlled by, or under
common control with the broker or dealer, or any employee of the
broker or dealer. 15 U.S.C. 78c(a)(18). Any person associated with a
broker or dealer whose functions are solely clerical or ministerial
is not included in the meaning this term for purposes of section
15(b) the Exchange Act (other than paragraph 6 thereof). See id.
Proposed Rule 1100 would apply to a natural person who is an
associated person of a broker-dealer, and would avoid the
application of proposed Rule 1100 to all associated persons of a
broker-dealer, as all associated persons would capture affiliated
entities of the broker-dealer and could extend the application of
proposed Rule 1100 to entities that are not themselves broker-
dealers.
\112\ FINRA Rule 5310.09(a) states that ``[n]o member can
transfer to another person its obligation to provide best execution
to its customers' orders.'' The standard proposed by the Commission
in Rule 1100 is consistent with the FINRA rule, and would not
establish any exception to allow a broker-dealer to transfer its
obligation to provide best execution to another person.
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The proposed best execution standard would apply to securities
transactions for or with a broker-dealer's own customers, as well as
securities transactions for or with customers of another broker-dealer.
A broker-dealer that initially receives customer orders may not
necessarily be the broker-dealer that engages in transactions for or
with those orders. Instead, the broker-dealer receiving the customer
orders may utilize the services of another broker-dealer to engage in
transactions for or with those orders (e.g., a wholesaler, executing
broker-dealer, or clearing firm that handles or executes those orders).
Even though the other broker-dealer does not have a direct relationship
with the customers of the receiving broker-dealer, the other broker-
dealer (or natural persons who are associated persons of that broker-
dealer) would be required to comply with the proposed best execution
standard because it would be engaged in transactions for or with a
customer.
In addition, the proposed best execution standard would apply to
transactions for or with a customer, regardless of whether the broker-
dealer is transacting for or with the customer on an agency basis or in
a principal capacity.\113\ For example, the proposed best execution
standard would apply to broker-dealers that internalize their
customers' orders, as well as to wholesalers or clearing firms that
trade
[[Page 5452]]
as principal with the customer orders routed to them from other broker-
dealers.
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\113\ The proposed application of the standard to both agency
and principal trades is consistent with FINRA and MSRB rules. See
FINRA Rule 5310(e) (stating that the best execution obligations in
FINRA Rule 5310(a)-(d) exist not only where the broker-dealer acts
as agent for the account of its customer but also where transactions
are executed as principal); MSRB Rule G-18(c) (stating that the best
execution obligations in MSRB Rule G-18(a)-(b) apply to transactions
in which the broker-dealer is acting as agent and transactions in
which the broker-dealer is acting as principal). In addition, the
application of the existing duty of best execution in both agency
and principal transactions is well-established in common law. See,
e.g., Newton, 135 F.3d 266, 270 (3d Cir.), cert. denied, 525 U.S.
811 (1998); E.F. Hutton & Co., Exchange Act Rel. No. 25887, 49 SEC.
829, 832 (1988) (``A broker-dealer's determination to execute an
order as principal or agent cannot be `a means by which the broker
may elect whether or not the law will impose fiduciary standards
upon him in the actual circumstances of any given relationship or
transaction.' '') (citations omitted).
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Proposed Rule 1100 would provide exemptions from the best execution
standard for a broker-dealer, or a natural person who is an associated
person of a broker-dealer, when the broker-dealer is (i) quoting a
price for a security where another broker-dealer routes a customer
order for execution against that quote or (ii) an institutional
customer, exercising independent judgment, executes its order against
the broker-dealer's quotation.\114\ These exemptions distinguish
between a broker-dealer that is acting solely as the buyer or seller of
securities (it would be exempt) from a broker-dealer that is accepting
order flow from another broker-dealer or institutional customer for the
purpose of facilitating the handling and execution of those orders (it
would not be exempt).
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\114\ The first proposed exemption is consistent with FINRA Rule
5310.04, which states that a broker-dealer's duty to provide best
execution does not apply in circumstances when another broker-dealer
is simply executing a customer order against the broker-dealer's
quote, and MSRB Rule G-18.05, which states that a broker-dealer's
duty to provide best execution does not apply in circumstances when
the other broker-dealer is simply executing a customer transaction
against the broker-dealer's quote. The second proposed exemption is
new. Like the first proposed exemption, the second would exempt a
broker-dealer that is acting solely as a buyer or seller of a
securities. However, under the second exemption, the broker-dealer
would be acting solely as a buyer or seller of securities in
transactions directly with an institutional customer. In the
corporate and municipal bond and government securities markets, for
example, institutional customers often handle and execute their own
orders. Institutional customers in these markets commonly request
prices from broker-dealers for particular securities (prices for any
given security are often not quoted and made widely available) and
exercise their own discretion concerning the execution of a
particular transaction. In these instances, a broker-dealer is
simply responding to the institutional customer's request (e.g.,
through widely known request for quote (``RFQ'') mechanisms) and the
institutional customer is exercising independent discretion over the
handling and execution of its orders. Accordingly, the Commission
believes that the broker-dealer in these circumstances should be
exempted from the best execution standard under proposed Rule 1100.
However, in these circumstances, the broker-dealer would still be
subject, if applicable, to FINRA Rule 2121 and MSRB Rule G-30
concerning fair prices and the fairness and reasonableness of
commission rates and markups or markdowns. See FINRA Rule 2121; MSRB
Rule G-30.
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Proposed Rule 1100 would also provide a third exemption from the
best execution standard for a broker-dealer or a natural person who is
an associated person of a broker-dealer, when the broker-dealer
receives an unsolicited instruction from a customer to route that
customer's order to a particular market for execution and the broker-
dealer processes that customer's order promptly and in accordance with
the terms of the order. In this scenario, the customer has determined
the market where it wants to execute its order and is not relying on
its broker-dealer to determine the best market for that order.\115\
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\115\ This exemption is consistent with FINRA and MSRB rules.
See FINRA Rule 5310.08 (stating that if a member receives an
unsolicited instruction from a customer to route that customer's
order to a particular market for execution, the member is not
required to make a best execution determination beyond the
customer's specific instruction); MSRB Rule G-18.07 (stating that if
a dealer receives an unsolicited instruction from a customer
designating a particular market for the execution of the customer's
transaction, the dealer is not required to make a best-execution
determination beyond the customer's specific instruction).
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Under proposed Rule 1100, the term ``market'' could include broker-
dealers (e.g., a broker-dealer's principal trading desk), exchange
markets, markets other than exchange markets, and any other venues that
emerge as markets evolve. The term ``market'' also could encompass the
wide range of mechanisms operated by any given market that a broker-
dealer may use to transact for or with customers. For example, markets
may include different execution protocols, such as limit order books
(some of which may provide for midpoint liquidity), floor auction
facilities, or electronic auction mechanisms. This description of
``market'' is expansive and would require a broker-dealer to take into
consideration a broad range of potential trading and market centers and
venues that may provide the best market for customers' orders so that
the resulting prices to the customers are as favorable as possible
under prevailing market conditions.\116\
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\116\ This expansive description of ``market'' is consistent
with how FINRA and the MSRB describe the term in their rules, and
therefore should be familiar to broker-dealers. In particular, FINRA
and the MSRB also broadly construe the term ``market'' for purposes
of their best execution rules. See FINRA Rule 5310.02 (stating that
``market'' encompasses a variety of different venues, including, but
not limited to, market centers that are trading a particular
security); MSRB Rule G-18.04 (stating that ``market'' encompasses a
variety of different venues, including but not limited to broker's
brokers, alternative trading systems or platforms, or other
counterparties, which may include the dealer itself as principal).
MSRB Rule G-18.04 also states that the term market ``is to be
construed broadly, recognizing that municipal securities currently
trade over the counter without a central exchange or platform. This
expansive interpretation is meant both to inform dealers as to the
breadth of the scope of venues that must be considered in the
furtherance of their best-execution obligations and to promote fair
competition among dealers (including broker's brokers), alternative
trading systems and platforms, and any other venue that may emerge,
by not mandating that certain trading venues have less relevance
than others in the course of determining a dealer's best-execution
obligations.'' Pursuant to FINRA guidance, broker-dealers are also
expected to consider new markets that become available as venues to
which the broker-dealer could potentially route customer orders for
execution. See FINRA Regulatory Notice 15-46, at 5. In doing so,
broker-dealers should consider the execution quality of venues to
which they are not connected and determine whether they should
connect to new markets. See id., at 4.
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Proposed Rule 1100 would codify, in a Commission rule, a best
execution standard that is consistent with how the Commission and the
courts have described the duty of best execution over the years.\117\
The proposed standard is also consistent with the best execution
standards under FINRA Rule 5310 \118\ and MSRB Rule G-18.\119\ However,
with respect to municipal securities, while MSRB Rule G-48 exempts
transactions with sophisticated municipal market participants
(``SMMPs'') \120\ from the MSRB best
[[Page 5453]]
execution rule, proposed Regulation Best Execution does not include a
similar exemption for SMMPs from Rule 1100.\121\ Unlike the MSRB rules,
proposed Rule 1100 is designed to apply broadly to transactions in all
securities and is not limited to transactions in municipal securities.
The Commission also preliminary believes that customers that meet the
MSRB's definition of SMMP would benefit from the protections offered by
proposed Regulation Best Execution, just as customers that do not meet
the definition of SMMP or customers that transact in securities other
than municipal securities would.\122\ At the same time, the Commission
believes that proposed Regulation Best Execution contains several
provisions that would mitigate the burdens on the broker-dealers that
engage in transactions for or with customers that meet the MSRB's
definition of SMMP, and proposed Regulation Best Execution would result
in similar treatment as MSRB Rule G-18 and G-48 in many instances. For
example, as discussed above in this section, a broker-dealer would be
exempt from proposed Rule 1100 if an institutional customer is
exercising independent judgment and executing its orders against a
broker-dealer's quotation, and is not providing the broker-dealer with
orders for handling and execution. Additionally, a broker-dealer would
be exempt from proposed Rule 1100 if a customer gave the broker-dealer
an unsolicited instruction to send its order to a particular market and
the broker-dealer processes that customer's order promptly and in
accordance with the terms of the order. Finally, as discussed in
section IV.B.2 below, if a customer provides the broker-dealer with
other instructions concerning the handling of its orders, the broker-
dealer's compliance with the best execution standard would be informed
by such customer instructions.
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\117\ See, e.g., Regulation NMS Adopting Release, supra note 21,
70 FR 37538 (stating that the duty of best execution requires, among
other things, a broker-dealer to execute customers' trades at the
most favorable terms reasonably available under the circumstances,
i.e., at the best reasonably available price); Newton, supra note 8,
135 F.3d at 270 (noting that a broker-dealer's duty of undivided
loyalty to its customer requires that it ``seek to obtain for its
customer orders the most favorable terms reasonably available under
the circumstances''). As discussed below throughout this section IV,
the Commission is also proposing requirements designed to help
ensure compliance with the proposed best execution standard.
\118\ FINRA Rule 5310(a)(1) provides 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. FINRA Rule 5310 applies to transactions by any FINRA
member in government securities. See FINRA Rule 0150(c).
\119\ MSRB Rule G-18(a) provides that, in any transaction in a
municipal security for or with a customer or a customer of another
broker, dealer, or municipal securities dealer (``dealer''), a
dealer must use reasonable diligence to ascertain the best market
for the subject security and buy or sell in that market so that the
resultant price to the customer is as favorable as possible under
prevailing market conditions.
\120\ MSRB Rule D-15 defines SMMP by three requirements: the
nature of the customer; a determination of sophistication by the
dealer; and an affirmation by the customer. Specifically, the rule
states that the customer must be: (i) a bank, savings and loan
association, insurance company, or registered investment company;
(ii) an investment adviser registered either with the Commission
under section 203 of the Investment Adviser Act of 1940 or with a
state securities commission; or (iii) any other person or entity
with total assets of at least $50 million. To achieve a
determination of customer sophistication, the broker-dealer must
have a reasonable basis to believe that the customer is capable of
evaluating investment risks and market value independently, both in
general and with regard to particular transactions and investment
strategies in municipal securities. Finally, the customer must
affirmatively indicate that it is exercising independent judgment in
evaluating: (a) the recommendations of the broker-dealer; (b) the
quality of execution of the customer's transactions by the broker-
dealer; and (c) the transaction price for non-recommended secondary
market agency transactions as to which (i) the broker-dealer's
services have been explicitly limited to providing anonymity,
communication, order matching, and/or clearance function and (ii)
the broker-dealer does not exercise discretion as to how or when the
transactions are executed. The affirmation may be given orally or in
writing, and may be given on a transaction-by-transaction basis, a
type-of-municipal security basis, or an account-wide basis.
\121\ Additionally, MSRB Rule G-18.09 states that Rule G-18 does
not apply to municipal fund securities. While proposed Regulation
Best Execution does not contain a similar exemption for municipal
fund securities, the Commission believes that the Commission's
proposal and MSRB Rule G-18 would result in similar treatment for
municipal fund securities. Transactions in municipal fund securities
must be executed directly with the issuer. For this reason, there is
only one market that can be accessed to fill a customer order in
this type of security and, therefore, only one way to comply with
Rule 1100 with respect to the handling and execution of a customer
order in a municipal fund security.
\122\ When the Commission approved the MSRB's exemption for
transactions with SMMPs from its best execution rule, the Commission
stated that the exemption ``will facilitate transactions in
municipal securities and help perfect the mechanism of a free and
open market in municipal securities by avoiding the imposition of
regulatory burdens if they are not needed.'' See MSRB Best Execution
Approval Order, supra note 47, 79 FR 73664. For the reasons
discussed in this section, the Commission believes that the proposed
rules are designed to mitigate the regulatory burdens for broker-
dealers that transact for or with SMMP customers, while providing
the benefit of the protections offered by the proposed rules under
appropriate circumstances.
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Request for Comment
The Commission requests comment on all aspects of proposed Rule
1100, and in particular:
5. Is the proposed best execution standard appropriate? Why or why
not? Has the Commission identified all the differences between the
proposed best execution standard and the standards under FINRA Rule
5310 and MSRB Rule G-18? If not, please explain any differences that
the Commission has not identified and any potential issues resulting
from those differences.
6. Are the differences between the proposed best execution standard
and the standards under FINRA Rule 5310 and MSRB Rule G-18 appropriate?
Why or why not?
7. Do commenters agree that proposed Rule 1100 is consistent with
prior Commission statements, including those described in section II.B
above? Why or why not? If not, should the Commission revise any of its
statements in light of the proposal? Please explain.
8. Do commenters agree that the proposed best execution standard
should apply to natural persons who are associated persons of a broker-
dealer? Why or why not?
9. Are there alternative definitions of ``natural person who is an
associated person'' that the Commission should use instead? Is the
application of proposed Rule 1100 appropriately limited to ``a natural
person who is an associated person'' of a broker-dealer? Please
explain.
10. Would the proposed best execution standard pose any challenges
or burdens for entities that are dually-registered broker-dealers and
investment advisers? As discussed above,\123\ an investment adviser has
its own duty to seek best execution of a client's transactions where
the adviser has the responsibility to select broker-dealers to execute
client trades. What effect, if any, would the proposed best execution
standard have on investment advisers and their duty to seek best
execution?
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\123\ See supra note 11.
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11. Are there elements of an investment adviser's duty to seek best
execution that are relevant in assessing the proposed best execution
standard for a broker-dealer?
12. Is it appropriate to provide an exemption from the proposed
best execution standard to a broker-dealer when another broker-dealer
is executing a customer order against the first broker-dealer's quote?
Why or why not?
13. Is it appropriate to provide an exemption from the proposed
best execution standard to a broker-dealer when an institutional
customer, exercising independent judgment, executes its order against
the broker-dealer's quotations? Why or why not?
14. Should the Commission define ``institutional customer'' for
purposes of proposed Rule 1100? If so, how should ``institutional
customer'' be defined? For example, should the Commission define
``institutional customer'' as any person that is a qualified
institutional buyer (``QIB'') as defined in Rule 144A under the
Securities Act of 1933?\124\ Why or why not?
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\124\ 17 CFR 230.144A (defining ``QIB'' to mean a variety of
entities such as insurance companies, investment companies
registered under the Investment Company Act of 1940, and investment
advisers registered under the Investment Advisers Act of 1940, among
others, that in the aggregate own or invest on a discretionary basis
at least $100 million).
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15. Should the Commission define ``institutional customer'' to
include a broader set of institutional customers than the QIB
definition, such as those entities that are included in the FINRA
definition of ``institutional account'' under FINRA Rule 4512(c)?\125\
Please explain.
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\125\ FINRA Rule 4512(c) defines ``institutional account'' as
the account of: (1) a bank, savings and loan association, insurance
company or registered investment company; (2) an investment adviser
registered either with the Commission under section 203 of the
Investment Advisers Act or with a state securities commission (or
any agency or office performing like functions); or (3) any other
person (whether a natural person, corporation, partnership, trust or
otherwise) with total assets of at least $50 million.
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16. Should the exemption concerning institutional customers in
proposed Rule 1100 be limited to situations where the broker-dealer
seeking the exemption has a reasonable basis to believe that the
institutional customer (i) has the capacity to evaluate independently
the prices offered by the broker-dealer and (ii) is exercising
independent judgment in deciding to enter into the transaction, such as
is provided for in FINRA Rule 2121 concerning suitability for
institutional customers? Please explain.
17. Should the Commission define ``institutional customer'' for
purposes of
[[Page 5454]]
the proposed exemption in Rule 1100 to be consistent with the MSRB's
definition of SMMP? For example, should an institutional customer be
required to make an affirmation to the broker-dealer concerning its
exercise of independent judgment in evaluating the quality of execution
of its transaction with the broker-dealer? Are there other affirmations
relevant to best execution that should be required?\126\ Please
explain.
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\126\ For example, the MSRB's definition of SMMP requires a
variety of other affirmations (e.g., relating to suitability, access
to timely information, fair pricing for agency transactions) as
broker-dealers are also exempt from other non-best execution related
obligations in transactions with SMMPs pursuant to MSRB Rules G-
48(a)-(d).
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18. If an institutional customer affirmation should be required,
how should such affirmation be provided? Should an institutional
customer be permitted to provide the affirmation to the broker-dealer
orally or in writing? Should an institutional customer be permitted to
provide its affirmation on a trade-by-trade basis, a type-of-
transaction basis, a type-of-security basis (e.g., municipal security,
including general obligation, revenue, variable rate municipal
security; corporate bond, including investment grade and non-investment
grade; OTC equity; NMS security), or an account-wide basis? Please
explain.
19. Should a broker-dealer seeking the exemption in proposed Rule
1100 in transactions with institutional customers be required to
disclose to the institutional customer that it is not required to
comply with the best execution standard of proposed Rule 1100 for the
relevant transactions? Should this disclosure be provided in lieu of or
in addition to a customer affirmation, if such affirmation should be
provided by the institutional customer? Please explain. If disclosure
should be required, what standards should apply to the disclosure? For
example, should a broker-dealer be required to make a disclosure to the
institutional customer on a transaction-by-transaction basis? If not,
what would be the appropriate manner for this disclosure? Please
explain. Should the disclosure be in writing or should a broker-dealer
be permitted to provide the disclosure orally to the institutional
customer? Please explain.
20. Should the proposed exemption concerning institutional
customers in Rule 1100 be limited to only certain types of securities
or only certain types of trading protocols where the institutional
customer is executing against the broker-dealer's quote? For example,
should the exemption be limited only to transactions in fixed income
securities? Should it be limited to transactions that occur through
multilateral RFQ systems where the institutional customer is able to
put multiple broker-dealers and other market participants in
competition when soliciting quotes? Should the exemption be available
to a broker-dealer that is responding to a request for quote by an
institutional customer in a bilateral communication, whether over the
phone or through another communication protocol? Please explain.
21. Should the Commission provide a broader exemption from the
proposed best execution standard for a broker-dealer when it engages in
any transaction for or with institutional customers, similar to the
exemption provided to broker-dealers under MSRB Rule G-48(e) for SMMPs?
Please explain why such exemption should or should not be provided.
22. If a broader exemption for transactions with institutional
customers should be provided, how should the Commission define
``institutional customer''? Similar to the requests for comment above,
should the Commission define institutional customer as ``QIB'' as
defined in Rule 144A under the Securities Act of 1933, an
``institutional account'' as defined in FINRA Rule 4512(c), or an SMMP
as defined in MSRB Rule D-15? Is there another definition that would be
appropriate? Please explain. Should other conditions apply to the
exemption, as requested above, such as broker-dealer disclosure to the
institutional customer, broker-dealer assessment of the institutional
customer's ability to evaluate the transaction, and institutional
customer affirmations? Please explain.
23. What are the typical order handling practices of broker-dealers
for the municipal bond orders of SMMPs? Do these order handling
practices vary depending on the type of SMMP under MSRB Rule D-15(a)?
Do SMMPs typically provide broker-dealers with orders to handle and
execute, or do SMMPs typically handle and execute their own orders?
Please explain. Do broker-dealers exercise any discretion in handling
the orders of SMMPs, whether executing such order on an agency or
principal basis? Please explain.
24. Do commenters agree that the proposed rules are designed to
mitigate the regulatory burdens for broker-dealers that transact for or
with SMMP customers, while providing the benefit of the protections
offered by the proposed rules under appropriate circumstances? Why or
why not?
25. Should the Commission provide an exemption from the proposed
best execution standard for a broker-dealer that engages in
transactions for or with sophisticated market professionals in asset
classes other than municipal securities? Please explain why such
exemption should or should not be provided.
26. Is it appropriate to provide an exemption from the proposed
best execution standard to a broker-dealer that receives an unsolicited
instruction from a customer to route that customer's order to a
particular market for execution, where the broker-dealer processes that
customer's order promptly and in accordance with the terms of the
order? Why or why not?
27. Should the Commission provide an exemption from the proposed
best execution standard for transactions in municipal fund securities
(which include interests in 529 college savings plans)? Should such
exemption only apply to municipal fund securities that are interests in
529 college savings plans? If the Commission were to provide an
exemption, should it apply similarly or differently to direct-sold and
advisor-sold municipal fund securities? Please explain why such
exemption should or should not be provided.
28. Should the Commission provide an exemption for mutual fund
securities, such as equity and corporate bond mutual funds? Should the
Commission provide an exemption for any other type of security? Please
explain why such exemption should or should not be provided.
29. Should the Commission provide any other exemptions from the
proposed best execution standard? If so, please explain.
30. Should proposed Regulation Best Execution be the sole best
execution rule applicable to broker-dealers? Why or why not?
B. Proposed Rule 1101(a)--Best Execution Policies and Procedures
Proposed Rule 1101(a) would require a broker-dealer that effects
any transaction for or with a customer or a customer of another broker-
dealer to establish, maintain, and enforce written policies and
procedures reasonably designed to comply with the best execution
standard under proposed Rule 1100 (``best execution policies and
procedures''). As discussed in sections IV.B.1 and 2 below, a broker-
dealer's best execution policies and procedures would be required to
address: (1) how the broker-dealer would comply with the best execution
standard; and (2) how the broker-dealer would determine the
[[Page 5455]]
best market for the customer orders that it receives.
Proposed Rule 1101 does not include specific requirements regarding
the manner in which broker-dealers would comply with the best execution
standard. Rather, proposed Rule 1100 would require a broker-dealer to
use reasonable diligence to ascertain the best market for a 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, and proposed Rule 1101 would additionally require a broker-
dealer to establish and maintain written policies and procedures
reasonably designed to comply with the proposed standard. The policies
and procedures would be required to reflect the elements specified in
proposed Rule 1101(a) (e.g., best displayed prices, opportunities for
price improvement including midpoint executions, attributes of
particular customer orders, the trading characteristics of the
security). For example, a broker-dealer could have policies and
procedures that are tailored for different types of customers (e.g.,
retail customers, institutional customers) or for securities with
different trading characteristics (e.g., NMS stocks, municipal
securities).\127\ All customer orders must be covered by a broker-
dealer's best execution policies and procedures, and the broker-dealer
would be required to enforce such policies and procedures.
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\127\ Similar to this proposal, FINRA and MSRB rules also
recognize that broker-dealers' best execution practices would be
tailored for securities with different characteristics. For example,
FINRA Rule 5310 recognizes that the markets for different securities
can vary and the standard of reasonable diligence must be assessed
by examining specific factors, such as the character of the market
for the security and the accessibility of the quotation. See, e.g.,
FINRA Rules 5310.03 (Best Execution and Debt Securities); 5310.06
(Orders Involving Securities with Limited Quotations or Pricing
Information); 5310.07 (Orders Involving Foreign Securities). See
also MSRB Rule G-18.06 (Securities with Limited Quotations or
Pricing Information) (recognizing that markets for municipal
securities may differ dramatically and referring to heightened
diligence with respect to customer transactions involving securities
with limited pricing information or quotations).
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While FINRA's best execution rule does not require broker-dealers
to have the same type of detailed best execution policies and
procedures as proposed Rule 1101,\128\ FINRA Rule 3110(b)(1) \129\
requires broker-dealers to have procedures for compliance with FINRA
rules and Federal securities laws and regulations. The MSRB's best
execution rule reflects a requirement for broker-dealers to have
policies and procedures for determining the best available market for
the executions of their customers' transactions.\130\ In addition, MSRB
Rule G-28 requires broker-dealers to have procedures for compliance
with MSRB rules and the Exchange Act and rules thereunder.\131\ The
Commission understands that broker-dealers currently have policies and
procedures relating to their compliance with the FINRA and MSRB best
execution rules, as applicable. However, unlike the FINRA and MSRB
rules, proposed Rule 1101(a)(1) would require broker-dealers' best
execution policies and procedures to include specific elements, as
discussed in sections IV.B.1 and 2 below.
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\128\ FINRA Rule 5310.
\129\ FINRA Rule 3110(b)(1) requires a FINRA member to
establish, maintain, and enforce written procedures to supervise the
types of business in which it engages and the activities of its
associated persons that are reasonably designed to achieve
compliance with applicable securities laws and regulations, and with
applicable FINRA rules. Separately, FINRA Rules 3130(b) and (c)
require the chief executive officer (or equivalent officer) of a
FINRA member to certify annually that the member has in place
processes to establish, maintain, review, test and modify written
compliance policies and written supervisory procedures reasonably
designed to achieve compliance with applicable FINRA rules, MSRB
rules, and Federal securities laws and regulations.
\130\ MSRB Rule G-18.08 states that a broker-dealer must, at a
minimum, conduct annual reviews of its policies and procedures for
determining the best available market for the executions of its
customers' transactions, including assessing whether its policies
and procedures are reasonably designed to achieve best execution,
taking into account the quality of the executions the broker-dealer
is obtaining under its current policies and procedures, among other
things.
\131\ MSRB Rule G-28 requires broker-dealers to adopt, maintain
and enforce written supervisory procedures reasonably designed to
ensure that the conduct of the municipal securities activities of
the broker-dealer and its associated persons are in compliance with
MSRB rules and the applicable provisions of the Exchange Act and
rules thereunder.
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1. Proposed Rule 1101(a)(1)--Framework for Compliance With the Best
Execution Standard
Proposed Rule 1101(a)(1) would require a broker-dealer's best
execution policies and procedures to address how it will comply with
the proposed best execution standard by: (i) obtaining and assessing
reasonably accessible information, including information about price,
volume, and execution quality, concerning the markets trading the
relevant securities; (ii) identifying markets that may be reasonably
likely to provide material potential liquidity sources (as defined
above); and (iii) incorporating material potential liquidity sources
into its order handling practices and ensuring that it can efficiently
access each such material potential liquidity source.
Proposed Rule 1101(a)(1)(i) would require a broker-dealer to have
policies and procedures for obtaining and assessing reasonably
accessible information regarding the markets trading the relevant
securities.\132\ Market information is relevant to a broker-dealer's
best execution analysis,\133\ and the Commission has previously
identified price and execution quality information as among the factors
relevant to that analysis.\134\ The Commission believes that the
ability of markets to attract trading interest as measured by trading
volume would also be relevant to a broker-dealer's best execution
analysis, because trading volume can be an indicator of whether
sufficient interest exists on a particular market to execute customer
orders.\135\
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\132\ Proposed Rule 1101 would not establish minimum data
elements needed to comply with the proposed best execution standard.
Rather, it would require broker-dealers to establish, maintain, and
enforce policies and procedures reasonably designed to comply with
the proposed best execution standard. In implementing its policies
and procedures (both for non-conflicted and conflicted
transactions), including policies and procedures that address how
the broker-dealer would obtain and assess reasonably accessible
information or how the broker-dealer would obtain and assess other
information for conflicted transactions (as discussed in section
IV.C below), a broker-dealer may determine that it is appropriate to
purchase certain proprietary data. See also supra note 38
(describing the Commission's statements in the MDI Adopting Release
that the Commission was not establishing minimum data elements
needed to achieve best execution nor mandating consumption of
certain data content, and acknowledging that different market
participants and different trading applications have different
market data needs).
\133\ See, e.g., Order Execution Obligations Adopting Release,
supra note 10, 61 FR at 48322-23 (stating that a broker-dealer's
practices for achieving best execution, including the data,
technology, and types of markets it accesses, must constantly be
updated as markets evolve); Order Execution and Routing Practice
Release, supra note 22, 65 FR at 75418 (stating that quotation
information contained in the public quotation system must be
considered in seeking best execution of customer orders); MDI
Adopting Release, supra note 38, 86 FR at 18605 (stating that
broker-dealers should consider the availability of consolidated
market data, including the various elements of data content and the
timeliness, accuracy, and reliability of the data in developing and
maintaining their best execution policies and procedures).
\134\ See, e.g., Order Execution Obligations Adopting Release,
supra note 10, 61 FR 48323 (identifying price improvement and
execution quality as among the relevant factors for a best execution
analysis); MDI Adopting Release, supra note 38, 86 FR 18605
(identifying order size, trading characteristics of the security,
speed of execution, clearing costs, and the cost and difficulty of
executing an order in a particular market as relevant factors for a
best execution analysis).
\135\ FINRA Rule 5310(a)(1) and MSRB Rule G-18(a) set forth
similar factors that are relevant to a best execution analysis,
including the character of the market for the security (e.g., price,
volatility, relative liquidity, and pressure on available
communications). However, unlike proposed Rule 1101(a), FINRA and
MSRB rules do not explicitly require relevant factors to be included
in a broker-dealer's best execution policies and procedures. The
considerations in FINRA and MSRB rules concerning volatility,
relative liquidity, and pressure on available communications could
be included as part of the best market policies and procedures in
proposed Rule 1101(a)(2), which requires consideration of the
trading characteristics of a security. See also FINRA Rule 5310.09
(requiring a member to conduct regular and rigorous reviews of the
quality of the executions of its customers' orders); MSRB Rule G-
18.08 (requiring a dealer to conduct periodic reviews of its best
execution policies and procedures, taking into account the quality
of the executions the dealer is obtaining under its current policies
and procedures, among other things).
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[[Page 5456]]
More specifically with respect to execution quality, the Commission
believes that the level of competition within a market can impact the
execution quality of that market and, therefore, broker-dealers should
generally consider including the level of competition of a market as an
element of its best execution policies and procedures.\136\
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\136\ This could include considerations of auction features,
such as allocation guarantees and fees, the types of market
participants that can participate in an auction, the breadth of
participation in an auction, and the accessibility of auction
processes. This assessment of auction mechanisms would apply to a
broker-dealer that is handling a customer order that is subject to
the proposed requirements in the Order Competition Rule (known as a
``segmented order''). See Securities Exchange Act Release No. 34-
96495 (Dec. 14, 2022). Were the Commission to adopt the proposed
Order Competition Rule, a broker-dealer that desires to trade as
principal with a segmented order would, absent an exception, be
required to expose certain orders to competition through use of
``qualified auctions,'' as defined by the proposed Order Competition
Rule. If the proposed Order Competition Rule were adopted, a broker-
dealer when evaluating which qualified auction to use for segmented
orders under proposed Regulation Best Execution (if adopted) would
have to have policies and procedures addressing how the broker-
dealer will assess the execution quality of different qualified
auctions and identify those that are likely to result in the most
favorable price for customer orders.
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With respect to price improvement auctions offered by options
exchanges, while the Commission believes that such auctions could
provide better executions for customer orders than routing such orders
to execute at the prevailing best bid or offer on an exchange, the
selection of a particular price improvement auction could impact the
execution quality of customer orders. A broker-dealer should generally
consider addressing in its policies and procedures how it would assess
the features of options price improvement auctions, how those features
might affect the level of competition and the execution quality offered
by the auctions, and whether those features would allow an auction to
provide the most favorable prices under prevailing market conditions.
For example, price improvement auctions have features, which have been
implemented pursuant to proposed rule changes filed with the
Commission, that allow a wholesaler to trade with much or all of the
customer orders represented in an auction.\137\ The current fee
structures for price improvement auctions may also affect market
participants' determination of whether to compete with a wholesaler for
customer orders and provide more favorable prices.\138\ As reflected in
the table below, as of May 25, 2022, the vast majority of options
exchanges charge market participants that may desire to compete for
customer orders response fees of $0.50 per contract (for options
classes priced in $0.01 increments (``penny classes'')) and $1.00 or
more per contract (for options classes priced in $0.05 increments
(``non-penny classes'')). These response fees are not charged to
wholesalers that initiate the price improvement auctions.
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\137\ See, e.g., Nasdaq ISE, LLC Options 3, Section 13; Nasdaq
Phlx LLC Options 3, Section 13; Miami International Securities
Exchange LLC Rule 515A; BOX Exchange LLC Rule 7150; NYSE American
LLC Rule 971.1NY; Cboe Exchange, Inc. Rule 5.37.
\138\ See Nasdaq ISE LLC Options 7, Section 3; Nasdaq GEMX LLC
Options 7, Section 3; Nasdaq MRX LLC Options 7, Section 3.A.; Nasdaq
Phlx LLC Options 7, Section 6.A.; BOX Exchange LLC Fee Schedule
Section IV.B.; Miami International Securities Exchange LLC Fee
Schedule Section (1)(a)(v); NYSE American LLC Options Fee Schedule
Section I.G.; Cboe Exchange, Inc. Fee Schedule; Cboe EDGX Exchange,
Inc. Options Fee Schedule n.6.
----------------------------------------------------------------------------------------------------------------
Auction market Auction market
Fees for maker response maker response
Exchange initiating fees (penny fees (non-penny
orders classes) classes)
----------------------------------------------------------------------------------------------------------------
CBOE...................................................... 0.07 0.50 1.05
EDGX...................................................... 0.05 0.50 1.05
PHLX...................................................... 0.07 0.25 0.40
MRX....................................................... 0.02 0.50 1.10
ISE....................................................... 0.10 0.50 1.10
GEMX...................................................... 0.05 0.50 0.94
AMEX...................................................... 0.05 0.50 1.05
MIAX...................................................... 0.05 0.50 1.10
BOX....................................................... 0.05 0.50 1.15
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In addition, allocation guarantees, which permit the wholesaler to
trade with a significant portion of the customer order, may affect
competing market participants' determinations of whether and how to
participate in price improvement auctions.\139\ Likewise, ``auto-
match'' features, which enable the wholesaler to automatically match
the best prices submitted by competing market participants, may affect
competing market participants' determinations of whether and how to
participate in price improvement auctions.\140\
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\139\ See supra note 137.
\140\ See, e.g., Nasdaq ISE, LLC Options 3, Section 13(d)(3);
Nasdaq Phlx LLC Options 3, Section 13(b)(1); Miami International
Securities Exchange LLC Rule 515A(a)(2)(i)(A); BOX Exchange LLC Rule
7150(f); NYSE American LLC Rule 971.1NY(c)(1); Cboe Exchange, Inc.
Rule 5.37(b)(5).
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As another example, in considering RFQ systems as material
potential liquidity sources for corporate and municipal bonds and
government securities, a broker-dealer's policies and procedures could
assess the filtering practices that may be applied by the RFQ system
operator and the impact that those practices may have on the execution
quality of those markets. If an RFQ system applies an automatic filter
that prevents a broker-dealer that initiates the RFQ from sending that
request to all participants on the RFQ system, a broker-dealer could
evaluate the potential impact that may have on that market's execution
quality. To the extent other RFQ systems do not apply such filters to
the broker-dealer's request, a broker-dealer could evaluate whether
these other RFQ systems would be a better alternative for executing
customer orders, taking into consideration other relevant information
that the broker-dealer may obtain concerning the RFQ systems.
[[Page 5457]]
Proposed Rule 1101(a)(1)(ii) would require a broker-dealer's
policies and procedures to address how it will identify material
potential liquidity sources, but it would not require a broker-dealer
to include in its policies and procedures a minimum number of markets
that it would need to identify as material potential liquidity sources.
Rather, under proposed Rules 1101(a)(1)(i) and (ii), a broker-dealer
would be required to follow its policies and procedures in assessing
reasonably accessible information and determining material potential
liquidity sources. The Commission believes a broker-dealer's
identification of material potential liquidity sources could be
influenced by the nature of the broker-dealer's business operation and
customer order flow. For example, some broker-dealers focus on the
handling and execution of institutional orders or large-size orders,
while some broker-dealers handle and execute retail orders or small-
size orders. These considerations may be relevant to the types of
markets or market information that the broker-dealer assesses for
purposes of identifying material potential liquidity sources. The
Commission further believes a broker-dealer's assessment of market
information and identification of material potential liquidity sources
could vary depending on the trading characteristics of the relevant
security, the level of transparency in the applicable market, and
accessibility of a market, including the cost of maintaining
connectivity, receiving market data, and transacting on the market. For
example, if a market charges unreasonably high fees for connectivity,
market data, or transactions, a broker-dealer could consider whether
such market's information is reasonably accessible and whether such
market should be identified as a material potential liquidity
source.\141\
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\141\ The Commission has previously described a non-exhaustive
list of factors that may be relevant to broker-dealers' best
execution analysis. These factors include the size of the order,
speed of execution, clearing costs, the trading characteristics of
the security involved, the availability of accurate information
affecting choices as to the most favorable market center for
execution and the availability of technological aids to process such
information, and the cost and difficulty associated with achieving
an execution in a particular market center. See supra note 23 and
accompanying text.
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While proposed Rules 1101(a)(1)(i) and (ii) do not include an
exhaustive list of the markets that might be considered material
potential liquidity sources, or the potential sources of reasonably
accessible information for different types of securities, some examples
may be helpful. For the NMS stock market, material potential liquidity
sources could include exchanges, ATSs, and broker-dealers, including
market makers and wholesalers. It could also include trading protocols
and auction mechanisms operated by these entities, including those that
may provide price improvement opportunities, such as exchange limit
order books, retail liquidity programs, midpoint liquidity, and
wholesaler price improvement guarantees. Concerning potential sources
of reasonably accessible information, the Commission has stated that
quotation data made publicly available must be considered by a broker-
dealer when seeking best execution of customer orders.\142\ In
addition, a broker-dealer generally should consider whether
consolidated trade information, exchange proprietary data feeds, odd
lot market data, and execution quality and order routing information
contained in reports made pursuant to Rules 605 and 606 of Regulation
NMS are readily accessible and needed in order for the broker-dealer to
identify material potential liquidity sources for its customers'
orders.\143\
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\142\ See Order Execution Obligations Adopting Release, supra
note 10, 61 FR 48324.
\143\ In a regulatory notice concerning its best execution rule,
FINRA has provided guidance regarding the relevance of proprietary
data feeds to a broker-dealer's best execution assessment. See FINRA
Regulatory Notice 15-46, at 13 n.12 (``[A] firm that regularly
accesses proprietary data feeds, in addition to consolidated data
from the Securities Information Processors (SIPs), for its
proprietary trading, would be expected to also use these data feeds
to determine the best market under prevailing market conditions when
handling customer orders.'').
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In the OTC equities market, a broker-dealer could consider whether
ATSs, wholesalers, and other OTC market makers may be potential
material liquidity sources. With regard to reasonably accessible
information, a broker-dealer could consider obtaining data from ATSs
and OTC market makers, in addition to obtaining the data concerning
transaction prices in OTC equities made publicly available through the
FINRA Over-the-Counter Reporting Facility (``ORF'').
In the options market, material potential liquidity sources could
include the options exchanges and the range of trading protocols and
auction mechanisms made available by them. These could include quotes
from market makers resting on exchange limit order books, price
improvement auctions, liquidity resting between the best bid and offer
that may be available on exchange limit order books, and floor trading
facilities that may provide a broker-dealer with the opportunity to
seek competitive prices from floor participants for larger or complex
options orders. Other broker-dealers in the options market could also
represent a type of market that generally should be considered when
assessing material potential liquidity sources. Specifically, many
options trades are arranged away from the exchanges by broker-dealers
and are often brought to the exchanges for order exposure and potential
price improvement prior to execution.\144\ Because options trades may
be arranged in this fashion, a broker-dealer would need to consider
whether other broker-dealers may represent material potential liquidity
sources for its customers' options orders. With regard to reasonably
accessible information, a broker-dealer should consider whether
proprietary data feeds and quarterly Rule 606 order routing reports are
readily accessible and needed to identify material potential liquidity
sources, in addition to consolidated trade and quotation data that is
made publicly available.
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\144\ See, e.g., Nasdaq ISE, LLC, Options 3, Section 11(b)-(e)
(providing exchange functionality for facilitation and solicitation
auctions, which permit an exchange member to attempt to execute
large-sized orders it represents as agent against principal interest
or contra-side orders it has solicited). See also, e.g., Miami
International Securities Exchange LLC Rule 515A(b); Cboe Exchange,
Inc. Rule 5.39. The ability to attempt to execute an agency order
against principal or solicited interest is also permitted in the
options exchange price improvement auctions. See supra note 137.
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In addition, a number of markets could be considered for purposes
of identifying material potential liquidity sources in the corporate
and municipal bond markets and government securities markets. These may
include, for example, ATS and non-ATS electronic trading systems, RFQ
systems, and other auction mechanisms. Material potential liquidity
sources in these fixed income markets could also include interdealer
brokers and other broker-dealers willing to be a counterparty upon
request.\145\ A broker-dealer's own principal trading desk could also
be a market for purposes of identifying material potential liquidity
sources.\146\ With respect to reasonably accessible information, a
broker-dealer could consider whether to obtain data from ATSs and other
trading platforms, such as RFQ systems, interdealer brokers, and
dealers that
[[Page 5458]]
handle and execute customer orders, in addition to obtaining
consolidated trade data in the corporate bond and municipal bond
markets made publicly available through FINRA's Trade Reporting and
Compliance Engine (``TRACE'') and the MSRB's Real-time Transaction
Reporting System (``RTRS'').\147\ A broker-dealer could also consider
obtaining relevant data from information sources that do not provide
execution services, such as price aggregator services or evaluated
pricing services.
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\145\ For example, for less widely-traded securities, broker-
dealers that have previously traded such securities or that are
otherwise known to trade in the securities can be markets for
certain segments of the fixed income market. See, e.g., MSRB
Implementation Guidance on MSRB Rule G-18, on Best Execution at Item
VI.1. (updated as of Feb. 7, 2019).
\146\ Principal trading with a customer by a broker-dealer would
be subject to more robust policies and procedures requirements under
proposed Rule 1101(b).
\147\ See, e.g., https://www.finra.org/filing-reporting/trace/data and https://emma.msrb.org/.
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Proposed Rule 1101(a)(1)(iii) would require a broker-dealer to have
policies and procedures that address how the broker-dealer will
incorporate material potential liquidity sources into its order
handling practices and ensure that it can efficiently access each such
material potential liquidity source. This requirement is designed to
enhance a broker-dealer's ability meet the proposed best execution
standard by helping to ensure that the broker-dealer incorporates the
identified material potential liquidity sources into its order handling
practices so that it can execute customer orders in those markets as
appropriate.\148\
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\148\ FINRA Rule 5310(c) provides that a failure to maintain or
adequately staff an OTC order room or other department assigned to
execute customers' orders is not a justification for a broker-dealer
executing away from the best available market. The provision further
states that channeling orders through a third party as reciprocation
for service or business does not relieve a broker-dealer of its
obligation under FINRA Rule 5310. FINRA Rule 5310(d) also provides
that a broker-dealer through which orders are channeled and that
knowingly is a party to an arrangement whereby the initiating member
has not fulfilled its obligations under FINRA Rule 5310 will be
deemed to have violated the rule. Similarly, MSRB Rule G-18.02
states that a broker-dealer's failure to maintain adequate resources
is not a justification for executing away from the best available
market. The proposed rules likewise would not exempt these scenarios
from the proposed best execution standard. The Commission also
believes that these provisions reflect the concept of efficient
access to the best market so that the resulting price to a customer
is as favorable as possible under prevailing market conditions, and
therefore are consistent with the Commission's proposal to require a
broker-dealer's best execution policies and procedures to address
how the broker-dealer will efficiently access material potential
liquidity sources.
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Efficient access to each material potential liquidity source, as
specified by proposed Rule 1101(a)(1)(iii), may require different order
handling processes and arrangements in different markets, and would not
necessarily require that a broker-dealer directly connect to a market,
as it may be efficient in some circumstances for a broker-dealer to use
another broker-dealer to access a particular market for a customer
order. However, interposing a third-party between the broker-dealer and
the market reasonably likely to provide the most favorable price for
its customer would not be consistent with the concept of ``efficient
access,'' if the broker-dealer could access the market directly but
chose instead to access the market indirectly resulting in a worse
execution for the customer.\149\ As stated above, interpositioning can
violate the broker-dealer's duty of best execution when it results in
unnecessary transaction costs at the expense of the customer.\150\
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\149\ The proposed requirement that a broker-dealer's policies
and procedures address how it will be able to efficiently access any
material potential liquidity source is consistent with FINRA and
MSRB rules concerning interpositioning. Specifically, FINRA Rule
5310(a)(2) states that no broker-dealer or person associated with a
broker-dealer may interject a third party between the broker-dealer
and the best market for the subject security in a manner that would
be inconsistent with FINRA's best execution standard. FINRA Rule
5310(b) states that when a broker-dealer cannot execute directly
with a market but must employ a broker's broker or some other means
in order to ensure an execution advantageous to the customer, the
burden of showing the acceptable circumstances for doing so is on
the broker-dealer. And FINRA Rule 5310.05 states that examples of
acceptable circumstances are where a customer's order is ``crossed''
with another firm that has a corresponding order on the other side,
or where the identity of the firm, if known, would likely cause
undue price movements adversely affecting the cost or proceeds to
the customer. MSRB Rule G-18(b) similarly prohibits a broker-dealer
from interjecting a third party between itself and the best market
for the subject security in a manner inconsistent with the MSRB's
best execution standard. However, unlike proposed Rule 1101(a),
FINRA and MSRB rules do not require a broker-dealer's best execution
policies and procedures to explicitly address the incorporation of
liquidity sources into its order handling practices or the efficient
access of liquidity sources.
\150\ See supra notes 29-30 and accompanying text.
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Request for Comment
The Commission requests comment on all aspects of proposed Rule
1101(a)(1), and in particular:
31. Do commenters believe that proposed Rule 1101(a)(1)(i)
appropriately requires a broker-dealer's policies and procedures to
reflect how it will obtain and assess reasonably accessible
information, including information about price, volume, and execution
quality, concerning the markets trading the relevant securities? Why or
why not?
32. What factors would a broker-dealer consider in determining
whether information is ``reasonably accessible'' for purposes of its
best execution policies and procedures under the proposed rules? Please
explain.
33. Should the Commission specify the types of information that
would be ``reasonably accessible'' under proposed Rule 1101(a)(1)(i)?
For example, should the Commission specify that consolidated market
data distributed by the securities information processors is a type of
``reasonably accessible'' information under the proposed rule? Please
explain.
34. Do commenters agree that proposed Rule 1101(a)(1) is consistent
with prior Commission statements, including those described in section
II.B above? Why or why not? If not, should the Commission revise any of
its statements in light of the proposal? Please explain.
35. Do commenters believe that proposed Rule 1101(a)(1)(ii)
appropriately requires a broker-dealer's policies and procedures to
reflect how it will identify material potential liquidity sources? Why
or why not?
36. Do commenters believe the Commission has appropriately defined
material potential liquidity sources in proposed Rule 1101(a)(1)(ii)?
Please explain.
37. What factors would a broker-dealer consider in identifying
material potential liquidity sources under the proposed rules? Please
explain.
38. In identifying material potential liquidity sources, do broker-
dealers consider market connectivity fees and other access and
transaction fees? Please explain.
39. Do commenters agree that proposed Rule 1101(a)(1)(ii) is
consistent with prior Commission statements, including those described
in section II.B above? Why or why not? If not, should the Commission
revise any of its statements in light of the proposal? Please explain.
40. Do commenters believe that proposed Rule 1101(a)(1)(iii)
appropriately requires a broker-dealer's policies and procedures to
reflect how it will incorporate material potential liquidity sources
into its order handling practices? Why or why not?
41. Do commenters believe that proposed Rule 1101(a)(1)(iii)
appropriately requires a broker-dealer's policies and procedures to
reflect how it will ensure efficient access to each material potential
liquidity source? Why or why not?
42. What factors would a broker-dealer consider to ensure that it
can efficiently access a material potential liquidity source under the
proposed rules? Please explain.
43. Do commenters agree that proposed Rule 1101(a)(1)(iii) is
consistent with prior Commission statements, including those described
in section II.B above? Why or why not? If not, should the Commission
revise any of its statements in light of the proposal? Please explain.
[[Page 5459]]
44. Do commenters agree with the Commission's understanding that
broker-dealers currently have policies and procedures for how they
comply with the FINRA and MSRB best execution rules, as applicable?
Please describe the types of best execution policies and procedures
that broker-dealers currently have. In particular, do broker-dealers'
policies and procedures address how they obtain and assess reasonably
accessible information, including information about price, volume, and
execution quality, concerning the markets trading the relevant
securities? Do broker-dealers' policies and procedures address how they
identify material potential liquidity sources? Do broker-dealers'
policies and procedures address how they incorporate material potential
liquidity sources into their order handling practices, and how they
ensure that they can efficiently access each such material potential
liquidity source?
45. Do commenters believe that the Commission should provide
staggered compliance dates for proposed Rule 1101(a)(1) for broker-
dealers of different sizes, if the Commission adopts proposed
Regulation Best Execution? For example, should the Commission provide
longer compliance dates for smaller broker-dealers? If so, should the
Commission define a smaller broker-dealer as a broker-dealer that
qualifies as a ``small entity'' under the Regulatory Flexibility Act
pursuant to 17 CFR 240.0-10(c) for this purpose? \151\ Or should the
Commission define a smaller broker-dealer in a different way? Please
explain.
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\151\ 17 CFR 240.0-10(c) defines a smaller broker-dealer as one
that: (1) had total capital (net worth plus subordinated
liabilities) of less than $500,000 on the date in the prior fiscal
year as of which its audited financial statements were prepared
pursuant to Rule 17a-5(d) under the Exchange Act, or, if not
required to file such statements, had total capital (net worth plus
subordinated liabilities) of less than $500,000 on the last business
day of the preceding fiscal year (or in the time that it has been in
business, if shorter); and (2) is not affiliated with any person
(other than a natural person) that is not a small business or small
organization.
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2. Proposed Rule 1101(a)(2)--Best Market Determination
Proposed Rule 1101(a)(2) would require a broker-dealer's best
execution policies and procedures to address how it will determine the
best market and make routing or execution decisions for customer orders
that it receives by: (i) 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;
(ii) 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 (iii) 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 worse prices.
In determining the best market for customer orders, the assessment
of reasonably accessible and timely information \152\ with respect to
the best displayed prices and opportunities for price improvement would
vary depending on the trading characteristics of particular securities.
Displayed prices can provide a useful reference price for a broker-
dealer to consider when assessing the best market in which to execute
customer orders, particularly in an asset class where there are
consolidated displays of the best prices across the market, or for
securities that are considered liquid and have firm prices that are
accessible. Accordingly, under proposed Rule 1101(a)(2)(i), a broker-
dealer's policies and procedures would be required to address how it
will assess reasonably accessible and timely information with respect
to the best displayed prices in any given market or security.\153\ In
addition, the Commission has previously stated that, when reviewing
their procedures for seeking to obtain best execution, ``broker-dealers
must take into account price improvement opportunities, and whether
different markets may be more suitable for different types of orders or
particular securities.'' \154\ Accordingly, under proposed Rule
1101(a)(2)(i), a broker-dealer's policies and procedures would be
required to specifically address how it will assess price improvement
opportunities,\155\ including midpoint execution opportunities.\156\
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\152\ See supra notes 132 and 141 and accompanying text.
\153\ For fixed income securities, FINRA has also recognized
that while a broker-dealer should consider using displayed prices on
electronic trading platforms as part of its reasonable diligence in
determining the best market for a security, executing a customer
order at the displayed price may not necessarily fulfill the broker-
dealer's best execution obligations. See FINRA Regulatory Notice 15-
46, at 8 (stating that displayed prices on electronic trading
platforms may not be the presumptive best prices, especially for
securities that are illiquid or trade infrequently). Accordingly,
the Commission believes that the concept of ``best displayed
prices'' is applicable to the fixed income securities market.
\154\ Regulation NMS Adopting Release, supra note 21, 70 FR
37538. See also Order Execution Obligations Adopting Release, supra
note 10, 61 FR 48323 n.357 (stating that any evaluation of price
improvement opportunities would have to consider not only the extent
to which orders are executed at prices better than the prevailing
quotes, but also the extent to which orders are executed at inferior
prices).
\155\ Price improvement is the execution of an order at a price
that is better than the best displayed buy or sell prices in the
market, and an execution between the best displayed bid and offer is
a form of price improvement. See, e.g., Order Execution Obligations
Adopting Release, supra note 10, 61 FR 48323 n.357 (stating that
price improvement means the difference between execution price and
the best quotes prevailing in the market at the time the order
arrived at the market or market maker); FINRA Rule 5310.09(b)(1)
(describing price improvement opportunities to mean the difference
between the execution price and the best quotes prevailing at the
time the order is received by the market).
\156\ These executions occur at the midpoint of the best
displayed buy and sell prices and may represent a significant amount
of price improvement as compared to executing at the best displayed
prices for customers seeking to trade immediately.
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In addition to displayed prices and opportunities for price
improvement, there may be other order exposure opportunities for
customer orders (e.g., order handling and execution protocols that may
provide exposure to a competitive process for customer orders). For
example, markets that operate limit order books and enable broker-
dealers to post customer limit orders could represent a best market for
customer orders. These markets may provide an opportunity for
executions at the prevailing best bid for customer buy orders or at the
prevailing best offer for customer sell orders, rather than executing
customer orders by crossing the prevailing bid-offer spread. As another
example, auctions may offer an opportunity to expose marketable
customer orders to prices that are more favorable than prices that
would be achieved by crossing the spread. Accordingly, under proposed
Rule 1101(a)(2)(i), a broker-dealer's policies and procedures would be
required to address how it will assess order exposure opportunities
that may result in the most favorable price.
FINRA Rule 5310(a)(1) and MSRB Rule G-18(a) also identify price
information as relevant when ascertaining the best market for a
security.\157\ MSRB Rule G-18(a) also includes as an additional factor:
the information reviewed to determine the current market for the
subject security
[[Page 5460]]
or similar securities.\158\ As described in section IV.B.1 above, FINRA
and MSRB rules reflect requirements for broker-dealers to have policies
and procedures for compliance with relevant laws and rules. However,
FINRA and MSRB rules do not require a broker-dealer's policies and
procedures to specifically address the elements that are relevant to
its best market determinations. The Commission understands that broker-
dealers currently generally have policies and procedures to ascertain
the best market for a security, although such policies and procedures
may need to be updated to address the elements specified in proposed
Rule 1101(a)(2).
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\157\ FINRA has also recognized the importance of considering
midpoint liquidity. See FINRA Regulatory Notice 15-46 at 4 n.25
(``For example, if a firm obtains price improvement at one venue of
$0.0005 per share, and it could obtain mid-point price improvement
at another venue of $0.025 per share, the firm should consider the
opportunity of such midpoint price improvement on that other venue
as part of its best execution analysis.''). In addition, FINRA Rule
5310.09(b)(1) recognizes the relevance of price improvement
opportunities.
\158\ This factor is consistent with proposed Rule 1101(a)(2)
because a broker-dealer's policies and procedures regarding the
assessment of reasonably accessible and timely best displayed prices
in the municipal bond market could include an assessment of
information to determine the current market for the subject security
or similar securities.
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For a retail broker-dealer in NMS stocks, its policies and
procedures for the best market determination could include assessments
of any assurances from a wholesaler that certain orders routed by the
retail broker-dealer to the wholesaler would be guaranteed midpoint
executions by the wholesaler or otherwise exposed to opportunities for
midpoint executions.\159\ If midpoint executions were not guaranteed by
a wholesaler, a retail broker-dealer's policies and procedures could
provide for assessments of whether customer orders would best be
executed with midpoint liquidity that may be available on an exchange,
ATS, or other market. Following an assessment of the opportunities for
midpoint executions, a broker-dealer's policies and procedures could
provide for an assessment of whether other price improvement
opportunities might be available, such as from wholesalers,\160\ from
resting liquidity between the best bid and offer on exchanges, through
auctions, or otherwise.
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\159\ If wholesalers do not have a practice of routinely seeking
and accessing midpoint liquidity as appropriate, the retail broker-
dealer's policies and procedures could address how it takes that
into account when assessing whether a wholesaler is the best market
for customer orders.
\160\ In considering wholesalers, such policies and procedures
could address how the retail broker-dealer assesses the price
improvement opportunities that may be available from different
wholesalers, including an assessment of guarantees for price
improvement that might be provided by wholesalers and the
performance of wholesalers, such as the execution quality that the
retail broker-dealer's customers received from the wholesalers in
the past.
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With respect to listed options, the Commission recognizes that
midpoint liquidity is not as commonly available on options exchanges as
it is in the NMS stock market.\161\ A broker-dealer's policies and
procedures nevertheless would be required to address how it will assess
potential midpoint executions, including to the extent additional
midpoint liquidity emerges. Following an assessment of potential
opportunities for midpoint executions, the Commission preliminarily
believes that a broker-dealer's policies and procedures could provide
for an assessment of other price improvement opportunities that might
be available. These price improvement opportunities could include
potential resting liquidity on exchange limit order books priced
between the best bid and offer. Price improvement opportunities may
also be available through exchange price improvement auctions.\162\ A
broker-dealer's policies and procedures could also address how it will
assess price improvement opportunities that may be available from
different wholesalers, including an assessment of guarantees for price
improvement that might be provided by wholesalers and the performance
of the wholesalers, including the execution quality that the retail
broker-dealer's customers received from the wholesalers in the past. In
doing so, a broker-dealer's policies and procedures could address how
it will assess the exchanges and exchange mechanisms that wholesalers
use, why they use those exchanges and mechanisms, and the relative
competitiveness of those exchanges and mechanisms in light of fee
differentials and functionality that can affect competitive responses
and facilitate internalization.
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\161\ Given the lack of order types concerning midpoint
liquidity, midpoint liquidity is not prevalent in the listed options
market.
\162\ Price improvement auctions currently available on options
exchanges are two-sided and thus may not be directly accessible by
many retail broker-dealers because they do not commit capital to
trade with customers. Specifically, options price improvement
auctions guarantee that a customer order will be executed by
requiring the broker-dealer initiating the auction to commit to
trade in a principal capacity with the customer order at a certain
price, with exposure to potential price improvement from competitive
responders. See, e.g., Nasdaq ISE, LLC Options 3, Section 13; Nasdaq
Phlx LLC Options 3, Section 13; Miami International Securities
Exchange LLC Rule 515A; BOX Exchange LLC Rule 7150; NYSE American
LLC Rule 971.1NY; Cboe Exchange, Inc. Rule 5.37. However, to the
extent one-sided auctions (or other trading protocols providing a
competitive process for exposing customer orders for the most
favorable price) exist or emerge, a broker-dealer's policies and
procedures generally should consider addressing whether such price
improvement opportunities represent the best market for customer
orders when making a routing or execution decision.
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The policies and procedures requirements under proposed Rule
1101(a)(2)(i) would also apply to wholesalers in the NMS stock and
options markets. For customer orders that a wholesaler intends to
execute at prices worse than the midpoint, its policies and procedures
could provide for an assessment of whether those orders would best be
executed with midpoint liquidity that may be available on an exchange,
ATS, or other market. A wholesaler's policies and procedures would also
need to address how it will consider other opportunities for price
improvement, which could include liquidity available on exchanges or
other markets priced between the best bid and offer. Finally, these
policies and procedures would need to address how the wholesaler will
assess order exposure opportunities for customer orders that may result
in the most favorable price for those orders.
In the corporate and municipal bond markets and government
securities markets, some broker-dealers display executable prices to
customers through proprietary customer-facing systems that enable
customers to transact at the displayed prices. Sometimes these prices
represent securities that are available on other venues such as ATSs,
interdealer brokers or otherwise, while other times these prices
represent securities held in inventory by the broker-dealer. The
policies and procedures of a broker-dealer in the corporate and
municipal bond markets and government securities markets would need to
address how it will assess reasonably accessible and timely information
with respect to the best displayed prices.
Information with respect to the best displayed prices would be
different between the corporate and municipal bond markets and
government securities markets, and the equities and options markets. In
particular, timely consolidated best prices are readily accessible in
the equities and options markets, but there are no similar consolidated
best prices in the corporate and municipal bond markets and government
securities markets. A broker-dealer's policies and procedures generally
should therefore be tailored to reflect best displayed price
information that is ``reasonably accessible and timely'' in the
corporate and municipal bond markets and government securities
markets.\163\
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\163\ FINRA Rule 5310 also states that ``when quotations are
available, FINRA will consider the accessibility of such quotations
when examining whether a member has used reasonable diligence.'' See
FINRA Rule 5310.03. FINRA has also discussed the importance of a
broker-dealer evaluating the quality of displayed prices in fixed
income securities. See FINRA Regulatory Notice 15-46, at 8 (``FINRA
also notes that prices of a fixed income security displayed on an
electronic trading platform may not be the presumptive best price of
that security for best execution purposes, especially for securities
that are illiquid or trade infrequently. Thus, although a firm
should consider using this information as part of its reasonable
diligence in determining the best market for the security, executing
a customer order at the displayed price may not fulfill the firm's
obligations, particularly if other sources of information indicate
the displayed price may not be the best price available. For
example, if . . . a firm regularly uses a reliable similar security
analysis to establish prices, that firm may need to use particular
care before executing a trade at a price that is displayed by a
trading system if its similar security analysis suggests that the
displayed price is not reflective of the market.'').
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[[Page 5461]]
The proposed rule requires policies and procedures of a broker-
dealer in the corporate and municipal bond markets and government
securities markets to also address how it will assess order exposure
opportunities that may result in the most favorable price, which could
include how it will assess RFQ mechanisms. These mechanisms may
represent the best market for customer orders in light of the trading
characteristics of these securities, where there may be limited
quotation or transaction pricing information available. In the absence
of reliable pricing information, such as bid, offer, or transaction
data for a security, a competitive auction mechanism may result in the
most favorable prices reasonably available.
The policies and procedures of a broker-dealer in the corporate and
municipal bond markets and government securities markets could also
assess how its use of RFQ systems may affect the opportunity to expose
a customer order to the most favorable price. For example, when a
customer wishes to buy or sell a bond, a broker-dealer may use an
electronic RFQ system to solicit prices from other participants on the
system.\164\ In this scenario, a broker-dealer's policies and
procedures could address how it will use ``filters'' and assess whether
the use of filters would affect the exposure for customer orders.
Specifically, a broker-dealer that submits an RFQ on behalf of a
customer typically has the option of deciding which participants it
wants to request prices from. While a broker-dealer may use filters in
a way that is consistent with its duty of best execution, a broker-
dealer could also potentially use filters to prevent certain market
participants from receiving and participating in the RFQ in a way that
prevents a customer order from being exposed to opportunities to
receive the most favorable price (e.g., the participants that might
have been willing to provide that price may have been precluded from
the RFQ by the broker-dealer).\165\
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\164\ It is the Commission's understanding that a broker-dealer
typically uses RFQ systems to solicit prices when customers are
selling bonds and that RFQ systems are used less for customers that
are buying bonds.
\165\ FINRA and the MSRB have recognized the potential misuse of
filters as well. See FINRA Regulatory Notice 15-46, at 5 (``If a
firm uses filters on counterparties or filters on specific
securities intended to limit accessing bids and offers in those
securities, they may be used only for a legitimate purpose
consistent with obtaining the most favorable executions for
customers, and should be reviewed on a periodic basis and adjusted
as needed.''). See MSRB Interpretive Guidance Section III.1 (``Some
dealers may employ `filters,' which generally refer to automated
tools that allow the dealer to limit its trading, with, for example,
specific parties or parties with specified attributes with which it
does not want to interact. If a dealer uses filters on
counterparties or filters on specific securities intended to limit
accessing bids or offers in those securities, they may be used only
for a legitimate purpose consistent with obtaining the most
favorable executions for non-SMMP customers, and should be reviewed
on a periodic basis and adjusted as needed. The dealer, accordingly,
should have policies and procedures in place that govern when and
how to: reasonably use filters without negatively impacting the
quality of execution of non-SMMP customer transactions; periodically
reevaluate their use; and determine whether to lift them upon
request.'').
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As another example, the policies and procedures of a broker-dealer
in the corporate and municipal bond markets and government securities
markets could address the use of ``last look'' functionalities. When a
broker-dealer uses an RFQ system, it will often receive responses in
the form of bids (most common) or offers, and it typically has a
certain amount of time to decide whether or not it chooses to execute
the transaction with the best price or to match or improve that price
in a principal trade with the customer. One effect of this ``last
look'' practice may be to deter market participants that might
otherwise vigorously compete to trade with the customer's order from
submitting their most favorable prices, in light of the possibility
that the broker-dealer is simply using the RFQ system for price
discovery and ultimately intends to trade with its customer in a
principal capacity.\166\ A broker-dealer's policies and procedures
could address how the broker-dealer uses ``last look'' in connection
with its RFQs and whether this practice affects the extent to which
customer orders are exposed to opportunities to receive the most
favorable price.\167\
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\166\ See Recommendation Regarding the Practice of Pennying in
the Corporate and Municipal Bond Markets, SEC Fixed Income Market
Structure Advisory Committee (June 11, 2019), available at https://www.sec.gov/spotlight/fixed-income-advisory-committee/fimsac-pennying-recommendations.pdf (describing that the abusive use of the
last look practice ``harms competitiveness'' and ``deters aggressive
pricing or participation in the auction process by other dealers who
fear that the submitting dealer is going to `step in front of' their
winning prices or is otherwise using the auction process solely for
price discovery purposes''). See also FINRA Regulatory Notice 20-29
(Aug. 17, 2020) (requesting comment on the impact of the broker-
dealer practice of trading with a customer as principal by matching
or slightly improving on the best auction responses without
participating in the auction); MSRB Notice 2018-22 (Sept. 7, 2018)
(requesting comment on the abusive practice of last look known as
pennying and stating ``[i]n recent outreach to a broad range of
market participants, it has been suggested that pennying is
prevalent in the municipal market and that widespread pennying does
indeed disincentivize participation in the bid-wanted process,
discourages bidders from giving their best price in a bid-wanted and
may impact the efficiency of the market'').
\167\ Last look practices can also be beneficial to customers.
For example, there could be situations where the responses received
by the broker-dealer all reflect prices that the broker-dealer has
reason to believe are not reflective of the most favorable price. In
these cases, last look enables the broker-dealer to evaluate those
prices, determine not to execute the customer order at those prices,
and either internalize the order at a price the broker-dealer
believes is the most favorable price or seek additional liquidity
for the customer order.
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As a third example, the policies and procedures of a broker-dealer
in the corporate and municipal bond markets and government securities
markets could address the response times that a broker-dealer may
require for responses to an RFQ. Broker-dealers frequently request
quotes and include a time limit by which all quotes must be received.
This practice permits market participants time to consider the request
and provide a price for the security, while establishing a time limit
so that the broker-dealer can execute its customer order in a timely
manner. The appropriate amount of time for responses can be influenced
by important and variable considerations for different customer orders.
Response times that are too short, however, can prevent market
participants that may otherwise be interested in competing for the
customer order from being able to submit prices in response to the
request. A broker-dealer's policies and procedures could address how
the broker-dealer uses response times in connection with its RFQs and
how its use might impact the exposure of a customer order to
opportunities to receive the most favorable price.
In addition to assessing reasonably accessible and timely
information regarding displayed prices and price improvement and order
exposure opportunities, proposed Rule 1101(a)(2)(ii) would require a
broker-dealer's policies and procedures to address how it will assess
the attributes of its customers' orders and consider the trading
characteristics of the security, the size of the orders, the likelihood
of execution, the accessibility of the market, and any customer
instructions in selecting the market most likely to
[[Page 5462]]
provide the most favorable price for the order.
Not all customer orders have the same attributes or size and a
broker-dealer's best market determination is affected by the attributes
of customer orders and the size of customer orders.\168\ For example,
when a broker-dealer is handling and executing large orders, it may
likely be more sensitive to the possibility of information leakage and
price impact that could harm the execution quality of such orders.
Therefore, the broker-dealer may make a best market determination
designed to minimize the risk of information leakage and price impact
concerns.\169\ In contrast, a broker-dealer handling and executing
small orders may not be as concerned with information leakage,
resulting in a different best market determination for execution of
such orders.\170\ Other relevant customer order attributes could
include whether or not the order is a market order or limit order. A
broker-dealer's assessment of the best market to execute customer
orders is different for customers interested in trading immediately
\171\ and customers willing to execute orders over a longer period of
time. Moreover, the likelihood of execution is a relevant consideration
for a broker-dealer, as the failure to receive an execution for orders
from a particular market may negatively impact the ultimate execution
quality received by customers.
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\168\ FINRA Rule 5310(a)(1) also recognizes the ``size and
type'' of transactions as factors relevant to a broker-dealer's
exercise of reasonable diligence to ascertain the best market,
although FINRA rules do not require a broker-dealer's policies and
procedures to explicitly address how it would assess these factors.
\169\ It is the Commission's understanding that when an
institutional customer gives a large order to be executed on behalf
of one account (e.g., a single mutual fund or pension fund), it
expects the broker-dealer that handles and executes such large order
to do so in a manner that ensures best execution is provided to the
``parent'' order. In other words, to the extent that a parent order
is split into smaller ``child'' orders, the institutional customer
expects the best execution analysis to evaluate whether the parent
order was executed at the most favorable price possible under
prevailing market conditions according to customer instructions.
See, e.g., Concept Release on Equity Market Structure, supra note
49, 75 FR at 3604-3605 (measuring the transaction costs of
institutional investors ``can be extremely complex'' because their
``large orders often are broken up into smaller child orders and
executed in a series of transactions'' and ``[m]etrics that apply to
small order executions may miss how well or poorly the large order
traded overall.'').
\170\ While the Commission has long-acknowledged a range of
factors relevant for a best execution analysis, it has recognized
price as a critical concern. See supra note 22 and accompanying
text. The Commission has stated, for example, that it ``strongly
believes, however, that most investors care a great deal about the
quality of prices at which their orders are executed . . . .'' See
Order Execution and Routing Practice Release supra note 22, 65 FR at
75418. Additionally, the Commission has stated that broker-dealers
handling small orders in listed and OTC equities should look for
price improvement opportunities when executing these orders. See
Order Execution Obligations Adopting Release, supra note 10, 61 FR
48323.
\171\ FINRA Rule 5310.01 requires a broker-dealer to make every
effort to execute marketable customer orders fully and promptly.
Similarly, MSRB Rule G-18.03 requires a broker-dealer to make every
effort to execute a customer transaction promptly, taking into
account prevailing market conditions, and recognizes that in certain
market conditions a broker-dealer may need more time to use
reasonable diligence to ascertain the best market for the subject
security. The MSRB has stated that while a broker-dealer must make
every effort to execute a customer transaction promptly, the
determination as to whether a firm exercised reasonable diligence
necessarily involves a ``facts and circumstances'' analysis, and
actions that in one instance may meet a broker-dealer's best-
execution obligation may not satisfy that obligation under another
set of circumstances. MSRB Interpretative Guidance, V1.1: Execution
timing (Nov. 20, 2015). Similarly, when assessing the attributes of
a customer order under proposed Rule 1101(a)(2), a broker-dealer
would be required to assess how it will execute marketable customer
orders fully and promptly, taking into account prevailing
conditions, given that the customer expectation when submitting a
market order is to have the order executed immediately at the
prevailing market price or better.
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A broker-dealer's best market determination is also affected by the
trading characteristics of a security and the accessibility of a
market. For example, some securities may not have readily available or
accessible quotation data or may trade in OTC markets.\172\ These
characteristics affect how a broker-dealer would identify the best
market for customer orders, and a broker-dealer may need to seek out
pricing information that may not otherwise be available or accessible
at the time it receives a customer order, such as by soliciting buy or
sell interest from market participants through auction mechanisms,
interdealer brokers, or otherwise.\173\ Furthermore, extreme market
conditions that result in heightened volatility or impact the liquidity
for a security may affect a broker-dealer's best market determination
for customer orders as trading in those conditions may merit different
order handling than in more normal market conditions.\174\
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\172\ See also FINRA Rule 5310(a)(1) (recognizing the relevance
of the pressure on available communications as relevant for a
broker-dealer's best market determination). A broker-dealer's
assessment of the accessibility of a market could vary depending on
the cost of maintaining connectivity, receiving market data, and
transacting on the market.
\173\ These considerations are consistent with FINRA and MSRB
rules concerning orders involving securities with limited quotations
or pricing information. See FINRA Rule 5310.06 (providing that a
broker-dealer must be especially diligent in ensuring that it has
met its best execution obligations with respect to customer orders
involving securities for which there is limited pricing information
or quotations available; requiring each member to have written
policies and procedures that address how it will determine the best
inter-dealer market for such a security in the absence of pricing
information or multiple quotations and document its compliance with
those policies and procedures; providing as an example that a
broker-dealer should analyze pricing information based on other
data, such as previous trades in the security, to determine whether
the resultant price to the customer is as favorable as possible
under prevailing market conditions; and providing that a broker-
dealer should generally seek out other sources of pricing
information or potential liquidity, which may include obtaining
quotations from other sources (e.g., other firms with which the
member previously has traded in the security)); MSRB Rule G-18.06
(providing that a broker-dealer must be especially diligent in
ensuring that it has met its best-execution obligations with respect
to customer transactions involving securities for which there is
limited pricing information or quotations available; requiring each
broker-dealer to have written policies and procedures in place to
address how it will make its best execution determinations with
respect to such a security in the absence of pricing information or
multiple quotations and document its compliance with those policies
and procedures; and providing as an example that a broker-dealer
generally should seek out other sources of pricing information and
potential liquidity for such a security, including other broker-
dealers with which the broker-dealer previously has traded in the
security; and providing that a broker-dealer generally should, in
determining whether the resultant price to the customer is as
favorable as possible under prevailing market conditions, analyze
other data to which it reasonably has access).
\174\ See also FINRA Regulatory Notice 21-12 (discussing the
best execution obligations of broker-dealers handling and executing
customer orders during extreme market conditions); FINRA Rule
5310(a)(1) (discussing the relevance of volatility and liquidity to
a broker-dealer's best market determination).
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Moreover, customer instructions are relevant for a broker-dealer's
best market determination. Customers may provide a broker-dealer with
specific instructions regarding how the broker-dealer should handle and
execute their orders, including institutional customers that also owe
their clients a duty to seek best execution. A broker-dealer's policies
and procedures generally should address how the broker-dealer will
assess the factors in proposed Rule 1101(a)(2) within the context of
and consistent with customer instructions.\175\ For example, some
institutional customers may instruct their broker-dealer to handle and
execute their orders with regard being given to the fees and rebates
that may be charged or paid by a particular market,\176\ and a broker-
dealer's policies
[[Page 5463]]
and procedures generally should address how it would assess the
relevant factors in proposed Rule 1101(a)(2) while taking into account
the customer instructions in determining the best market for the
customers' orders.\177\
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\175\ A broker-dealer that receives an unsolicited instruction
from a customer to route that customer's order to a particular
market for execution and otherwise qualifies for the exemption from
the proposed best execution standard in Rule 1100(c) would not be
subject to the requirements of proposed Rule 1101, including the
requirement to have policies and procedures that address how the
broker-dealer would consider customer instructions in selecting the
market most likely to provide the most favorable price.
\176\ The Commission understands that these customers often pay
the broker-dealer a lower commission or service fee for handling
their orders, and the fees and rebates that are charged or paid by a
market are often passed through to the customers.
\177\ To the extent rebates cause certain transactions to be
``conflicted transactions'' as defined in proposed Rule 1101(b), a
broker-dealer's policies and procedures must also address how it
would assess the relevant factors in proposed Rule 1101(b) while
taking into account the customer instructions.
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Proposed Rule 1101(a)(2)(iii) would require a broker-dealer's
policies and procedures to address how it will reasonably balance the
likelihood of obtaining better prices with the risk that delay could
result in worse prices in determining the number and sequencing of
markets to be assessed for its customers' orders.\178\ An undue delay
in execution of customer orders may detrimentally impact the execution
of those orders, if there was a change in the price or liquidity
available at the time of execution that was not favorable to the
customer. For example, in a volatile market, executing customer orders
quickly may be necessary for the customer to receive the most favorable
prices or to receive an execution at all. Doing so may require the
broker-dealer to execute customer orders using fewer or different
execution methods than it might otherwise use in a less volatile
market. Similarly, a broker-dealer that is handling large customer
orders may determine that preventing information leakage is necessary
in order for the large orders to be executed at the most favorable
prices, which may affect the number and sequencing of the markets that
it assesses. Accordingly, the broker-dealer's best execution policies
and procedures generally should be tailored for the different
circumstances in order to reflect a reasonable balance between the
likelihood of obtaining better prices with the risk that delay could
result in worse prices.
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\178\ For example, a broker-dealer could develop an automated
process for determining the specific markets to which it routes
orders and the sequence in which the orders are routed.
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FINRA Rule 5310(a)(1) and MSRB Rule G-18(a) set forth similar
factors that are relevant to ascertaining the best market for customer
orders, including the character of the market for the security (e.g.,
price, volatility, relative liquidity, and pressure on available
communications), the size and type of transaction, the number of
markets checked, the accessibility of the quotation,\179\ and the terms
and conditions of the order that result in the transaction as
communicated to the broker-dealer. As described in section IV.B.1
above, FINRA and MSRB rules require broker-dealers to have policies and
procedures for compliance with relevant laws and rules. In addition,
the FINRA and MSRB rules specifically require a broker-dealer to
establish written policies and procedures that address how it will
determine the best market for a security in the absence of pricing
information or multiple quotations and document its compliance with
those policies and procedures.\180\ However, FINRA and MSRB rules do
not require a broker-dealer's policies and procedures to specifically
address the elements that are relevant to its best market
determinations. The Commission understands that broker-dealers
generally have policies and procedures to ascertain the best market for
a security, although such policies and procedures may need to be
updated to address the elements specified in proposed Rule 1101(a)(2).
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\179\ FINRA Rule 5310.03 provides that, for purposes of debt
securities, the term ``quotation'' refers to either dollar (or other
currency) pricing or yield pricing. It also states that
accessibility is only one of the non-exhaustive reasonable diligence
factors, and in the absence of accessibility, members are not
relieved from taking reasonable steps and employing their market
expertise in achieving the best execution of customer orders.
Proposed Rule 1101(a) similarly provides a list of non-exhaustive
reasonable diligence factors that would be addressed in a broker-
dealer's best execution policies and procedures.
\180\ See supra note 173.
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Request for Comment
The Commission requests comment on all aspects of proposed Rule
1101(a)(2), and in particular:
46. Has the Commission appropriately identified the considerations
for determining the best market for customer orders? Why or why not?
47. Do commenters believe that proposed Rule 1101(a)(2)(i)
appropriately requires a broker-dealer's policies and procedures to
reflect how it will assess 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? Why or why
not?
48. Do commenters believe that proposed Rule 1101(a)(2)(ii)
appropriately requires a broker-dealer's policies and procedures to
reflect how it will assess the attributes of customer orders and
consider 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? Why or why not?
49. Do commenters believe that proposed Rule 1101(a)(2)(iii)
appropriately requires a broker-dealer's policies and procedures to
reflect how it will reasonably balance the likelihood of obtaining
better prices with the risk that delay could result in a worse price,
in determining the number and sequencing of markets to be assessed? Why
or why not?
50. Do commenters agree that proposed Rule 1101(a)(2) is consistent
with prior Commission statements, including those described in section
II.B above? Why or why not? If not, should the Commission revise any of
its statements in light of the proposal? Please explain.
51. While the considerations for determining the best market
included in proposed Rule 1101(a)(2) are non-exhaustive, should the
Commission explicitly include other considerations in the rule? If so,
please explain.
52. Is the list of considerations for determining the best market
included in proposed Rule 1101(a)(2) consistent with the considerations
included in FINRA Rule 5310 and MSRB Rule G-18? If not, please explain
any differences and whether the considerations should be consistent.
53. Do commenters agree with the Commission's understanding that
midpoint liquidity is not as commonly available in the options market
as it is in the NMS stock market? Why or why not?
54. Should the Commission specify transaction fees in the rule text
as considerations for determining the best market? If so, please
explain how fees may be relevant to the best execution standard and a
broker-dealer's best market determination. Do broker-dealers route and
execute customer orders based on a favorable transaction fee and does
that impact the execution quality of customer orders? Please explain.
55. What factors should a broker-dealer consider in determining the
number and sequencing of markets to be assessed, in addition to the
likelihood of obtaining better prices and the risk that a delay could
result in a worse price? Please explain.
56. Do commenters agree with the Commission's understanding that
institutional customers expect broker-dealers that handle and execute
their large orders for a single account to do so in a manner that
ensures best execution is provided to the ``parent'' order?
[[Page 5464]]
57. Do commenters agree with the Commission's understanding that
broker-dealers currently generally have policies and procedures to
ascertain the best market for a security? Please describe the types of
best market policies and procedures that broker-dealers currently have.
In particular, do broker-dealers' policies and procedures address how
they assess 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? Do broker-dealers' policies and
procedures address how they assess the attributes of customer orders
and consider 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? Do broker-dealers' policies
and procedures address how they reasonably balance the likelihood of
obtaining better prices with the risk that delay could result in a
worse price, in determining the number and sequencing of markets to be
assessed?
58. Do commenters believe that the Commission should provide
staggered compliance dates for proposed Rule 1101(a)(2) for broker-
dealers of different sizes, if the Commission adopts proposed
Regulation Best Execution? For example, should the Commission provide
longer compliance dates for smaller broker-dealers? If so, should the
Commission define a smaller broker-dealer as a broker-dealer that
qualifies as a ``small entity'' under the Regulatory Flexibility Act
pursuant to 17 CFR 240.0-10(c) for this purpose? \181\ Or should the
Commission define a smaller broker-dealer in a different way? Please
explain.
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\181\ See supra note 151 and accompanying text (describing the
broker-dealers that qualify as small entities under the Regulatory
Flexibility Act).
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C. Proposed Rule 1101(b)--Policies and Procedures and Documentation for
Conflicted Transactions
Proposed Rule 1101(b) would require a broker-dealer's best
execution policies and procedures to address additional considerations
with respect to ``conflicted transactions.'' It would also require a
broker-dealer to document its compliance with the proposed best
execution standard for conflicted transactions and document any
arrangement concerning payment for order flow.
Proposed Rule 1101(b) would define a ``conflicted transaction'' for
purposes of proposed Regulation Best Execution as any ``transaction for
or with a retail customer'' where a broker-dealer: (i) executes an
order as principal, including riskless principal; \182\ (ii) routes an
order to, or receives an order from, an affiliate for execution; or
(iii) provides or receives payment for order flow as defined in Rule
10b-10(d)(8) under the Exchange Act.\183\ For purposes of paragraph
(b), ``affiliate'' would be defined by proposed Rule 1101(b)(4)(iii)
as, with respect to a specified person, any person that, directly or
indirectly, controls, is under common control with, or is controlled
by, the specified person. ``Control'' would be defined for purposes of
the proposed definition of ``affiliate'' by proposed Rule
1101(b)(4)(iii) as the power, directly or indirectly, to direct the
management or policies of the broker-dealer whether through ownership
of securities, by contract, or otherwise. A person is presumed to
control a broker-dealer if that person is a director, general partner,
or officer exercising executive responsibility (or having similar
status or performing similar functions); directly or indirectly has the
right to vote 25 percent or more of a class of voting securities or has
the power to sell or direct the sale of 25 percent or more of a class
of voting securities of the broker-dealer; or in the case of a
partnership, has contributed, or has the right to receive upon
dissolution, 25 percent or more of the capital of the broker-
dealer.\184\ In each of these types of conflicted transactions, the
broker-dealer has a financial interest that could disincentivize the
broker-dealer from achieving best execution for its customer's
orders.\185\ Accordingly, the Commission proposes to require more
robust policies and procedures, as well as documentation, for
conflicted transactions with retail customers to better address these
disincentives.
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\182\ For purposes of proposed Rule 1101(b), a broker-dealer
would be executing an order as ``riskless principal'' if, after
having received an order to buy from a customer, the broker-dealer
purchases the security from another person to offset a
contemporaneous sale to the customer or, after having received an
order to sell, the broker-dealer sells the security to another
person to offset a contemporaneous purchase from the customer. See
also, Exchange Act Rule 3a5-1; U.S. Securities and Exchange
Commission, Report on the Municipal Securities Market (July 31,
2012) available at https://www.sec.gov/news/studies/2012/munireport073112.pdf. The Commission preliminarily believes that it
is appropriate to include riskless principal transactions as a type
of conflicted transactions because of the variability of markups and
markdowns associated with riskless principal transactions, which
impacts the ultimate price paid by the customer (i.e., the ultimate
execution received by the customer) and often is not known to the
customer prior to transacting. See, e.g., John M. Griffin, et al.,
supra note 66.
\183\ See supra note 43 (setting forth the definition of
``payment for order flow'' under Rule 10b-10(d)(8)). Given the
widespread use of the Rule 10b-10(d)(8) definition of ``payment for
order flow'' and the collective understanding of the term by market
participants, the Commission proposes to use the existing Rule 10b-
10(d)(8) definition in proposed Regulation Best Execution. As
reflected in this definition, payment for order flow would include
any payments from a wholesaler to a retail broker-dealer in return
for order flow. It would also include any exchange rebates paid to a
broker-dealer in return for sending orders to the exchange. When all
payment for order flow for a customer order from a particular market
is passed through to the customer and the broker-dealer retains no
part of the payment for order flow associated with that customer
order, the broker-dealer would not be engaging in a conflicted
transaction under proposed Rule 1101(b) with respect to that
customer order.
\184\ These definitions are substantially the same as the
definitions of ``affiliate'' and ``control'' prescribed for purposes
of the disclosures required of an ATS that trades NMS stocks (``NMS
Stock ATS'') about its operations on Form ATS-N with the following
modifications: the Form ATS-N definition of ``affiliate'' uses a
separately-defined term ``Person'' instead of the statutory
definition of ``person,'' and Form ATS-N defines ``control'' as
applicable to the ``broker-dealer of the alternative trading
system'' instead of as applicable to a ``broker or dealer.'' The
Commission believes that it would be appropriate to use
substantially similar definitions of ``affiliate'' and ``control''
in the context of proposed Rule 1101(b) because, for purposes of
Form ATS-N, the Commission defined such terms for use with respect
to disclosures designed to enable market participants to better
evaluate how relationships between certain persons could affect the
handling of orders on a particular NMS Stock ATS. See Securities
Exchange Act Release No. 83663 (July 18, 2018), 83 FR 38768 (Aug. 7,
2018). The substantially similar proposed definitions, as used in
the context of proposed Rule 1101(b), are similarly designed to
recognize that relationships among certain persons may impact the
handling of orders, and are designed to help ensure that broker-
dealers that have conflicts of interest in their order handing are
subject to additional obligations under proposed Rule 1101(b).
\185\ See generally section III.A.2 (discussing in more detail
these conflicts of interest); see also 2022 Report on FINRA's
Examination and Risk Monitoring Program 45 (Feb. 2022), available at
https://www.finra.org/sites/default/files/2022-02/2022-report-finras-examination-risk-monitoring-program.pdf (describing FINRA
exam findings, including firms 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 payment for order flow from
wholesale market makers and exchange liquidity rebates).
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Proposed Rule 1101(b) would apply to conflicted transactions for or
with a retail customer, and proposed Rule 1101(b)(4)(i) would define a
``transaction for or with a retail customer'' as any transaction for or
with the account of a natural person or held in legal form on behalf of
a natural person or group of related family members. The proposed
definition's limitation to accounts of natural persons is consistent
with existing rules that are designed to identify the orders of
individual investors. For example, the definition of ``retail
customer'' in the
[[Page 5465]]
Commission's Regulation Best Interest rule is limited to a ``natural
person.'' \186\ Moreover, several national securities exchanges operate
programs for trading ``retail'' orders that are limited to accounts of
natural persons or certain accounts on behalf of natural persons.\187\
The proposed definition of retail customer is also consistent with
FINRA's rule for certain trade reporting.\188\ Proposing a definition
of retail customer that is similar to existing Commission and SRO rules
would facilitate compliance with proposed Rule 1101(b) and help
mitigate the costs of compliance because broker-dealers would already
be familiar with identifying orders for the accounts of natural
persons, or for related accounts, in these other contexts.
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\186\ 17 CFR 240.15l-1(b)(1) (defining ``retail customer'' to
mean, among other things, a natural person who receives a
recommendation of any securities transaction from a broker or dealer
and uses the recommendation primarily for personal, family, or
household purposes). Proposed 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.
\187\ See, e.g., Investors Exchange LLC Rule 11.190(b)(15)
(providing, among other things, that ``[a] Retail order must reflect
trading interest of a natural person'' and that ``[a]n order from a
retail customer can include orders submitted on behalf of accounts
that are held in a corporate legal form--such as an Individual
Retirement Account, Corporation, or a Limited Liability Company--
that have been established for the benefit of an individual or group
of related family members, provided that the order is submitted by
an individual''); The Nasdaq Stock Market LLC, Equity 7, Section 118
(defining a ``Designated Retail Order'' as originating from a
``natural person'' and explaining that ``[a]n order from a `natural
person' can include orders on behalf of accounts that are held in a
corporate legal form--such as an Individual Retirement Account,
Corporation, or a Limited Liability Company--that has been
established for the benefit of an individual or group of related
family members, provided that the order is submitted by an
individual'').
\188\ FINRA Rule 7620A.01 (defining a ``retail order'' as
originating from a ``natural person'' and explaining that ``[a]n
order from a `natural person' can include orders on behalf of
accounts that are held in a corporate legal form, such as an
Individual Retirement Account, Corporation, or a Limited Liability
Corporation that has been established for the benefit of an
individual or group of related family members, provided that the
order is submitted by an individual'').
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In addition to the accounts of natural persons, the proposed
definition of ``transaction for or with a retail customer'' would cover
accounts held in legal form on behalf of a natural person or a group of
related family members. A ``group of related family members'' would be
defined broadly in proposed Rule 1101(b)(4)(i) to include a group of
natural persons with any of the following relationships: child,
stepchild, grandchild, great grandchild, parent, stepparent,
grandparent, great grandparent, spouse, domestic partner, sibling,
stepbrother, stepsister, niece, nephew, aunt, uncle, mother-in-law,
father-in-law, son-in-law, daughter-in-law, brother-in-law, or sister-
in-law, including adoptive and foster relationships; and any other
natural person (other than a tenant or employee) sharing a household
with any of the foregoing natural persons. This proposed definition is
broad so as not to restrict 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.
Proposed Rule 1101(b) would create new requirements for broker-
dealers' conflicted transactions that are not currently required by
FINRA or the MSRB. Because a broker-dealer engaging in conflicted
transactions for or with retail customers has an incentive to handle
those orders in a manner that prioritizes its own interests over its
customers' interests, the Commission preliminarily believes that,
correspondingly, additional policies and procedures elements and
documentation requirements should apply to such transactions in order
to help mitigate the potential for these incentives to negatively
affect the broker-dealer's best execution determinations. The
Commission preliminarily believes that proposed Rule 1101(b) would help
broker-dealers to comply with the proposed best execution standard with
respect to conflicted transactions, because it would require heightened
attention by broker-dealers for conflicted transactions and would
require broker-dealers to document the basis for their determinations
that, despite the conflicts of interest, they have complied with the
best execution standard for their conflicted transactions.
The Commission also preliminarily believes that retail customers
generally would benefit more than non-retail customers from the more
robust conflicted transactions requirements because retail customers
are likely to have fewer resources for evaluating the best execution
practices of their broker-dealers than non-retail customers. For
example, institutional customers likely have additional knowledge,
experience, and analytical resources as compared to retail customers
and, thus, are more readily able to evaluate the impact of their
broker-dealers' conflicted transactions. In contrast, retail customers
are less likely to have the same level of knowledge, experience, and
resources to make such evaluations.
Request for Comment
The Commission requests comment on the types of conflicted
transactions under proposed Rule 1101(b), and in particular:
59. Is it appropriate for proposed Rule 1101(b) to incorporate the
definition of ``payment for order flow'' from Exchange Act Rule 10b-
10(d)(8)? Why or why not? If not, how should ``payment for order flow''
be defined for purposes of proposed Regulation Best Execution? Please
describe any alternative definition and explain why such definition
would be appropriate.
60. Does proposed Rule 1101(b) appropriately identify the conflicts
of interest of broker-dealers that are most relevant to the handling of
retail customer orders? If not, why not? Are there other conflicted
transactions that should be included in proposed Rule 1101(b) or are
there transactions that are included that should be omitted? If so,
please explain.
61. Should the principal trading conflict identified in proposed
Rule 1101(b) include riskless principal trades with customers, as
proposed? Why or why not? If riskless principal trades should be
included, should they be defined as proposed--after having received an
order to buy from a customer, the broker-dealer purchases the security
from another person to offset a contemporaneous sale to the customer
or, after having received an order to sell, the broker-dealer sells the
security to another person to offset a contemporaneous purchase from
the customer--similar to the definition of riskless principal in
Exchange Act Rule 3a5-1? Why or why not?
62. Should the Commission provide an exemption from the definition
of conflicted transactions for certain types of riskless principal
trades? For example, should the Commission exempt from the definition
of ``riskless principal'' in proposed Rule 1101 (b)(4)(ii) trades where
the broker-dealer discloses to its customer the markup or markdown that
it charges on these trades on a pre-trade basis? Please explain. If
this type of exemption should be provided, what would be an appropriate
method of pre-trade markup or markdown disclosure by the broker-dealer?
For example, would it be appropriate for the broker-dealer to disclose
a markup or markdown schedule in a readily accessible place such as its
website? Please explain.
63. Alternatively, should the Commission exempt from the definition
of ``riskless principal'' in proposed Rule
[[Page 5466]]
1101(b)(4)(ii) trades where the contemporaneous purchases and sales are
executed at the same price resulting in a transaction with the customer
that does not include any markup or markdown? Please explain. In these
types of transactions, how would the broker-dealer be compensated by
the customer? Would it charge a commission that is separately disclosed
to the customer on the confirmation? Would the customer know the
commission that it would pay the broker-dealer prior to engaging in the
transaction?
64. Is the proposed definition of a ``transaction for or with a
retail customer'' in Rule 1101(b)(4)(i), which would include accounts
held in legal form on behalf of a natural person or a group of related
family members, appropriate? Why or why not? Should the proposed
definition be broadened or narrowed? If so, please explain how the
definition should be broadened or narrowed and why.
65. Is the proposed definition of ``group of related family
members'' in proposed Rule 1101(b)(4)(i) appropriate? Why or why not?
Should it be more or less inclusive, and if so, in what regard? Please
explain. For example, instead of capturing a group of natural persons
with ``any'' of the relationships in the proposed definition (child,
stepchild, grandchild, great grandchild, parent, stepparent,
grandparent, great grandparent, spouse, domestic partner, sibling,
stepbrother, stepsister, niece, nephew, aunt, uncle, mother-in-law,
father-in-law, son-in-law, daughter-in-law, brother-in-law, or sister
in law, including adoptive and foster relationships; and any other
natural person (other than a tenant or employee) sharing a household
with any of the foregoing natural persons), should the proposed
definition be limited to a group of natural persons consisting ``only''
of those relationships?
66. Should the definition of a ``transaction for or with a retail
customer'' exclude a transaction with a ``family office,'' which is
defined in Rule 202(a)(11)(G)-1(b) under the Investment Advisers Act of
1940 as a company (including its directors, partners, members,
managers, trustees, and employees acting within the scope of their
position or employment) that: (1) has no clients other than family
clients (as defined in the rule) (provided that if a person that is not
a family client becomes a client of the family office as a result of
the death of a family member or key employee (as defined in the rule)
or other involuntary transfer from a family member or key employee,
that person shall be deemed to be a family client for purposes of the
rule for one year following the completion of the transfer of legal
title to the assets resulting from the involuntary event); (2) is
wholly owned by family clients and is exclusively controlled (directly
or indirectly) by one or more family members and/or family entities;
and (3) does not hold itself out to the public as an investment
adviser? Why or why not?
67. Alternatively, should the definition of a ``transaction for or
with a retail customer'' only exclude a subset of ``family offices''?
For example, should it exclude a family office (as defined above) that
(1) has one or more experienced securities or financial services
professionals, (2) manages a threshold level of total assets (e.g., $50
million or more) that are indicative of an institutional account, (3)
has the capacity to evaluate independently the execution quality
received from the broker-dealer, and (4) has professionals who are
independent representatives of their family clients? Please explain.
68. Is the proposed definition of an ``affiliate'' in proposed Rule
1101(b)(4)(iii) appropriate? Why or why not? Should the proposed
definition be broadened or narrowed? If so, please explain how the
definition should be broadened or narrowed and why.
69. Is the proposed definition of ``control'' for purposes of the
proposed definition of ``affiliate'' in proposed Rule 1101(b)(4)(iii)
appropriate? Why or why not? Should the proposed definition be
broadened or narrowed? If so, please explain how the definition should
be broadened or narrowed and why.
70. Should some or all institutional customers' orders also have
the protections afforded by proposed Rule 1101(b)? Please explain. If
only certain categories of institutional customers' orders should also
have the protections afforded by proposed Rule 1101(b), how should the
Commission identify and define the institutional customers' orders that
should benefit?
71. Should the size of institutional customers be considered when
determining whether or not they should be afforded the protections of
proposed Rule 1101(b)? If so, what would be the appropriate metric to
identify such institutional customers? For example, should the
Commission consider the amount of assets under management when
determining which institutional customers should be afforded the
protections of proposed Rule 1101(b)?
72. If the Commission were to apply the protections of proposed
Rule 1101(b) to conflicted transactions for or with institutional
customers, should it define ``institutional customer'' as any person
that does not qualify as a QIB?\189\ Should it define ``institutional
customer'' to include any person that qualifies as a QIB? Or should it
define ``institutional customer'' to include a broader set of
institutional customers than the QIB definition, such as those entities
that are included in the FINRA definition of ``institutional account''
under FINRA Rule 4512(c)?\190\
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\189\ See supra note 124 (providing the definition of QIB under
Rule 144A under the Securities Act of 1933).
\190\ See supra note 125 and accompanying text (describing the
definition of institutional account in FINRA Rule 4512(c)).
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73. Do commenters believe there is another definition of
``institutional customer'' that would be more appropriate if the
Commission were to apply the protections of proposed Rule 1101(b) to
conflicted transactions for or with institutional customers? Please
explain.
74. If institutional customers' orders should be afforded the
additional protections, are some or all of the conflicts of interest
identified in proposed Rule 1101(b) also relevant for institutional
customers? Are there other conflicts of interest relevant for
institutional customers that should be included in proposed Rule
1101(b)? Please explain.
75. If institutional customers' orders should be afforded the
additional protections, should all the requirements under proposed Rule
1101(b) be extended to institutional customers' orders, or should only
certain of the requirements be extended to institutional customers'
orders? Should the Commission include other requirements for the
protection of institutional customers' orders? Please explain.
1. Proposed Rules 1101(b)(1) and (2)--Policies and Procedures for
Conflicted Transactions
Proposed Rules 1101(b)(1) and (2) would require a broker-dealer's
best execution policies and procedures to address the following with
respect to conflicted transactions: (1) how the broker-dealer will
obtain and assess information beyond that required by proposed Rule
1101(a)(1)(i), including additional information about price, volume,
and execution quality, in identifying a broader range of markets beyond
those identified as material potential liquidity sources; and (2) how
the broker-dealer will evaluate a broader range of markets, beyond
those identified as material potential liquidity sources, that might
provide the most favorable price for customer orders,
[[Page 5467]]
including a broader range of order exposure opportunities and markets
that may be smaller or less accessible.
Proposed Rule 1101(b) is not designed to eliminate order handling
conflicts of interest, and does not ban conflicted transactions.
However, because a broker-dealer engaging in conflicted transactions
for or with retail customers has an incentive to handle those orders in
a manner that prioritizes its own interests over its customers'
interests, the Commission preliminarily believes that, correspondingly,
such transactions should be subject to more robust policies and
procedures in order to help mitigate the potential for these incentives
to negatively affect the broker-dealer's best execution determinations.
Specifically, to help ensure that a broker-dealer exercises the
reasonable diligence required by proposed Rule 1100 despite its
incentives not to, a broker-dealer would be required to have policies
and procedures that are specific to conflicted transactions to address
how it will assess information beyond what is required for non-
conflicted transactions and how it will identify and evaluate of a
broader set of liquidity sources than for non-conflicted transactions.
These policies and procedures are designed to help ensure that a
broker-dealer exercises additional diligence in considering relevant
information and identifying the best market for customer orders,
despite their conflicts of interest.
Specifically, proposed Rule 1101(b)(1) would require a broker-
dealer's policies and procedures for conflicted transactions to address
how it will obtain and assess information beyond what it would obtain
and assess for non-conflicted transactions, including additional
information about price, volume, and execution quality, in identifying
a broader range of markets beyond those identified as material
potential liquidity sources. While a broker-dealer would use reasonably
accessible information in identifying material potential liquidity
sources for non-conflicted transactions, a broker-dealer would
additionally be required to consider how it would use information
beyond what it used for non-conflicted transactions in identifying a
broader range of markets beyond material potential liquidity sources
for conflicted transactions.\191\
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\191\ Proposed Rule 1101(b) would require a broker-dealer to
consider a broader range of markets for conflicted transactions than
non-conflicted transactions. In doing so, the broker-dealer may need
to obtain and assess information beyond what it obtains and assesses
for non-conflicted transactions. It is possible, however, that a
broker-dealer obtains and assesses information beyond what is needed
to identify material potential liquidity sources for non-conflicted
transactions, including information concerning markets that it did
not identify as material potential liquidity sources. Under these
circumstances, the information the broker-dealer obtained and
assessed for non-conflicted transactions may include information
beyond what is required by proposed Rule 1101(a)(1), and this
information may be sufficient for it to identify a broader set of
markets beyond those identified as material potential liquidity
sources. See also supra note 132 and accompanying text.
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Proposed Rule 1101(b)(2) would require a broker-dealer's policies
and procedures for conflicted transactions to address how it will
evaluate a broader range of markets, beyond those identified as
material potential liquidity sources, that might provide the most
favorable price for retail 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. Because a broker-dealer may have a financial incentive to
engage in conflicted transactions, it may have an incentive to more
quickly conclude that the conflicted transactions represent the best
market and thus execute the trade in a conflicted transaction.
Accordingly, the proposed rule would require a broker-dealer to have
policies and procedures that reflect additional efforts to identify a
broader range of markets, including a broader range of order exposure
opportunities, that may provide retail customers with the most
favorable price and the establishment of order handling, routing, and
execution arrangements with this broader range of potential liquidity
sources.\192\
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\192\ For example, a retail broker-dealer, in accordance with
its policies and procedures related to the identification of
material potential liquidity sources as required by proposed Rule
1101(a), may have evaluated a certain number of markets and
identified a subset of those markets as material potential liquidity
sources for non-conflicted transactions. For conflicted
transactions, the broker-dealer, in accordance with its policies and
procedures for conflicted transactions, would additionally evaluate
some of the markets that it did not identify as material potential
liquidity sources for non-conflicted transactions. Conflicted
transactions, such as routing orders to an affiliated ATS for
execution, may involve financial incentives for the broker-dealer
and could result in the broker-dealer prioritizing its own interests
over its customers' interests. The additional requirements of
proposed Rule 1101(b) are designed to help ensure that the broker-
dealer exercises reasonable diligence for conflicted transactions in
light of these incentives. As stated above, proposed Rule
1101(a)(1)(ii) would not prescribe the minimum number of markets
that a broker-dealer would need to identify as material potential
liquidity sources. See supra section IV.B.1. Rather, as stated
above, the Commission believes that the identification of these
markets could be influenced by the nature of the broker-dealer's
business operation and customer order flow, such as whether it
handles institutional or retail orders. See id.
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Request for Comment
The Commission requests comment on all aspects of proposed Rules
1101(b)(1) and (2), and in particular:
76. Do proposed Rules 1101(b)(1) and (2) represent an appropriate
approach to addressing conflicted transactions? Why or why not?
77. Should a broker-dealer be required to establish, maintain, and
enforce best execution policies and procedures for conflicted
transactions that address the additional requirements under proposed
Rules 1101(b)(1) and (2)? Why or why not?
78. Should a broker-dealer's policies and procedures for conflicted
transactions be required to address how it will obtain and assess
information beyond what it would obtain and assess for non-conflicted
transactions, including additional information about price, volume, and
execution quality, in identifying a broader range of markets beyond the
material potential liquidity sources? Why or why not?
79. Should a broker-dealer's policies and procedures for conflicted
transactions be required to address how it will evaluate a broader
range of markets beyond material potential liquidity sources, including
a broader range of order exposure opportunities and markets that may be
smaller or less accessible? Why or why not?
80. Would retail customers benefit from potentially having their
orders exposed by a broker-dealer to a broader array of liquidity
sources where the broker-dealer would have a conflict of interest? Why
or why not?
81. Should proposed Rules 1101(b)(1) and (2) include different or
additional requirements for conflicted transactions in different asset
classes? Please explain.
82. What challenges, if any, would broker-dealers encounter in
implementing proposed Rules 1101(b)(1) and (2)? Please explain.
83. Do commenters believe that the Commission should provide
staggered compliance dates for proposed Rules 1101(b)(1) and (2) for
broker-dealers of different sizes, if the Commission adopts proposed
Regulation Best Execution? For example, should the Commission provide
longer compliance dates for smaller broker-dealers? If so, should the
Commission define a smaller broker-dealer as a broker-dealer that
qualifies as a ``small entity'' under the Regulatory Flexibility Act
pursuant to 17 CFR 240.0-10(c) for this purpose? \193\
[[Page 5468]]
Or should the Commission define a smaller broker-dealer in a different
way? Please explain.
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\193\ See supra note 151 and accompanying text (describing the
broker-dealers that qualify as small entities under the Regulatory
Flexibility Act).
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2. Proposed Rule 1101(b)(3)--Documentation for Conflicted Transactions
Proposed Rule 1101(b)(3) would require a broker-dealer to document
its compliance with the best execution standard for conflicted
transactions, including all efforts taken to enforce its policies and
procedures for conflicted transactions and the basis and information
relied on for its determination that such conflicted transactions would
comply with the best execution standard. Proposed Rule 1101(b)(3) would
require that such documentation be done in accordance with written
procedures.
The Commission understands that broker-dealers currently differ in
documentation practices relating to their compliance with their duty of
best execution, and some broker-dealers currently retain information
that allows them to recreate the prices that were available at the time
of an execution. While proposed Rule 1101(b)(3) would not require a
broker-dealer to document its compliance with the best execution
standard with respect to its conflicted transactions in any specific
way, the broker-dealer would need to document all efforts taken to
enforce its policies and procedures for its conflicted transactions
\194\ and to demonstrate the basis and information relied on for its
determination that its conflicted transactions would comply with the
best execution standard.\195\ Proposed Rule 1101(b)(3) also would not
prescribe the manner in which a broker-dealer would need to document
its compliance with the proposed best execution standard, and the
Commission preliminarily believes that the manner of documentation may
vary depending on various considerations specific to the broker-dealer,
such as the nature of its customers and the characteristics of the
securities traded. The Commission preliminarily believes that, in
connection with documenting its compliance with the proposed best
execution standard and its best execution determinations for conflicted
transactions, the broker-dealer could document the prices received from
those markets that it checked pursuant to its policies and procedures.
The Commission preliminarily believes that such information could serve
as a basis for demonstrating a broker-dealer's best execution efforts
and determinations, and broker-dealers already maintain much of this
information pursuant to existing regulatory or operational
requirements.\196\
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\194\ A failure to have the policies and procedures required by
proposed Rule 1101(b) that are applicable to all conflicted
transactions, or a failure to enforce such policies and procedures,
would be a violation of proposed Regulation Best Execution.
\195\ This proposed documentation requirement would differ from
proposed Rule 1101(a), which would more generally require the
broker-dealer's policies and procedures to be reasonably designed to
comply with the best execution standard and to address a number of
specified elements.
\196\ The Commission preliminarily believes that this
documentation would be similar to many of the records that broker-
dealers currently maintain pursuant to regulatory requirements, such
as trade-through prohibitions and the National Market System Plan
Governing the Consolidated Audit Trail (``CAT Plan'') reporting. For
example, the CAT Plan requires a broker-dealer to report the entire
lifecycle of an order. See CAT Plan, Appendix C, Section A. 2 (3);
See also Rule 613(c)(1) of Regulation NMS, 17 CFR 242.613(c)(1)
(stating that the CAT plan must provide for an accurate, time-
sequenced record of orders beginning with the receipt or origination
of an order by a member of a national securities exchange or
national securities association, and document the life of the order
through the process of routing, modification, cancellation, and
execution (in whole or in part) of the order). This order lifecycle
information that today is reported to the CAT Plan could include
information that is relevant for the documentation provision of
proposed Rule 1101(b). For example, in documenting the markets
checked, a broker-dealer that routes customer orders to markets in
an attempt to access midpoint liquidity could retain records
concerning the markets it pinged for potential midpoint executions.
---------------------------------------------------------------------------
The proposed documentation requirement, including the obligation to
document pursuant to written procedures, would assist broker-dealers in
complying with proposed Regulation Best Execution and regulators in
overseeing broker-dealers' compliance. As stated above in this section,
while the Commission understands that some broker-dealers retain
information that allows them to recreate the prices that were available
at the time of an execution (for example, in response to a regulatory
inquiry), the Commission understands that broker-dealers have varying
degrees of documentation with respect to their best execution
practices. By specifically requiring all broker-dealers that engage in
conflicted transactions to document their compliance with the proposed
best execution standard, including all efforts to enforce their
policies and procedures, and the basis and information relied on for
their determinations that the conflicted transactions would comply with
the best execution standard, such broker-dealers would be required to
collect important information concerning the application of their best
execution process. This information may help broker-dealers better
evaluate the effectiveness of their best execution policies and
procedures, including their order handling practices. Moreover, by
requiring that the documentation be conducted pursuant to written
procedures, the proposed rule would help ensure that all broker-dealers
that engage in conflicted transactions (and any applicable associated
persons of such broker-dealers) document their compliance with the best
execution standard in a consistently robust manner.\197\ Similarly, the
proposed documentation requirement would help ensure that regulators
have access to a consistent and minimum level of information in
overseeing broker-dealers' efforts to satisfy the best execution
standard in proposed Rule 1100 with respect to conflicted transactions
with retail customers.
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\197\ For example, the written procedures concerning
documentation could describe the obligations of various personnel
within the broker-dealer with respect to this documentation
requirement.
---------------------------------------------------------------------------
Proposed Rule 1101(b)(3) would also require a broker-dealer to
document any arrangement, whether written or oral, concerning payment
for order flow, including but not limited to the parties to the
arrangement, all qualitative and quantitative terms concerning the
arrangement,\198\ and the date and terms of any changes\199\ to the
arrangement.\200\ This proposed documentation requirement would
complement the other requirements of proposed Rule 1101(b), and could
facilitate a broker-dealer's understanding of the effect of such
arrangements on its order handling and execution practices, and more
broadly, on its compliance with the best execution standard and
proposed Rules
[[Page 5469]]
1100-1102. This proposed requirement would also help ensure that
regulators have fuller and more efficient access to details regarding
broker-dealers' payment for order flow arrangements,\201\ which in turn
should facilitate regulators' oversight of broker-dealers' compliance
with the proposed rules by providing more context with respect to
broker-dealers' operations, business model, and order handling and
execution practices.
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\198\ Qualitative and quantitative terms would include any terms
that impact the variability or establish a condition concerning
payment for order flow. These could include, for example, any terms
based on the characteristics of an order (e.g., size, marketability,
held or not held, special order handling instructions, whether the
order is a complex options order) and the type of security involved
(e.g., whether the security is in the S&P 500 Index, ETF) or the
price of a security.
\199\ The proposed rule would require a broker-dealer to
document the date and terms of any changes to an existing payment
for order flow arrangement.
\200\ This proposed requirement would apply whether or not there
is any contractual obligation associated with the payment for order
flow arrangement, and is intended to capture payment for order flow
arrangements between broker-dealers and between broker-dealers and
other markets, such as exchanges. Such documentation would be
required in any scenario where payment for order flow is actually
made or received by a broker-dealer. This proposed documentation
requirement would also apply to rebates paid by an exchange to a
broker-dealer in return for routing orders to the exchange. For
example, a broker-dealer must document the specific rebate tiers
that it qualifies for with respect to each exchange from which it
receives payment for order flow. Furthermore, should a broker-dealer
have an arrangement with an exchange for the establishment of a tier
aimed at earning that broker-dealer's order flow, the broker-dealer
must document that arrangement.
\201\ Existing Commission rules, such as Rule 10b-10(d)(8), 17
CFR 240.10b-10(d)(8), and Rule 606 under Regulation NMS, 17 CFR
242.606, do not require the same level of detail with respect to the
payment for order flow practices of broker-dealers that would be
required under proposed Rule 1101(b)(3).
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Request for Comment
The Commission requests comment on all aspects of the proposed
documentation requirement under proposed Rule 1101(b)(3), and in
particular:
84. Are the proposed documentation requirements appropriate? Why or
why not?
85. Should such documentation requirements apply only to broker-
dealers' conflicted transactions? Alternatively, should they apply to
all transactions, including non-conflicted transactions? Or should they
apply to all conflicted transactions and to a subset of non-conflicted
transactions? Please explain.
86. Should such documentation be required to be done pursuant to
written procedures? Please explain.
87. As proposed, a broker-dealer would need to document, for its
conflicted transactions, its compliance with the best execution
standard, including all efforts taken to enforce its best execution
policies and procedures for conflicted transactions and the basis and
information relied on for its determinations that the conflicted
transactions would comply with the best execution standard. What
challenges, if any, would a broker-dealer encounter in complying with
the proposed documentation requirements? Would such challenges differ
based on the type of security being traded or the type of broker-dealer
engaging in the conflicted transactions? Please explain.
88. Do commenters agree with the Commission's understanding that
broker-dealers have varying degrees of documentation with respect to
their best execution practices? Why or why not?
89. Should the proposed documentation requirements apply only to
certain types of conflicted transactions or for all types of conflicted
transactions? Please explain.
90. Should broker-dealers in the NMS stock and listed options
markets be subject to the documentation requirements for the orders
they execute on a principal basis, or for which they have paid or
received payment for order flow, or routed to an affiliate, as
proposed? Why or why not?
91. Should broker-dealers in the corporate and municipal bond
markets and government securities markets be subject to the
documentation requirements for the orders they execute on a principal
basis, as proposed? Why or why not?
92. Are there other aspects of the proposed additional requirements
for a broker-dealer's policies and procedures for conflicted
transactions that should also be required to be documented? Please
explain.
93. Are there practices other than the proposed additional
requirements for conflicted transactions that should be required to be
documented? Please explain.
94. Should a broker-dealer be required to document any payment for
order flow arrangement, whether written or oral, as proposed? Why or
why not? If so, should such documentation requirements include the
parties to the arrangement, all qualitative and quantitative terms
concerning the arrangement, and the date and terms of any changes to
the arrangement? Why or why not? Are there other aspects of the
arrangements that should also be included in the documentation
requirement? If so, please describe.
95. Are there other types of arrangements involving conflicted
transactions that should also be subject to a documentation
requirement? Please explain.
96. Do commenters believe that the Commission should provide
staggered compliance dates for proposed Rule 1101(b)(3) for broker-
dealers of different sizes, if the Commission adopts proposed
Regulation Best Execution? For example, should the Commission provide
longer compliance dates for smaller broker-dealers? If so, should the
Commission define a smaller broker-dealer as a broker-dealer that
qualifies as a ``small entity'' under the Regulatory Flexibility Act
pursuant to 17 CFR 240.0-10(c) for this purpose? \202\ Or should the
Commission define a smaller broker-dealer in a different way? Please
explain.
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\202\ See supra note 151 and accompanying text (describing the
broker-dealers that qualify as small entities under the Regulatory
Flexibility Act).
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3. Application of Proposed Rule 1101(b) to NMS Stock Market Conflicts
of Interest
Broker-dealers that engage in conflicted transactions for or with
retail customers in NMS stocks would be required to comply with the
additional policies and procedures requirements under proposed Rule
1101(b). For example, a retail broker-dealer that receives payment for
order flow from a wholesaler would need to establish, maintain, and
enforce policies and procedures to address how it will evaluate
additional liquidity sources that the broker-dealer would not need to
evaluate if it did not receive payment for order flow. Therefore, in
connection with a determination of whether to route customer orders to
the wholesaler that pays for order flow, the retail broker-dealer could
evaluate other exchanges, ATSs, or order exposure opportunities that
may not have been determined by the retail broker-dealer to be material
potential liquidity sources for non-conflicted transactions under
proposed Rule 1101(a)(1).
Retail broker-dealers that receive payment for order flow for
retail customer orders must also comply with the documentation
requirement under proposed Rule 1101(b)(3). For example, to the extent
a retail broker-dealer attempts to execute customer orders prior to
sending them to a wholesaler in return for payment, it could document
such efforts by, for example, retaining a record of the markets at
which it attempted to execute customer orders at prices better than the
NBBO (e.g., markets pinged for midpoint liquidity),\203\ or documenting
how it otherwise used reasonable diligence in assessing whether those
markets may be the best market for customer orders. For retail
nonmarketable orders routed to markets (e.g., exchanges) that pay
rebates for those orders, a retail broker-dealer would need to document
its basis for determining that routing orders to such markets would
comply with the best execution standard, as well as the information
relied on for such determination. It could do so by, for example,
documenting its assessment of fill rates and the likelihood of
execution for nonmarketable orders at such
[[Page 5470]]
markets as compared to other markets that do not provide such rebates.
---------------------------------------------------------------------------
\203\ See supra note 196 (describing records and documentations
under the CAT Plan). As discussed above in section IV.C.2, proposed
Rule 1101(b)(3) would not require a broker-dealer to document its
efforts to comply with the best execution standard with respect to
its conflicted transactions in any specific way. However, the
broker-dealer would need to document in accordance with its written
procedures the basis and information relied on for its determination
that its conflicted transactions would comply with the best
execution standard.
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Furthermore, in documenting its determination that transactions
that are conflicted due to payment for order flow from a wholesaler
would comply with the best execution standard, a retail broker-dealer
could document its process for evaluating and routing to wholesalers
that pay it for order flow, including its assessment of wholesaler
performance and any price improvement commitments. Additionally, a
retail broker-dealer would be required to document its determination
that customer transactions for which it receives payment for order flow
would comply with the best execution standard.\204\ A retail broker-
dealer could do this by, for example, soliciting price improvement
commitments from wholesalers for customer orders in the absence of
payment for order flow and comparing those commitments to the price
improvement commitments that the wholesaler would make if it were to
pay the retail broker-dealer for order flow, and documenting these
efforts. Finally, as described above in section IV.C.2, a retail
broker-dealer would be required to document any arrangement concerning
payment for order flow.
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\204\ Similarly, FINRA has stated that broker-dealers may not
negotiate the terms of order routing arrangements for customer
orders in a manner that reduces the price improvement opportunities
that, absent payment for order flow, otherwise would be available to
those customer orders. See FINRA Regulatory Notice 21-23.
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A wholesaler that executes customer orders in a principal capacity
or pays a retail broker-dealer for order flow would also be required to
document its compliance with the best execution standard for conflicted
transactions.\205\ For example, a wholesaler could document the prices
received from those markets that it checked pursuant to its policies
and procedures, such as by retaining a record of the markets at which
it attempted to execute customer orders at prices better than the NBBO
(e.g., markets pinged for midpoint liquidity) \206\ and by retaining
records of market data feeds that the wholesaler uses when handling
retail customer orders. A wholesaler could also document how it
otherwise used reasonable diligence in its best execution
determinations. For retail nonmarketable orders routed to markets that
pay rebates for those orders, a wholesaler could document its basis for
determining that routing to such markets would comply with the best
execution standard and the information relied on for such determination
by, for example, documenting its assessment of fill rates and the
likelihood of execution for nonmarketable orders at such markets as
compared to other markets that do not provide such rebates.
---------------------------------------------------------------------------
\205\ See supra note 200.
\206\ See supra note 203.
---------------------------------------------------------------------------
The wholesaler would also be required to document any arrangement
concerning payment for order flow as described above in section IV.C.2.
Furthermore, the wholesaler would be required to document its
determination that its transactions with customer orders that were sent
to it in return for payment would comply with the best execution
standard. For example, a wholesaler could document that it provides the
same price improvement to the customers of retail broker-dealers to
which it does not pay for order flow that it provides to the customers
of broker-dealers to which it pays for order flow.
4. Application of Proposed Rule 1101(b) to the Options Market
As discussed above, payment for order flow, principal trading, and
affiliated routing conflicts of interest in the execution of retail
customer orders also exist in the options market.\207\ Under proposed
Rule 1101(b), a wholesaler that pays for order flow or transacts with
retail customers in a principal capacity would need to establish,
maintain, and enforce policies and procedures for conflicted
transactions that address how it will obtain and assess information
beyond that required by proposed Rule 1101(a)(1)(i) and evaluate a
broader range of liquidity sources, including a broader range of order
exposure opportunities, which could include an evaluation of whether
any price improvement auctions may provide an opportunity to execute a
customer order at a price that is better than the displayed best bid
and offer.\208\
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\207\ See supra section III.A.2 (discussing the payment for
order flow, affiliated routing and principal trading conflicts of
interest in the options market).
\208\ As discussed above, the wholesaler's policies and
procedures that would be required by proposed Rule 1101(a)(1) could
address how the wholesaler assesses price improvement auctions,
including their relative competitiveness, when identifying material
potential liquidity sources. A similar assessment would be required
under proposed Rule 1101(b)(2) for a broader range of order exposure
opportunities that may result in the most favorable price for
customer orders. A wholesaler's best execution policies and
procedures that favor one price improvement auction when other, more
competitive, price improvement auctions exist may be relevant to an
assessment of whether such policies and procedures are reasonably
designed to identify material potential liquidity sources or to
evaluate a broader range of order exposure opportunities that may
result in the most favorable price for the customer order, as
required by proposed Rules 1101(a) and 1101(b).
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Under proposed Rule 1101(b)(3), a wholesaler that engages in
conflicted transactions would also be required to document, in
accordance with written procedures, its compliance with the best
execution standard for such conflicted transactions, including all
efforts to enforce its policies and procedures for conflicted
transactions and the basis and information relied on for its
determinations that such conflicted transactions would comply with the
best execution standard. For example, as with conflicted transactions
in NMS stocks, a wholesaler could document the prices received from
those markets that it checked pursuant to its policies and procedures,
such as by retaining records of market data feeds that the wholesaler
uses when handling retail customer orders. The wholesaler's
documentation could also include a description of its decision making
process for routing retail customer orders to execute against the
wholesaler's or its affiliates' displayed prices on exchanges and when
it chooses to execute through a price improvement auction that may
provide an opportunity for price improvement. For retail nonmarketable
orders routed to markets that pay rebates for those orders, a
wholesaler would need to document its basis for determining that
routing to such markets would comply with the best execution standard
and the information relied on for such determination. It could do so
by, for example, documenting its assessment of fill rates and the
likelihood of execution for nonmarketable orders at such markets as
compared to other markets that do not provide such rebates.
The wholesaler would also be required to document any arrangement
concerning payment for order flow as described above in section IV.C.2.
Furthermore, the wholesaler would be required to document its
determination that its transactions with the customer orders that were
sent to it in return for payment would comply with the best execution
standard. For example, a wholesaler could document that it provides the
same execution quality to the customers of retail broker-dealers to
which it does not pay for order flow that it provides to the customers
of broker-dealers to which it pays for order flow.
A retail broker-dealer in the listed options market would be
engaged in a conflicted transaction under proposed Rule 1101(b) if it
receives payment for order flow and its policies and procedures would
have to address how it evaluates a broader range of markets, including
opportunities to expose customer orders for the most favorable price. A
retail broker-dealer's policies
[[Page 5471]]
and procedures could evaluate wholesaler practices concerning the use
of price improvement auctions and whether such wholesalers are
appropriately considering a broader range of opportunities to expose
customer orders and identifying exposure opportunities that are
designed to enhance competition for customer orders.
Retail broker-dealers that accept payment for order flow for retail
customer orders would also be required to comply with the documentation
requirement under proposed Rule 1101(b)(3). To the extent a retail
broker-dealer routes retail customer nonmarketable orders to markets
that pay rebates for those orders, a retail broker-dealer would need to
document its basis for determining that routing to such markets would
comply with the best execution standard and the information relied on
for such determination. It could do so by, for example, documenting its
assessment of fill rates and the likelihood of execution for
nonmarketable orders at such markets as compared to other markets that
do not provide such rebates.
Furthermore, in documenting its determination that transactions
conflicted due to payment for order flow from a wholesaler would comply
with the best execution standard, a retail broker-dealer could document
its process for evaluating and routing to wholesalers that pay it for
order flow, including its assessment of wholesaler performance and any
price improvement commitments. Additionally, under proposed Rule
1101(b)(3), a retail broker-dealer would need to document its
determination that customer transactions for which it receives payment
for order flow would comply with the best execution standard and the
information relied on for such determination. A retail broker-dealer
could do this by, for example, soliciting price improvement commitments
from wholesalers for customer orders in the absence of payment for
order flow and comparing those commitments to the price improvement
commitments that the wholesaler would make if it were to pay the retail
broker-dealer for order flow. Finally, a retail broker-dealer would be
required to document any arrangement concerning payment for order flow,
as described above in section IV.C.2.
5. Application of Proposed Rule 1101(b) to the Corporate and Municipal
Bond Markets and Government Securities Markets
Many broker-dealers in the corporate and municipal bond markets and
government securities markets trade with retail customers in a
principal capacity and therefore engage in conflicted transactions.
Such broker-dealers would also be subject to proposed Rule 1101(b) with
respect to their conflicted transactions. A broker-dealer's policies
and procedures for conflicted transactions would be required to address
how it will evaluate a broader range of markets, including a broader
range of order exposure opportunities. This could include evaluation of
a broader range of ATSs, broker's brokers, RFQ systems, and other
broker-dealers that trade corporate and municipal bonds and government
securities, than the markets that the broker-dealer identifies as
material potential liquidity sources under proposed Rule 1101(a)(1).
Under proposed Rule 1101(b)(3), a retail broker-dealer that trades
in a principal capacity with retail customers would be required to
document, in accordance with written procedures, its compliance with
the best execution standard for conflicted transactions, including all
efforts taken to enforce its policies and procedures for conflicted
transactions and the basis and information relied on for its
determinations that such conflicted transactions would comply with the
best execution standard. In doing so, a retail broker-dealer could
retain records of any data feeds or other pricing information that the
retail broker-dealer uses when handling retail customer orders,
including ATS data feeds, responses to RFQs, transaction prices, and
evaluated pricing information.\209\ In documenting its efforts to
comply with the best execution standard, a retail broker-dealer could
also document its order handling practices that can impact whether
customer orders are executed in compliance with the best execution
standard. This could include, for example, its practices concerning the
use of RFQ systems, including its filtering, response time, and last
look practices and how those practices promote the execution of retail
customer orders in a manner that complies with the best execution
standard. Finally, broker-dealers could document their markup policies
for principal trades, including documenting how the broker-dealer
assesses markups for trades with customers and any variation in its
markups depending on the nature of the transaction (e.g., riskless
principal trades versus trades with the broker-dealer's inventory).
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\209\ As discussed above in section IV.C.2, proposed Rule
1101(b)(3) would not require a broker-dealer to document its efforts
to comply with the best execution standard with respect to its
conflicted transactions in any specific way. However, the broker-
dealer would need to document the basis and information relied on
for its determination that its conflicted transactions would comply
with the best execution standard, and the Commission preliminarily
believes that the manner of documentation may vary depending on
asset class. For example, a broker-dealer's best execution policies
and procedures may provide for more individualized handling of
customer orders in corporate and municipal bonds and government
securities than in equities securities. Accordingly, the broker-
dealer's documentation for conflicted retail transactions in
corporate and municipal bonds and government securities would need
to reflect the more individualized best execution process.
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Request for Comment
The Commission requests comment on the application of proposed Rule
1101(b) to the NMS stock, options, corporate and municipal bond
markets, and government securities markets, and in particular:
97. Has the Commission appropriately described the various
practices in sections IV.C.3-5 that should be addressed in a broker-
dealer's policies and procedures for conflicted transactions? Please
explain.
98. Are there other practices not described in sections IV.C.3-5
that should be addressed in a broker-dealer's policies and procedures
for conflicted transactions, or any that are described that should be
not be addressed? Please explain.
D. Proposed Rule 1101(c)--Regular Review of Execution Quality
Proposed Rule 1101(c) would require a broker-dealer, no less
frequently than quarterly, to review the execution quality of its
transactions for or with its customers or customers of another broker-
dealer, and how such execution quality compares with the execution
quality the broker-dealer might have obtained from other markets, and
to revise its best execution policies and procedures, including its
order handling and routing practices, accordingly. Proposed Rule
1101(c) would also require a broker-dealer to document the results of
this review.
While the Commission understands that broker-dealers generally
currently conduct certain execution quality reviews,\210\ including
pursuant to
[[Page 5472]]
FINRA's best execution rule, the scope of proposed Rule 1101(c) differs
from FINRA's best execution rule in that it would apply to a broader
range of broker-dealers.\211\ Specifically, while FINRA's execution
quality review requirement applies only to a broker-dealer that routes
customer orders to other broker-dealers for execution on an automated,
nondiscretionary basis or that internalizes customer order flow,\212\
proposed Rule 1101(c) would apply to all broker-dealers that are not
introducing brokers (discussed in section IV.E below) that transact for
or with customers. The Commission preliminarily believes that it would
be beneficial to customers for a broader range of broker-dealers to
regularly review the execution quality that their customer orders
receive. Aside from this distinction in scope, proposed Rule 1101(c) is
designed to be consistent with FINRA Rule 5310.09.
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\210\ FINRA describes the findings from its best execution exams
in an annual report. See, e.g., 2022 Report on FINRA's Examination
and Risk Monitoring Program, supra note 185, at 44-45 (describing
FINRA exam findings, including: 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; not conducting adequate reviews on
a type-of-order basis, including, for example, on market, marketable
limit, or non-marketable limit orders; 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).
\211\ The MSRB rule does not require broker-dealers to conduct
quarterly (or more frequent) comparative analysis of execution
quality. Rather, MSRB Rule G-18 requires an annual review of the
broker-dealer's policies and procedures that takes ``into account
the quality of the executions the [broker-dealer] is obtaining under
its current policies and procedures, changes in market structure,
new entrants, the availability of additional pre-trade and post-
trade data, and the availability of new technologies'' and requires
the broker-dealer ``to make promptly any necessary modifications to
such policies and procedures as may be appropriate in light of such
reviews.'' See MSRB Rule G-18.08(a).
\212\ See FINRA Rule 5310.09.
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The requirements of proposed Rule 1101(c) would complement a
broker-dealer's policies and procedures concerning how it will comply
with the proposed best execution standard and the determination of the
best market for customer orders, as well as the additional policies and
procedures for conflicted transactions. As proposed, a broker-dealer
must compare the execution quality it obtains via its current order
routing and execution arrangements (including through the
internalization of its order flow or executing its order flow through
another broker-dealer in a wholesaler or other arrangement) to the
execution quality it might have obtained from other markets. A broker-
dealer would not meet the requirements of proposed Rule 1101(c) if it
solely conducted its review based on the markets to which it currently
routes customer orders without considering other markets or trading
venues.\213\ Rather, a broker-dealer would be required to consider the
potential execution quality at trading venues that it does not
currently use to execute customer orders, including new markets to the
extent they become available, and consider whether it needs to access
such markets in order to attain best execution for its customer
orders.\214\
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\213\ This is consistent with FINRA's rule concerning the review
of execution quality. See FINRA Rule 5310.09(b) (``To assure that
order flow is directed to markets providing the most beneficial
terms for their customers' orders, the member must compare, among
other things, the quality of the executions the member is obtaining
via current order routing and execution arrangements (including the
internalization of order flow) to the quality of the executions that
the member could obtain from competing markets.'').
\214\ FINRA has pursued enforcement against broker-dealers
relating to compliance with FINRA Rule 5310.09 concerning the
regular and rigorous review of execution quality. See, e.g.,
TradeStation Securities, Inc., Letter of Acceptance, Waiver and
Consent (FINRA Case No. 2014041812501) (Mar. 2021) (describing
violations of FINRA's best execution rule where the firm ``did not
exercise reasonable diligence to ascertain whether the venues where
it routed certain equity and option customer orders provided the
best market for the subject securities as compared to the execution
quality that was being provided at competing markets''); Robinhood
FINRA, supra note 69 (describing violations of FINRA's best
execution rule where the firm routed its customers' orders to four
broker-dealers that all paid for order flow and ``did not exercise
reasonable diligence to ascertain whether these four broker-dealers
provided the best market for the subject securities to ensure its
customers received the best execution quality from these as compared
to other execution venues''); E*Trade Securities LLC, Letter of
Acceptance, Waiver, and Consent (FINRA Case No. 20130368815-01)
(June 2016) (describing violations of FINRA's best execution rule
where the firm lacked sufficient information to reasonably assess
the execution quality it provided to its customer because, among
other things, the firm ``did not take into account the
internalization model employed by the firm'' and ``was overly
reliant on comparisons of the firm's overall execution quality with
industry and custom averages, rather than focusing on comparisons to
the actual execution quality provided by the market centers to which
the firm routed orders'').
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In reviewing and comparing the execution quality of its customer
transactions to the execution quality that might have been obtained
from other markets, a broker-dealer could consider various factors,
including price improvement opportunities, differences in price
disimprovement,\215\ likelihood of execution of limit orders, speed of
execution, size of execution, transaction costs, customer needs and
expectations, and the existence of internalization or payment for order
flow arrangements.\216\ Furthermore, a broker-dealer that routinely
routes customer orders to multiple trading centers, whether internal or
external, could evaluate the latency impacts, fill rates, information
leakage, and resulting execution quality harms.\217\ And when
conducting these reviews, a broker-dealer could consider the procedures
it uses or would use for executing the same or similar transactions for
its own accounts.\218\ The Commission believes that, when compared to
the execution quality that the broker-dealer might have obtained from
other markets, the review could help the broker-dealer evaluate the
effectiveness of its current best execution policies and procedures,
including its order handling practices, and enable the broker-dealer to
make informed judgments regarding whether these policies and procedures
and practices need to be modified.
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\215\ Price disimprovement occurs when a customer receives a
worse price than the best quotes prevailing at the time the order is
received by the market. See, e.g., FINRA Rule 5310.09(b)(2).
\216\ These considerations are consistent with FINRA's rule
regarding the review of execution quality. See FINRA Rule 5310.09(b)
(providing that, in reviewing and comparing the execution quality of
its current order routing and execution arrangements to the
execution quality of other markets, a member should consider: (1)
price improvement opportunities; (2) differences in price
disimprovement; (3) the likelihood of execution of limit orders; (4)
the speed of execution; (5) the size of execution; (6) transaction
costs; (7) customer needs and expectations; and (8) the existence of
internalization or payment for order flow arrangements).
\217\ This is also consistent with existing FINRA guidance
concerning these types of reviews. See FINRA Regulatory Notice 15-
46, at 4-5.
\218\ This is consistent with existing FINRA guidance. See FINRA
Regulatory Notice 15-46, at 4-5. FINRA states that ``firms should
consider the risk of information leakage by routing orders to a
particular venue in light of the fill rates achieved at that venue
and carefully assess whether the risks outweigh the potential for an
execution.'' Id. at 5.
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As described in this section IV.D above, proposed Rule 1101(c)
would apply to a broader range of broker-dealers than FINRA Rule
5310.09. However, the substantive review requirements of proposed Rule
1101(c) are similar to FINRA Rule 5310.09, which requires a broker-
dealer to compare, among other things, the quality of the executions it
is obtaining via current order routing and execution arrangements to
the quality of the executions that the broker-dealer could obtain from
competing markets.
While the review under FINRA Rule 5310.09 must be conducted on a
security-by-security, type-of-order basis (e.g., limit order, market
order, and market on open order), proposed Rule 1101(c) does not
provide this level of specificity concerning the manner of execution
quality reviews. The Commission believes that execution quality reviews
would differ based on the characteristics of a market or of a broker-
dealer's business, and the methods for conducting execution quality
reviews would evolve over time
[[Page 5473]]
based on the availability of data and advancements in technology. A
broker-dealer generally should conduct such reviews in a manner that
will provide it with robust information concerning its customer orders'
execution quality so that it can assess whether it needs to revise its
best execution policies and procedures. In doing so, a broker-dealer
should exercise its expertise and judgment in this regard and the
manner of its execution quality reviews may be tailored to reflect
various factors (e.g., whether the broker-dealer engages in conflicted
transactions, the sizes of customer orders).\219\
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\219\ Under FINRA Rule 5310.09, a broker-dealer must have
procedures in place to ensure it periodically conducts regular and
rigorous reviews of the quality of the executions of its customers'
orders if it does not conduct an order-by-order review. FINRA has
stated in a regulatory notice that broker-dealers must conduct
order-by-order best execution reviews rather than relying on regular
and rigorous reviews in certain circumstances. In particular, FINRA
has stated that a ``regular and rigorous review alone (as opposed to
an order-by-order review) may not satisfy best execution
requirements, given that the execution of larger-size orders `often
requires more judgment in terms of market timing and capital
commitment.' '' FINRA has also stated that ``[o]rders that a firm
determines to execute internally are subject to an order-by-order
best execution analysis.'' Finally, FINRA has recognized that
advances in order routing technology make order-by-order reviews of
execution quality for a range of orders in all equity and
standardized options increasingly possible. See FINRA Regulatory
Notice 15-46, at 3-4. As stated above, proposed Regulation Best
Execution would not affect a broker-dealer's obligation to comply
with the FINRA or MSRB best execution rule. Accordingly, a broker-
dealer would be required to comply with proposed Regulation Best
Execution, in addition to the FINRA and MSRB best execution rules,
as applicable. See supra note 109 and accompanying text. To the
extent FINRA or the MSRB impose more specific requirements than
proposed Regulation Best Execution, broker-dealers must continue to
comply with those requirements, as applicable.
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FINRA Rule 5310.09 also requires a broker-dealer to determine
whether any material differences in execution quality exist among the
markets trading the security and, if so, modify its routing
arrangements or justify why it is not modifying its routing
arrangements. While proposed Rule 1101(c) does not include
``materiality'' language or require a broker-dealer to justify why it
is not modifying its routing arrangements, these concepts are
consistent with the language of proposed Rule 1101(c). Proposed Rule
1101(c) states that a broker-dealer would be obligated to ``revise its
best execution policies and procedures, including its order handling
practices, accordingly'' after it has conducted its comparative
execution quality analysis. The Commission preliminarily believes that
revisions to the broker-dealer's policies and procedures, including its
order handling practices, would be appropriate if there were material
differences in execution quality that were not otherwise justifiable.
Moreover, proposed amendments to Rule 17a-4 would require a broker-
dealer to retain documentation of the results of its execution quality
review, which could include any justifications for not modifying its
policies and procedures if a comparative analysis revealed material
differences in execution quality.\220\
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\220\ For a discussion of recordkeeping requirements of the
proposed rules, see infra section IV.G.
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MSRB rules do not require broker-dealers to conduct comparative
analysis of execution quality.\221\ Rather, MSRB Rule G-18.08 states
that, when conducting its periodic reviews, a broker-dealer must assess
whether its policies and procedures are reasonably designed to achieve
best execution, taking into account the quality of the executions the
broker-dealer is obtaining under its current policies and procedures,
changes in market structure, new entrants, the availability of
additional pre-trade and post-trade data, and the availability of new
technologies, and make promptly any necessary modifications to such
policies and procedures as may be appropriate in light of such reviews.
While MSRB Rule G-18.08 reflects an execution quality review by broker-
dealers, proposed Rule 1101(c) would impose a specific requirement for
review of execution quality on at least a quarterly basis, including a
comparative analysis requirement, for all broker-dealers regardless of
whether they are currently subject to MSRB or FINRA rules.
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\221\ See supra note 211.
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Proposed Rule 1101(c) would require a broker-dealer to review the
execution quality of customer orders no less frequently than
quarterly.\222\ In complying with the proposed rule, a broker-dealer
should determine the appropriate frequency of review by considering,
for example: the nature of its business; the asset class transacted;
new pools of liquidity, trading protocols, or sources of data that have
emerged; the availability of technology needed to conduct execution
quality reviews; and the level of transparency in a particular market.
In doing so, the Commission believes that, in many cases, broker-
dealers may determine that a more frequent review of execution quality
than quarterly is appropriate. For example, market participants subject
to Rule 605 of Regulation NMS are required to disclose on a monthly
basis certain execution quality statistics in NMS stocks. These Rule
605 reports provide a broker-dealer with information that it could use
to evaluate the execution quality of customer transactions in NMS
stocks more frequently than quarterly.\223\ In contrast, a broker-
dealer may determine that it is appropriate to review the execution
quality of customer transactions in non-NMS stocks less frequently due
to the characteristics of those other markets.\224\
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\222\ FINRA also requires a broker-dealer to conduct regular and
rigorous reviews of its customer execution quality at least
quarterly, but has specified that a broker-dealer should consider,
based on its business, whether more frequent reviews are needed. See
FINRA Rule 5310.09; FINRA Regulatory Notice 15-46, at 4. MSRB Rule
G-18 requires a broker-dealer to, at a minimum, conduct annual
reviews of its policies and procedures for determining the best
available market for the executions of its customers' transactions,
but the broker-dealer should consider a frequency reasonably related
to the nature of its municipal securities business, including but
not limited to its level of sales and trading activity. See MSRB
Rule G-18.08(a).
\223\ FINRA has stated that some broker-dealers conduct monthly
reviews of execution quality, recognizing that market participants
are required to publish Rule 605 execution quality statistics on a
monthly basis. See FINRA Regulatory Notice 15-46, at 4, 15 n.21.
\224\ FINRA has also stated that orders in the fixed income
market may be handled and executed differently than in equity and
options markets. Because of these differences, FINRA stated that
broker-dealers may determine to conduct execution quality reviews of
such securities under FINRA's rule less frequently than for equities
and options. See FINRA Regulatory Notice 15-46, at 8.
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Finally, proposed Rule 1101(c) would require a broker-dealer to
document the results of its execution quality reviews.\225\ By
documenting its execution quality reviews, a broker-dealer would
maintain and preserve a robust record of its order execution quality
over time that could assist the broker-dealer to better evaluate the
effectiveness of its best execution policies and procedures, including
its order handling practices, on an ongoing basis. Similarly, such
documentation would allow regulators to more effectively oversee the
broker-dealer's efforts to meet the best execution standard of proposed
Rule 1100 and the requirements of proposed Rules 1101 and 1102.
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\225\ See proposed amendments to Rule 17a-4; infra section IV.G
(describing the recordkeeping obligations applicable to any
documentation made pursuant to proposed Regulation Best Execution).
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Request for Comment
The Commission requests comment on all aspects of proposed Rule
1101(c), and in particular:
99. Should broker-dealers be required to conduct reviews of
execution quality of their transactions for or with customers at least
quarterly, including how such execution quality compares with the
execution quality that might
[[Page 5474]]
have been obtained from other markets, as required by proposed Rule
1101(c)? Why or why not? Should broker-dealers document the results of
their execution quality reviews, as required by proposed Rule 1101(c)?
Why or why not?
100. Should a review of execution quality include factors similar
to those identified in FINRA rules and guidance, such as price
improvement opportunities, differences in price disimprovement,
likelihood of execution of customer limit orders, speed of execution,
size of execution, transaction costs, customer needs and expectations,
and the existence of internalization or payment for order flow
arrangements? Why or why not? Are there other factors that should also
be included in a review of execution quality? If so, please explain.
Should these factors be specified in proposed Rule 1101(c)? Please
explain.
101. Would the proposed documentation requirement improve the
utility of the reviews of execution quality by a broker-dealer? Please
explain. Should the proposed rule include other specific documentation
requirements to supplement the documentation of the execution quality
reviews? If so, please explain.
102. Should proposed Rule 1101(c) apply to broker-dealers that
currently rely on their executing brokers to conduct such reviews, if
they otherwise would not qualify as introducing brokers as defined in
proposed Rule 1101(d) and discussed in section IV.E below? Please
explain. Would broker-dealers that currently rely on the execution
quality reviews of their executing brokers (and do not qualify as
introducing brokers as defined in proposed Rule 1101(d) and discussed
in section IV.E below) have the resources and expertise to conduct the
reviews required by proposed Rule 1101(c)? Would such broker-dealers
have the information necessary to compare the executions received for
their customers and the customers of other broker-dealers with the
execution quality that could have been obtained on other markets to
which they did not route customer orders? Please explain.
103. Should the Commission require a different frequency for the
reviews of execution quality? If so, how frequently should such reviews
be required and should the frequency be different for different asset
classes? Should the frequency be monthly, semi-annually, annually, or
another time period? Please explain.
104. Should the frequency of such reviews be dependent on any
unique characteristics of the broker-dealer, its customers, its order
flow, or the securities traded? For example, should the frequency
standard be at least monthly for reviews of execution quality for NMS
stocks because broker-dealers and market centers are required to
disclose execution quality on a monthly basis under Rules 605 of
Regulation NMS? Or does the availability of Rule 605 reports suggest
that reviews of execution quality in NMS stocks should be less
frequent? Please explain.
105. Should broker-dealers that handle and execute customer
municipal bond orders be required to conduct reviews of execution
quality at least quarterly as required by proposed Rule 1101(c)? Please
explain. Is there a different frequency for these reviews that would be
more appropriate for the municipal bond market? If so, please explain.
Is there a frequency standard that would be more appropriate for other
fixed income markets, such as the corporate bond and government
securities markets? Is it appropriate to require that a broker-dealer's
best execution policies and procedures, including its order handling
practices, be revised based on the outcome of the proposed execution
quality reviews? Please explain. Should there be more specificity
concerning when a broker-dealer would be required to revise its best
execution policies and procedures, including its order handling
practices? For example, should the rule specify that best execution
policies and procedures, including order handling practices, must be
revised if the broker-dealer identifies material differences in
execution quality among the various markets and trading venues that
trade the applicable security? Please explain.
106. Should the proposed requirement that a broker-dealer revise
its best execution policies and procedures, including its order
handling practices, based on its review of execution quality apply
differently depending on the type of asset class or any unique
characteristics of the broker-dealer, its customers, its order flow, or
the securities traded? Please explain.
107. Do commenters agree with the Commission's understanding that
broker-dealers currently conduct certain execution quality reviews and
those reviews vary in rigor? Please describe the frequency and rigor of
any such reviews and whether broker-dealers document the results of
such reviews.
108. Do commenters believe that the Commission should provide
staggered compliance dates for proposed Rule 1101(c) for broker-dealers
of different sizes, if the Commission adopts proposed Regulation Best
Execution? For example, should the Commission provide longer compliance
dates for smaller broker-dealers? If so, should the Commission define a
smaller broker-dealer as a broker-dealer that qualifies as a ``small
entity'' under the Regulatory Flexibility Act pursuant to 17 CFR 240.0-
10(c) for this purpose? \226\ Or should the Commission define a smaller
broker-dealer in a different way? Please explain.
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\226\ See supra note 151 and accompanying text (describing the
broker-dealers that qualify as small entities under the Regulatory
Flexibility Act).
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E. Proposed Rule 1101(d)--Introducing Brokers
Proposed Rule 1101(d) would permit a broker-dealer that qualifies
as an introducing broker to rely on its executing broker to comply with
proposed Rules 1101(a), (b), and (c), subject to certain review
requirements.
Broker-dealers have different business models, including whether
they accept, and the extent to which they handle and execute, customer
orders. Certain broker-dealers commit their own capital by executing
customer transactions on a principal basis, while some broker-dealers
employ an agency model that requires them to find another buyer or
seller in order to execute a customer order. The sizes and resources of
broker-dealers also vary, with some broker-dealers carrying the
accounts of millions of customers, while others carry few customer
accounts and employ significantly fewer in-house personnel.
Many broker-dealers do not provide the service of holding customer
funds and securities and instead enter into agreements with other
broker-dealers to provide such services and handle and execute their
customers' orders. Such agreements generally allocate various functions
among the broker-dealers, including the opening and approval of
accounts, acceptance of orders, transmission of orders for execution,
execution of orders, extension of credit, receipt and delivery of funds
and securities, preparation and transmission of confirmations,
maintenance of books and records, and monitoring of accounts.\227\
Typically, a broker-dealer that does not carry customer accounts enters
into an agreement with another broker-dealer that would require the
initial broker-dealer to transmit all of its customer orders to the
other broker-dealer for order handling and execution. In this
circumstance, the second broker-dealer, which accepts the
responsibility to handle and execute the customer orders, would be
subject to the full obligations of proposed Regulation Best
[[Page 5475]]
Execution. On the other hand, the first broker-dealer is not making any
decisions or exercising discretion regarding the manner in which its
customer orders will be handled and executed, beyond its determination
to engage the services of the second broker-dealer, and it would not be
subject to the full obligations of proposed Regulation Best Execution.
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\227\ See FINRA Rule 4311 (establishing standards for carrying
agreements between executing firms and introducing firms).
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FINRA Rule 5310.09(c) provides that a broker-dealer that routes its
order flow to another broker-dealer that has agreed to handle that
order flow as agent for the customer can rely on that broker-dealer's
regular and rigorous review, as long as the statistical results and
rationale of the review are fully disclosed to the first broker-dealer
and the first broker-dealer periodically reviews how the review is
conducted, as well as the results of the review.\228\ MSRB Rule G-
18.08(b) provides that a broker-dealer that routes its customers'
transactions to another broker-dealer that has agreed to handle those
transactions as agent or riskless principal for the customer may rely
on that other broker-dealer's periodic reviews as long as the results
and rationale of the review are fully disclosed to the first broker-
dealer and the first broker-dealer periodically reviews how the other
broker-dealer's review is conducted and the results of the review.\229\
As discussed in section IV.E.1 below, the exemption under proposed Rule
1101(d) would be provided to a narrower group of broker-dealers than
contemplated by FINRA and MSRB rules, because it would apply only to
broker-dealers that meet the proposed definition of ``introducing
broker.'' Accordingly, certain broker-dealers that qualify under the
current FINRA and MSRB exemptions may not similarly qualify for the
exemption under proposed Rule 1101(d), absent a change in business
practices that would allow them to meet the additional criteria
described below in section IV.E.1. Moreover, as discussed in section
IV.E.2 below, the exemption under proposed Rule 1101(d) would require
the introducing broker's policies and procedures to provide for
comparisons between the execution quality obtained from its executing
broker and the execution quality it might have obtained from other
executing brokers, which would be a more specific policies and
procedures obligation for introducing brokers than required under the
current FINRA and MSRB rules. Finally, a broker-dealer that qualifies
as an introducing broker under proposed Rule 1101(d) would be exempt
from the requirement to separately comply with proposed Rules 1101(a),
(b), and (c), while the FINRA and MSRB rules only provide certain
broker-dealers with exemptions from conducting either the regular and
rigorous execution quality review under the FINRA rule or the periodic
review under the MSRB rule.
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\228\ See FINRA Rule 5310.09(c).
\229\ See MSRB Rule G-18.08(b). The MSRB has further interpreted
the obligations of introducing brokers under this provision. See
MSRB Implementation Guidance on MSRB Rule G-18, on Best Execution,
at Section II.1 (last updated Feb. 7, 2019) (``Under this provision,
introducing dealers may rely on the best-execution policies and
procedures of their clearing firms or other executing dealers, all
of which are subject to their own best-execution obligations under
the rule. An introducing dealer, however, is not relieved of its
obligations to establish written policies and procedures of its own.
For example, such an introducing dealer's policies and procedures
could provide for the reliance on another dealer's policies and
procedures and periodic reviews by the introducing dealer of the
other dealer's reviews of its policies and procedures.'').
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1. Definition of Introducing Broker and Executing Broker
For purpose of proposed Rule 1101(d), the Commission would define
an ``introducing broker'' as 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 broker-dealer that
has agreed to handle and execute on an agency basis all of the
introducing broker's customer orders (``executing broker''); 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.\230\ Broadly, these
proposed conditions are designed to identify those entities that, due
to their business models, expertise, and resources, need to be able to
rely on their executing brokers, and to ensure that these entities do
not have order handling conflicts of interest such that their reliance
on their executing brokers would be appropriate.
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\230\ This proposed definition of ``introducing broker'' would
be used only for purposes of proposed Rule 1101(d), and would not
affect the use of this term under existing Exchange Act rules. See,
e.g., 17 CFR 240.15c3-3 (defining introducing broker as a broker-
dealer that ``clears all transactions with and for customers on a
fully disclosed basis with a clearing broker or dealer, and who
promptly transmits all customer funds and securities to the clearing
broker or dealer which carries all of the accounts of such customers
and maintains and preserves such books and records pertaining
thereto . . . as are customarily made and kept by a clearing broker
or dealer''). While the term ``introducing broker'' is defined
differently for purposes of other Commission rules, the Commission
preliminarily believes the definition in proposed Rule 1101(d) is
appropriately tailored for application in the best execution
context. As discussed in this section, the proposed definition is
designed to identify introducing brokers that rely on their
executing brokers and to ensure that they do not have order handling
conflicts of interest in their reliance on their executing brokers.
See also section IV.E.1 (describing FINRA Rule 5310.09(c), MSRB Rule
G-18.08(b), and the definition of introducing broker in proposed
Rule 1101(d)).
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The first proposed condition of this definition (in proposed
paragraph (d)(1)) would require that an introducing broker not carry
customer accounts or hold customer funds or securities. This proposed
condition is designed to identify those broker-dealers that do not
handle or execute customer orders and therefore need to enter into
arrangements with other broker-dealers to provide those services. The
Commission preliminarily believes that this proposed condition would
identify broker-dealers that do not exercise any discretion with
respect to how their customer orders are handled and executed, beyond
the selection of the executing broker. Because these introducing
brokers do not handle or execute customer orders in a manner that would
warrant the application of the proposed best execution rules, the
Commission proposes to permit these broker-dealers to rely on their
executing brokers for purposes of complying with proposed Rules
1101(a), (b), and (c). In addition, these introducing brokers may not
be in a position to implement certain of the proposed best execution
rules because they have chosen to outsource order handling and
execution functions to another broker-dealer.
The second proposed condition in the definition (in proposed
paragraph (d)(2)) would require an introducing broker to enter into an
arrangement with an unaffiliated broker-dealer that has agreed to
handle and execute on an agency basis all of the introducing broker's
customer orders. This proposed condition contains several elements.
First, the proposed requirement that an arrangement be in place for the
handling and execution of all customer orders by another broker-dealer
would help ensure that the introducing broker does not exercise
discretion concerning the routing and execution of customer orders in a
manner that would otherwise necessitate the application of all of the
provisions of proposed Regulation Best Execution.\231\ Second, the
introducing broker would be required to have an order handling and
execution arrangement with an unaffiliated broker-dealer. Because the
[[Page 5476]]
introducing broker would be permitted to rely on the executing broker
rather than having policies and procedures that address independently
many of the operative provisions of proposed Regulation Best Execution
(including the additional obligations for conflicts of interest with
retail customers), the introducing broker should not be permitted to be
subject to a conflict of interest by selecting an affiliated executing
broker. Such conflict of interest could impede the introducing broker's
efforts to achieve best execution by providing the introducing broker
an incentive to act in manner that benefits its own or its affiliate's
interests. Third, the executing broker that has been selected by the
introducing broker would be required to agree to handle all of the
introducing broker's customer orders on an agency basis. If an
executing broker could trade with the introducing broker's customers in
a principal capacity, the introducing broker would effectively be
making a determination concerning how its customer order should be
executed, and the introducing broker should be subject to the full
requirements of proposed Regulation Best Execution.
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\231\ The broker-dealer that has agreed to handle all of the
introducing broker's customer orders on an agency basis would be
subject to proposed Regulation Best Execution, including proposed
Rules 1101(a)-(c).
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There are two principal trading scenarios that, under proposed Rule
1101(d)(2), would be considered to be orders handled on an agency basis
solely for the purposes of proposed Rule 1101(d)(2): fractional share
trading in NMS stocks and riskless principal trading in corporate and
municipal bonds and government securities. The Commission understands
that many broker-dealers permit their customers to submit orders for
fractional shares of a stock. These orders are often the result of a
retail customer submitting an order for a security for a certain dollar
amount, rather than for a specific number of shares. In order for an
executing broker to fill the fractional share orders of an introducing
broker's customer buy orders, for example, the executing broker may buy
a whole share into its inventory and allocate a portion of that share
to fill the customer's fractional share order. This scenario involves a
principal trade between the executing broker and the customer that is
necessary to fill the customer's fractional share order. The Commission
preliminarily believes that an executing broker filling the fractional
share components of an introducing broker's customer orders in this
manner should not disqualify the initial broker-dealer from meeting
prong (2) of the definition of an introducing broker, because the
executing broker is filling the fractional share components on a
principal basis solely for the purpose of completing transactions that
otherwise would be executed on an agency basis. Therefore, in this
context, the executing broker filling a customer's fractional share
order would be considered to be acting on an agency basis.
In the corporate and municipal bond markets and government
securities markets, the Commission understands that executing brokers
most often execute an introducing broker's customer orders on a
riskless principal basis.\232\ In these transactions, the executing
broker does not fill a customer order out of its own inventory, but
rather finds a counterparty for the customer order prior to executing
the customer order.\233\ The bond simply flows through the executing
broker's account for transaction processing before ultimately being
transferred to the appropriate customer. For purposes of proposed Rule
1101(d)(2), riskless principal would be defined as proposed under Rule
1101(b)(4)(ii). In particular, a transaction would be riskless
principal if, after having received an order to buy from the
introducing broker on behalf of its customer, the executing broker
purchased the security from another person to offset a contemporaneous
sale to such introducing broker on behalf of a customer or, after
having received an order to sell, the executing broker sold the
security to another person to offset a contemporaneous purchase from
such introducing broker on behalf of its customer.\234\ The Commission
preliminarily believes that this riskless principal transaction
scenario in the corporate and municipal bond markets and government
securities markets should not disqualify the initial broker-dealer from
meeting the definition of an introducing broker in proposed Rule
1101(d), as the riskless principal trading in this context is analogous
to the executing broker trading on an agency basis.
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\232\ The MSRB best execution rule recognizes that introducing
brokers may have a relationship with clearing firms that handle and
execute customer orders on a riskless principal basis. See, e.g.,
MSRB Rule G-18.08(b) (``A dealer that routes its customers'
transactions to another dealer that has agreed to handle those
transactions as agent or riskless principal for the customer (e.g.,
a clearing firm or other executing dealer) may rely on that other
dealer's periodic reviews as long as the results and rationale of
the review are fully disclosed to the dealer and the dealer
periodically reviews how the other dealer's review is conducted and
the results of the review.'').
\233\ As the Commission has stated, ``[t]rading on a riskless
principal basis is similar, conceptually, to a municipal bond dealer
trading on an agency basis. In these transactions, the municipal
bond dealer is not putting its capital at risk. For example, when it
receives a customer order to buy, the [dealer] will offset the sale
to the customer by contemporaneously purchasing the security sold to
the customer.'' See U.S. Securities and Exchange Commission, Report
on the Municipal Securities Market (2012), available at https://www.sec.gov/news/studies/2012/munireport073112.pdf. See also 17 CFR
240.3a5-1(b) (defining the term ``riskless principal transaction''
for purposes of a bank's exemption from the definition of dealer).
\234\ This riskless principal trading scenario would be limited
to these types of transactions in the corporate and municipal bond
markets and government securities markets and is consistent with the
concept in MSRB Rule G-18.08(b) and with the Commission's defined
term of riskless principal in Exchange Act Rule 3a5-1, which exempts
banks from the definition of ``dealer'' under the Exchange Act when
acting in a riskless principal capacity. See 17 CFR 240.3a5-1
(defining riskless principal as a transaction in which, after having
received an order to buy from a customer, the bank purchased the
security from another person to offset a contemporaneous sale to
such customer or, after having received an order to sell from a
customer, the bank sold the security to another person to offset a
contemporaneous purchase from such customer). Furthermore, the
Commission believes that this definition of a riskless principal
trade is a commonly used and understood definition of the term. But
see 17 CFR 240.10b-18 (defining a riskless principal transaction in
the context of a safe harbor for issuers from liability under the
Exchange Act fraud provisions as a transaction in which a broker or
dealer after having received an order from an issuer to buy its
security, buys the security as principal in the market at the same
price to satisfy the issuer's buy order, where the issuer's buy
order must be effected at the same price per share at which the
broker or dealer bought the shares to satisfy the issuer's buy
order, exclusive of any explicitly disclosed markup or markdown,
commission equivalent, or other fee).
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The third proposed condition in the definition of introducing
broker (in proposed paragraph (d)(3)) is that the introducing broker
may not accept 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.\235\ Similar to the
second proposed condition concerning the use of unaffiliated executing
brokers, the Commission preliminarily believes that this proposed
condition is appropriate because the introducing broker, which would be
exempt from many of the operative provisions of proposed Regulation
Best Execution, should not be subject to a conflict of interest that
could influence its selection of a broker-dealer that will handle and
execute its customers' orders.
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\235\ This proposed condition is based on the definition of
payment for order flow in Exchange Act Rule 10b-10(d)(8), 17 CFR
240.10b-10(d)(8). See supra note 43 (stating the definition of
payment for order flow under Rule 10b-10(d)(8)).
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2. Review of Executing Broker's Execution Quality
Proposed Rule 1101(d) would provide that an introducing broker that
routes customer orders to an executing broker
[[Page 5477]]
does not need to separately comply with proposed Rules 1101(a), (b),
and (c) so long as the introducing broker establishes, maintains, and
enforces policies and procedures that require the introducing broker to
regularly review the execution quality obtained from such executing
broker, compare it with the execution quality it might have obtained
from other executing brokers, and revise its order handling practices,
accordingly. The introducing broker would also be required to document
the results of this review.
Because proposed Rule 1101(d) would require the introducing broker
to establish, maintain, and enforce policies and procedures that
provide for regular reviews of the execution quality obtained from its
executing broker, as part of its agreement with the executing broker,
an introducing broker may wish to consider requiring the executing
broker to fully disclose its execution quality reviews of the
introducing broker's customer orders to the introducing broker, in lieu
of conducting its own independent analysis of the execution quality
ultimately received from the executing broker.\236\ This aspect of
proposed Rule 1101(d) would impose a direct obligation on introducing
brokers to regularly review the execution quality obtained from their
executing brokers, in addition to what is required under current FINRA
and MSRB rules.\237\
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\236\ The executing broker's review of execution quality that
the introducing broker relies on would be required to be an
execution quality review specific to the introducing broker's
customer orders. The Commission preliminarily believes that it would
not be appropriate for the introducing broker to rely on the
executing broker's execution quality review if that review involved
the executing broker's aggregate executions, including those of
other introducing brokers' customers. As a result, proposed Rule
1101(d) would require the introducing broker to evaluate the
execution quality its customers received from the executing broker.
\237\ See FINRA Rule 5310.09(c); MSRB Rule G-18.08(b) (providing
that an introducing broker can ``rely on'' its executing broker's
execution quality reviews as long as the results and rationale of
the review are fully disclosed to the introducing broker and the
introducing broker periodically reviews how the review is conducted
and the results of the review). Under these rules, broker-dealers
are permitted to rely on the execution quality reviews of their
executing brokers and are required only to periodically review how
the review is conducted and the results of the review. These broker-
dealers are not required to compare the execution quality they are
receiving to the execution quality that might have been received
from another executing broker.
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In addition, because proposed Rule 1101(d) would require the
introducing broker's policies and procedures to provide for comparisons
of its executing broker's execution quality with the execution quality
it might have obtained from other executing brokers, the introducing
broker would need to obtain execution quality information concerning
other executing brokers that could handle and execute the introducing
broker's customer orders.\238\ While the information concerning the
execution quality that might be obtained from other executing brokers
would not include information concerning the execution of the
introducing broker's customer orders, this information would
nevertheless better inform the introducing broker's decisions
concerning the selection of an executing broker. This aspect of
proposed Rule 1101(d) would impose a direct obligation on introducing
brokers to conduct comparisons of execution quality, in addition to
what is required under current FINRA and MSRB rules.\239\ While the
broker-dealer would be afforded discretion in how it evaluates the
execution quality that could be provided by other executing brokers,
the Commission believes that introducing brokers could consider the
execution quality and order routing disclosures of these executing
brokers along with the information that these executing brokers might
provide to the introducing broker directly in connection with this
obligation.
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\238\ The Commission preliminarily believes that other executing
brokers would have an incentive to provide the introducing broker
with accurate and comparable execution quality information that the
introducing broker could use to evaluate its existing arrangement
due to their financial interest in potentially providing the
introducing broker with order handling and execution services.
\239\ See supra note 236.
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Proposed Rule 1101(d) would also require an introducing broker's
policies and procedures to address how it would revise its order
handling practices, if its execution quality comparison shows that a
change is warranted. This aspect of proposed Rule 1101(d) would
establish an obligation for an introducing broker to revise its
policies and procedures following an execution quality comparison,
which is not explicitly required under the current FINRA and MSRB
rules.\240\ An introducing broker may consider it appropriate to change
its routing practices to the extent a material difference exists
between the execution quality provided by its existing executing broker
and the execution quality that might have been obtained from other
executing brokers. Alternatively, the Commission preliminarily believes
that an introducing broker could discuss the results of its review with
its executing broker and whether it is appropriate for the executing
broker to modify its order handling and execution practices in order to
provide better execution quality for the introducing broker's
customers.\241\ If the executing broker were to either provide a
reasonable explanation for the execution quality disparity identified
by the introducing broker or agree to modify its order handling and
execution practices in order to provide better execution quality, it
could be appropriate for the introducing broker to continue to retain
the services of its executing broker. Should the introducing broker's
regular review demonstrate persistent execution quality issues that are
not justifiable by the executing broker, the introducing broker should
consider retaining the services of another executing broker. As a
result, the Commission preliminarily believes that this regular review
process would promote competition among executing brokers and help
ensure that customer orders are executed consistently with the proposed
best execution standard.
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\240\ See FINRA Rule 5310.09(c) (``A member that routes its
order flow to another member that has agreed to handle that order
flow as agent for the customer (e.g., a clearing firm or other
executing broker-dealer) can rely on that member's regular and
rigorous review as long as the statistical results and rationale of
the review are fully disclosed to the member and the member
periodically reviews how the review is conducted, as well as the
results of the review.''). See also MSRB Rule G-18.08(b) (``A dealer
that routes its customers' transactions to another dealer that has
agreed to handle those transactions as agent or riskless principal
for the customer (e.g., a clearing firm or other executing dealer)
may rely on that other dealer's periodic reviews as long as the
results and rationale of the review are fully disclosed to the
dealer and the dealer periodically reviews how the other dealer's
review is conducted and the results of the review.''). These
provisions do not obligate the broker-dealers that rely on the
regular and rigorous review of other broker-dealer under FINRA Rule
5310.09(c) and MSRB Rule G-18.08(b) to modify the order handling
arrangements if execution quality analysis merits modification.
\241\ As part of this process, the introducing broker and
executing broker could assess why execution quality may be different
as between the executing broker and other executing brokers, and the
reason for these differences may inform the introducing broker's
decision as to whether to retain the executing broker or change
executing brokers. As discussed above with respect to proposed Rule
1101(c), an executing broker would be required to revise its best
execution policies and procedures, including its order handling and
routing practices, if warranted by its regular review of the
execution quality of the introducing broker's customer orders.
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Moreover, proposed Rule 1101(d) would require an introducing broker
to document the results of its execution quality review,\242\ which
would assist the introducing broker and regulators by helping to ensure
that the introducing broker maintains and retains a robust record of
the execution quality its customers receive from its executing
[[Page 5478]]
broker over time. This documentation should enable the introducing
broker to better evaluate the effectiveness of its executing broker on
an ongoing basis. This documentation would also help ensure that
regulators have access to information to effectively oversee the
introducing broker's efforts to satisfy its obligations under proposed
Rule 1101(d).
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\242\ See proposed amendments to Rule 17a-4; infra section IV.G
(describing the recordkeeping obligations applicable to any
documentation made pursuant to proposed Regulation Best Execution).
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Request for Comment
The Commission requests comment on proposed Rule 1101(d) relating
to the proposed definitions of introducing broker and executing broker,
and the proposed exemptions for introducing brokers, and in particular:
109. Are the proposed definitions of introducing broker (including
the three proposed conditions to qualify as an introducing broker) and
executing broker appropriate? If not, please explain whether and how
the definitions should be more broadly or narrowly drawn, including
whether certain market participants should be included or excluded from
the definitions.
110. Do commenters believe the use of the term ``introducing
broker'' in proposed Regulation Best Execution is appropriate? Should
the Commission use an alternative term to describe the types of
entities contemplated by proposed Rule 1101(d)? If so, what alternative
term would be appropriate?
111. Does an introducing broker typically exercise any discretion
with respect to how its customer orders are handled and executed by its
executing broker, beyond the selection of the executing broker? If so,
should the definition of introducing broker be modified in any manner
to account for this discretion by the introducing broker? Please
describe.
112. Does an introducing broker typically have multiple executing
brokers or does it typically have an arrangement with only one
executing broker to handle and execute all of its customer orders?
113. Are the proposed conditions concerning the arrangement between
the introducing broker and its executing broker appropriate? Please
explain.
114. Is it appropriate to require the executing broker to handle
and execute all of the introducing broker's customer orders on an
agency basis in order for the introducing broker to meet the definition
of introducing broker under proposed Rule 1101(d)? Please explain.
115. Do executing brokers, which can include many clearing firms
that provide these types of services to other broker-dealers, typically
execute transactions to fill an introducing broker's customer orders in
a riskless principal capacity? Do these executing brokers often use
inventory to fill the introducing broker's customer orders?
116. Would the proposed condition that an executing broker execute
customer orders on an agency basis harm liquidity for the introducing
broker's customer orders for any asset class or classes? If so, please
explain. For example, is the principal trading desk of an executing
broker (e.g., clearing firm) in the corporate or municipal bond markets
and government securities markets an important source of potential
liquidity for the customers of an introducing broker?
117. Does the proposed introducing broker definition and the
proposed approach concerning riskless principal trading appropriately
capture the manner in which introducing brokers and executing brokers
do business in the corporate and municipal bond markets and government
securities markets? Please explain.
118. Should riskless principal transactions by an executing broker
disqualify the introducing broker from meeting the definition of
introducing broker under proposed Rule 1101(d)? Please explain.
119. Is the description of a riskless principal trade in section
IV.E.1 above appropriate? Why or why not?
120. In contrast to the discussion of riskless principal trades in
section IV.E.1 above, would it be more appropriate to require the two
legs of a riskless principal trade to be executed at the same price,
exclusive of any explicitly disclosed markup or markdown, commission
equivalent, or other fee? For example, should a riskless principal
trade for purposes of proposed Rule 1101(d)(2) be defined to mean: a
transaction in which the executing broker, after having received an
order from the introducing broker on behalf of its customer to buy a
security, buys the security from another person as principal to offset
a contemporaneous sale to such introducing broker on behalf of a
customer at the same price, or after having received an order to sell,
the executing broker sold the security to another person to offset a
contemporaneous purchase from the introducing broker on behalf of its
customer at the same price? Please explain. Would a potential benefit
of this alternative definition of riskless principal transaction be
that the bond transaction between the introducing broker and its
customer would reflect the entire markup or markdown on the customer's
trade, which would be disclosed to the customer pursuant to existing
FINRA and MSRB confirmation disclosure rules?
121. Do commenters agree that principal trades by an executing
broker to fill fractional share orders in NMS stocks and riskless
principal trades by an executing broker in fixed income securities
should be order handling on an agency basis for purposes of proposed
Rule 1101(d)(2)? Why or why not? Are there additional types of
principal transactions that should also be considered order handling on
an agency basis for purposes of proposed Rule 1101(d)(2)? If so, please
describe.
122. Do commenters agree with the proposed requirement that there
be no affiliation between an introducing broker and its executing
broker in order for the introducing broker to meet the definition of
introducing broker under proposed Rule 1101(d)? Why or why not?
123. What is the typical relationship between an introducing broker
and its executing broker for handling and executing customer orders in
different asset classes?
124. The proposal would prohibit a broker-dealer from receiving any
payment for order flow from its executing broker in order to qualify as
an introducing broker under proposed Rule 1101(d). Currently, to what
extent do introducing brokers accept payment for order flow for their
customer orders from an executing broker? What are the common payment
for order flow arrangements between introducing brokers and their
executing brokers?
125. Do commenters agree with the proposed requirement that there
be no payment for order flow between an introducing broker and its
executing broker in order for the introducing broker to meet the
definition of introducing broker under proposed Rule 1101(d)? Please
explain. What are the implications for introducing brokers resulting
from the requirement that they not accept payment for order flow from
their executing brokers in order to qualify as introducing brokers
under proposed Rule 1101(d)?
126. Should an executing broker be prohibited from accepting
payment for order flow from other broker-dealers that the executing
broker uses to execute the introducing broker's customer orders? Why or
why not?
127. Do commenters agree that the proposed exemptions for
introducing brokers from proposed Rule 1101(a), (b), and (c) are
appropriate? Why or why not?
128. Do commenters believe that the approaches taken by FINRA and
the MSRB with respect to the definition of introducing broker are
preferable to the
[[Page 5479]]
Commission's proposal? \243\ Please explain. Would an approach that is
more restrictive than the FINRA and MSRB approach but less restrictive
than the Commission's proposal be preferable? If so, please explain.
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\243\ See supra notes 228-230 and accompanying text.
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The Commission also seeks comment on the proposed requirement that,
to avail itself of the exemptions under proposed Rule 1101(d), an
introducing broker must establish, maintain, and enforce policies and
procedures that require it to regularly review the execution quality
obtained from its executing broker, compare such execution quality with
the execution quality it might have obtained from other executing
brokers, and revise its routing practices accordingly. In particular:
129. How do introducing brokers currently evaluate the execution
quality of their executing brokers? How often is this evaluation
typically performed?
130. Would introducing brokers be able to obtain execution quality
information concerning other executing brokers? If so, how? Would
executing brokers have an incentive to share execution quality
information with introducing brokers for which they do not handle
orders or handle few orders?
131. Would an introducing broker be able to perform a comparison of
execution quality received with execution quality that it might have
obtained from other executing brokers? Please explain any challenges in
making such a comparison and whether any challenges depend on the asset
class or classes involved. Please describe any distinctions that should
be drawn among executing brokers handling and executing orders in
various asset classes.
132. Should the Commission require that an introducing broker
compare the execution quality received with the execution quality it
might have obtained from other executing brokers only to the extent
that such execution quality information is reasonably accessible to the
introducing broker? Please explain.
133. Would introducing brokers have the capacity and resources to
independently compare the quality of executions received from their
executing brokers to the quality of executions that they might have
received from other executing brokers? Are introducing brokers likely
to rely on third parties to facilitate this comparison? Please explain.
134. How frequently should an introducing broker be required to
perform a comparative analysis of execution quality as proposed in Rule
1101(d)? For example, should it be required quarterly, similar to what
FINRA requires under FINRA Rule 5310.09? Alternatively, should the
review be required with a different frequency, such as on a monthly,
semiannual, or annual basis, instead of quarterly? Please explain.
135. Should introducing brokers be required to evaluate the
execution quality of a minimum number of alternative executing brokers
when they compare the execution quality received from their own
executing brokers? If so, how many and why?
136. Would the proposed documentation requirement improve the
utility of an introducing broker's execution quality comparison? Why or
why not? Should the Commission require additional documentation to
supplement the documentation of the introducing broker's review? If so,
please explain.
137. Rather than conducting the execution quality review under
proposed Rule 1101(d), should introducing brokers be subject to the
regular review of execution quality requirement under proposed Rule
1101(c)? Are there other factors that would make one more appropriate
for introducing brokers than the other? Please explain.
138. Do commenters believe there are any concerns with the proposed
requirement that an introducing broker's policies and procedures
require it to revise its order handling practices to the extent
justified by its execution quality reviews? If so, please explain.
Should the Commission provide more specificity concerning when order
handling practices would be required to be revised? For example, should
the Commission specify that order handling practices be revised if
there are material differences between the execution quality received
from the executing broker and the execution quality that could have
been obtained from another executing broker?
139. How do introducing brokers currently address execution quality
concerns relating to their executing brokers' order handling? Please
describe.
140. Do introducing brokers have a number of executing brokers to
choose from when determining the firm they will use to handle and
execute their customer orders?
141. Is the approach in FINRA Rule 5310.09(c) and MSRB Rule G-
18.08(b) preferable to the Commission's proposal? Why or why not? Would
some combination of the FINRA and MSRB approaches and the Commission's
proposal be preferable to either? Please explain.
142. Do commenters believe that the Commission should provide
staggered compliance dates for proposed Rule 1101(d) for broker-dealers
of different sizes, if the Commission adopts proposed Regulation Best
Execution? For example, should the Commission provide longer compliance
dates for smaller broker-dealers? If so, should the Commission define a
smaller broker-dealer as a broker-dealer that qualifies as a ``small
entity'' under the Regulatory Flexibility Act pursuant to 17 CFR 240.0-
10(c) for this purpose? \244\ Or should the Commission define a smaller
broker-dealer in a different way? Please explain.
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\244\ See supra note 151 and accompanying text (describing the
broker-dealers that qualify as small entities under the Regulatory
Flexibility Act).
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F. Proposed Rule 1102--Annual Report
Proposed Rule 1102 would require a broker-dealer that effects any
transaction for or with a customer or a customer of another broker-
dealer to, no less frequently than annually, review and assess the
design and overall effectiveness of its best execution policies and
procedures, including its order handling practices. Such review and
assessment would be required to be conducted in accordance with written
procedures and would be required to be documented.\245\ The broker-
dealer also would be required to prepare a written report detailing the
results of such review and assessment, including a description of all
deficiencies found and any plan to address such deficiencies. The
report would be required to be presented to the board of directors (or
equivalent governing body) of the broker-dealer. The proposed annual
review requirement is designed to require broker-dealers to evaluate
whether their best execution policies and procedures continue to work
as designed and whether changes are needed to ensure their continued
effectiveness.
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\245\ The Commission believes that broker-dealers currently have
written compliance procedures reasonably designed to review their
business activity, which a broker-dealer could update to document
the method in which the broker-dealer plans to conduct its review
pursuant to proposed Rule 1102.
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In assessing the overall effectiveness of its best execution
policies and procedures, a broker-dealer should consider its policies
and procedures holistically, and may utilize its execution quality
reviews and any documentation with respect to conflicted transactions
prepared during
[[Page 5480]]
the course of the review period.\246\ Although proposed Rule 1101(c),
as discussed in section IV.D above, would require a broker-dealer to
implement an at least quarterly review of the execution quality of its
customer transactions, the annual review requirement in proposed Rule
1102 would be a broader, more holistic review of the broker-dealer's
policies and procedures not focused solely on execution quality. As
part of its annual review, a broker-dealer may review the findings of
its execution quality reviews in conjunction with its overall review of
its policies and procedures, to the extent it would assist the broker-
dealer in identifying any inadequacies and supporting any revisions to
its best execution policies and procedures, including its order
handling practices, as appropriate.\247\ Ongoing changes in order
handling technology and differing broker-dealer trading models and
practices may present a need for a broker-dealer to reconsider its best
execution policies and procedures in a way that is not identified
during the course of a broker-dealer's regular execution quality
reviews conducted pursuant to proposed Rule 1101(c). For example, the
proposed annual review process may encourage the broker-dealer to
consider investments in new technologies to improve its overall best
execution process, despite the fact that the broker-dealer has not
identified any issues with its existing execution quality. Accordingly,
the Commission believes that the proposed annual review requirement,
including the associated written report that would be presented to the
broker-dealer's board of directors or equivalent governing body, would
create a robust internal compliance process under the oversight of the
highest level of a broker-dealer's internal governance to help ensure
the broker-dealer maintains robust best execution policies and
procedures and complies with proposed Regulation Best Execution. The
written report prepared pursuant to proposed Rule 1102 would also help
regulators better understand the broker-dealer's compliance with
proposed Regulation Best Execution.
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\246\ While a broker-dealer that qualifies as an introducing
broker under proposed Rule 1101(d) would need to conduct a review
and prepare a written report pursuant to proposed Rule 1102, an
introducing broker's review should appropriately reflect its
obligations under proposed Rule 1101(d), rather than the aspects of
proposed Rules 1101(a), (b), and (c) that would be considered as
part of the executing broker's annual review.
\247\ By utilizing its regular reviews of execution quality as
part of its annual review, a broker-dealer may avoid any duplication
of efforts to the extent it needs to conduct any execution quality
analysis in order to assess the overall effectiveness of its best
execution policies and procedures as required by proposed Rule 1102.
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FINRA's best execution rule does not require a periodic review of a
broker-dealer's best execution policies and procedures.\248\ However,
FINRA Rule 3130(c) requires a broker-dealer to have a report that
describes its processes to: establish, maintain, and review its
policies and procedures reasonably designed to achieve compliance with
applicable FINRA rules, MSRB rules, and Federal securities laws and
regulations; modify such policies and procedures as changes and events
dictate; and test the effectiveness of such policies and procedures on
a periodic basis, the timing and extent of which is reasonably designed
to ensure continuing compliance with FINRA rules, MSRB rules, and
Federal securities laws and regulations. FINRA Rule 3130(c) further
requires the broker-dealer's chief executive officer(s) (or equivalent
officer(s)) to certify to the existence of such processes, and to
certify that the report of such processes has been submitted to the
broker-dealer's board of directors and audit committee (or equivalent
bodies). The Commission understands that, currently, broker-dealers
periodically review their policies and procedures (including those
related to best execution), although the frequency of review may vary.
However, because the Commission is proposing its own best execution
rule, proposed Rule 1102 would help ensure the effectiveness of the
broker-dealer's best execution policies and procedures that it adopts
pursuant to the proposed rules.
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\248\ FINRA Rule 5310.
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MSRB Rule G-18.08(a) requires a broker-dealer to, at a minimum,
conduct annual reviews of its policies and procedures for determining
the best available market for the executions of its customers'
transactions. In conducting these reviews, a dealer must assess whether
its policies and procedures are reasonably designed to achieve best
execution, taking into account the quality of the executions the dealer
is obtaining under its current policies and procedures, changes in
market structure, new entrants, the availability of additional pre-
trade and post-trade data, and the availability of new technologies,
and to make promptly any necessary modifications to such policies and
procedures as may be appropriate in light of such reviews. As described
above in connection with the FINRA rules, because the Commission is
proposing its own best execution rule, proposed Rule 1102 would help
ensure the effectiveness of the broker-dealer's best execution policies
and procedures that it adopts pursuant to the proposed rules. Moreover,
as compared to MSRB Rule G-18.08(a), proposed Rule 1102 would include a
specific requirement that a broker-dealer review its order handling
practices, require that a report be maintained of this annual review,
and require that the broker-dealer provide the annual report to its
governing body.
Request for Comment
The Commission requests comment on all aspects of proposed Rule
1102, and in particular:
143. Should a broker-dealer be required to have written procedures
for annual (or more frequent) reviews of the overall effectiveness of
its best execution policies and procedures, including its order
handling practices, and be required to document such review, as
proposed? Why or why not?
144. Would the proposed requirement for written procedures for
annual (or more frequent) reviews help to ensure the overall
effectiveness of a broker-dealer's best execution policies and
procedures? Why or why not?
145. Should a broker-dealer be required to prepare a written report
detailing the results of its review, including any plan to address
deficiencies, as proposed? Why or why not? Should the Commission
require specific information to be included in the written report? If
so, what specific information should be required?
146. Should the written report of the review be presented to the
broker-dealer's board of directors (or equivalent governing body), as
proposed? Why or why not?
147. Would the proposed requirement for annual (or more frequent)
reviews and for presenting written reports of the reviews to the board
of directors help to ensure a broker-dealer's compliance with proposed
Regulation Best Execution? Why or why not?
148. Should a broker-dealer's board of directors (or governing
body) also be required to approve the best execution policies and
procedures that would initially be established under proposed
Regulation Best Execution? Please explain.
149. Do commenters agree with the Commission's understanding that,
currently, broker-dealers periodically review their best execution
policies and procedures? Please describe the rigor of any such reviews,
whether broker-dealers document such reviews, and whether broker-
dealers present the results of such reviews to their boards of
directors (or equivalent governing bodies).
[[Page 5481]]
150. Do commenters agree with the Commission's understanding that
such reviews vary in frequency among broker-dealers? Please describe
the frequency of such reviews. Does the frequency of review vary
depending on whether the broker-dealer is subject to the FINRA rules or
the MSRB rules? Please explain.
151. Should management, a committee, or an expert be designated to
conduct the annual review and prepare the report? Should specific
experience or expertise be required to conduct the annual review and
prepare the report? Would additional specificity in the rule promote
accountability over the annual review and report and ensure that
adequate resources are devoted to such review and report? Why or why
not?
152. Does the annual review raise any particular challenges for
smaller broker-dealers? If so, what could the Commission do to mitigate
those challenges?
153. Are there any conflicts of interest if the same personnel that
designs or implements the policies and procedures also conduct the
annual reviews? If so, how can those conflicts be mitigated or
eliminated? Should broker-dealers be required to have their policies
and procedures periodically audited by an unaffiliated third party to
assess their design and effectiveness? Why or why not? If so, should
the rule define the term ``affiliate'' to specify the entities that
would be eligible to perform such an audit and should the Commission
use the definition of ``affiliate'' in proposed Rule 1101(b)(4)(iii)
for this purpose? Please explain. What types of unaffiliated third
parties might have the necessary specific experience and expertise to
review a broker-dealer's best execution policies and procedures? For
example, should an unaffiliated consulting firm, accounting firm, or
law firm be permitted to provide this service, if required? Should the
rule prescribe the types of unaffiliated third parties that would have
the requisite experience and expertise? Please explain.
154. Do commenters believe that the Commission should provide
staggered compliance dates for proposed Rule 1102 for broker-dealers of
different sizes, if the Commission adopts proposed Regulation Best
Execution? For example, should the Commission provide longer compliance
dates for smaller broker-dealers? If so, should the Commission define a
smaller broker-dealer as a broker-dealer that qualifies as a ``small
entity'' under the Regulatory Flexibility Act pursuant to 17 CFR 240.0-
10(c) for this purpose? \249\ Or should the Commission define a smaller
broker-dealer in a different way? Please explain.
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\249\ See supra note 151 and accompanying text (describing the
broker-dealers that qualify as small entities under the Regulatory
Flexibility Act).
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G. Recordkeeping Requirements Under Rule 17a-4
In connection with proposed Regulation Best Execution, the
Commission is proposing new recordkeeping requirements for broker-
dealers. Section 17(a)(1) of the Exchange Act requires registered
broker-dealers to keep for prescribed periods such records as the
Commission prescribes as necessary or appropriate in the public
interest, for the protection of investors, or otherwise in furtherance
of the purposes of the Exchange Act.\250\ Rule 17a-4 under the Exchange
Act specifies how long broker-dealers must preserve required records
and other documents.\251\
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\250\ 15 U.S.C. 78q(a)(1).
\251\ 17 CFR 240.17a-4.
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Proposed Regulation Best Execution would require broker-dealers to
make the following records:
Policies and procedures under proposed Rules 1101(a), (b),
and (d) and Rule 1102;
Documentation of compliance with the best execution
standard for conflicted transactions under proposed Rule 1101(b);
Documentation of payment for order flow arrangements under
proposed Rule 1101(b);
Documentation of the results of the regular review of
execution quality under proposed Rule 1101(c);
Documentation of the results of the regular review of
execution quality by introducing brokers under proposed Rule 1101(d);
Documentation of the annual review under proposed Rule
1102; and
Annual report under proposed Rule 1102.
Current Rule 17a-4(e)(7) under the Exchange Act would apply to the
policies and procedures required by proposed Regulation Best
Execution.\252\ The Commission proposes to amend Rule 17a-4 to add new
paragraph (b)(17) to require broker-dealers to preserve all other
records made pursuant to proposed Rules 1101 and 1102 for a period of
not less than three years, the first two years in a readily accessible
place.
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\252\ Rule 17a-4(e)(7) requires broker-dealers to maintain and
preserve in an easily accessible place compliance, supervisory, and
procedures manuals (and any updates, modifications, and revisions
thereto) describing the policies and practices of the broker-dealer
with respect to compliance with applicable laws and rules, and
supervision of the activities of associated persons until three
years after the termination of the use of the manual. 17 CFR
240.17a-4(e)(7).
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The Commission preliminarily believes that the preservation of
records made pursuant to proposed Regulation Best Execution for this
time period would assist broker-dealers in ensuring that they continue
to maintain robust best execution practices for an appropriate amount
of time. In addition, the preservation and availability of records that
support and document broker-dealers' compliance with proposed
Regulation Best Execution would also assist the Commission and SROs in
assessing the broker-dealer's efforts to comply with proposed
Regulation Best Execution.
Request for Comment
The Commission requests comment on the proposed record preservation
requirements related to proposed Regulation Best Execution:
155. Should all records made pursuant to proposed Regulation Best
Execution be required to be preserved? Please explain.
156. Do commenters agree that the policies and procedures required
by proposed Regulation Best Execution should be subject to Rule 17a-
4(e)(7) and preserved until three years after the termination of their
use? Please explain.
157. Do commenters agree that all other records required by
proposed Regulation Best Execution should be subject to Rule 17a-4(b)
and preserved for a period of not less than three years, the first two
years in a readily accessible place? Please explain.
158. Should the Commission impose additional record preservation
requirements related to proposed Regulation Best Execution? Why or why
not? If the Commission were to impose additional requirements, what
specific records should broker-dealers be required to preserve? Please
explain.
V. Economic Analysis
A. Introduction
The Commission is mindful of the economic effects that may result
from proposed Regulation Best Execution, including the benefits, costs,
and the effects on efficiency, competition, and capital formation.\253\
This section
[[Page 5482]]
analyzes the expected economic effects of proposed Regulation Best
Execution relative to the current baseline, which consists of the
current market and regulatory framework in existence today.
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\253\ Exchange Act Section 3(f) requires the Commission, when it
is engaged in rulemaking pursuant to the Exchange Act, and is
required to consider or determine whether an action is necessary or
appropriate in the public interest, to consider, in addition to the
protection of investors, whether the action will promote efficiency,
competition, and capital formation. See 15 U.S.C. 78c(f). In
addition, Exchange Act Section 23(a)(2) requires the Commission,
when making rules pursuant to the Exchange Act, to consider among
other matters, the impact that any such rule would have on
competition, and not to adopt any rule that would impose a burden on
competition that is not necessary or appropriate in furtherance of
the purposes of the Exchange Act. See 15 U.S.C. 78w(a)(2).
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A broker-dealer's duty of best execution predates the Federal
securities laws and, as noted previously, has ``its roots in the common
law agency obligations of undivided loyalty and reasonable care that an
agent owes to his principal.'' \254\ In general terms, the Commission
position is, and has been, that ``the duty of best execution requires
broker-dealers to execute customers' trades at the most favorable terms
reasonably available under the circumstances, i.e., at the best
reasonably available price.''\255\ FINRA Rule 5310(a) and MSRB Rule G-
18(a) codify essentially the same requirement that members must ``use
reasonable diligence to ascertain the best market for the subject
security and buy or sell [there] so that the resultant price to the
customer is as favorable as possible under prevailing market
conditions.''
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\254\ Newton v. Merrill, Lynch, Pierce, Fenner & Smith, Inc.,
135 F.3d 266, 270, n. 30 (3rd Cir. 1998). As the Commission
explained when adopting rules governing payment for order flow
almost three decades ago, ``[a] broker-dealer's duty to seek to
obtain best execution of customer orders derives, in part, from the
common law agency duty of loyalty, which obligates an agent to act
exclusively in the principal's best interest. Restatement (Second)
of Agency section 387 (1958). Thus, when an agent acts on behalf of
a customer in a transaction, the agent is under a duty to exercise
reasonable care to obtain the most advantageous terms for the
customer. Id. at section 424.'' Payment For Order Flow Release,
supra note 33, at n. 15.
\255\ Regulation NMS Adopting Release, supra note 21, at 37538
(citations omitted). See also, Special Study, supra note 10, at 623
(``A broker-dealer acting as an agent for a customer in the
execution of a transaction assumes the obligations of a fiduciary .
. . . A corollary of the fiduciary's duty of loyalty to his
principal is his duty to obtain or dispose of property for his
principal at the best price discoverable in the exercise of
reasonable diligence.'') (citations omitted), available athttps://www.sechistorical.org/collection/papers/1960/1963_SSMkt_Chapter_07_2.pdf
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The duty of best execution is a foundational component of the
current best execution regulatory framework that helps protect
investors in a setting of imperfect markets. The duty serves to
counteract market failures that arise, for example, when an agent (in
this case, a broker or broker-dealer) has different incentives than a
principal (investor), and the principal, particularly the retail
investor, is not in a position to monitor the agent. This is known in
economics as a principal-agent problem.\256\ A principal-agent problem
arises when a broker-dealer undertakes costly actions to achieve best
execution and the principal (investor) cannot observe the broker-
dealer's actions. The broker-dealer in this situation has financial
incentives to take (or not take) certain actions to reduce its costs or
increase its profits.
---------------------------------------------------------------------------
\256\ See Joseph E. Stiglitz, Principal and Agent, in
Allocation, Information and Markets 241 (John Eatwell et al. eds.,
1989).
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The principal-agent problem can be exacerbated by a specific
conflict of interest that arises when the broker-dealer executes a
customer order in a principal capacity.\257\ In these instances, the
broker-dealer acting as principal on the trade has a financial
incentive to maximize its gains from the trade, which would be at the
expense of the counterparty, here the broker-dealer's customer, in a
zero-sum game.\258\ This conflict of interest should be mitigated
because the broker-dealer as agent for its customer also has a duty to
ensure that the order was executed at the most favorable terms
reasonably available to the customer under the circumstances. However,
retail customers typically lack access to the information that would
allow them to determine independently whether an order received best
execution from a broker-dealer. Further, obtaining and analyzing such
information could be costly for retail customers.
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\257\ For instance, a broker-dealer may decide to act in a
principal capacity in a situation where there is a liquidity
externality in that the investor's order lacks a counterparty,
though the presence of such an externality is not necessary to the
broker-dealer's decision.
\258\ ``Trading is a zero-sum game in an important accounting
sense. In a zero-sum game, the total gains of the winners are
exactly equal to the total losses of the losers. Trading is a zero-
sum game, because the combined gains and losses of buyers and
sellers always sum to zero.'' Larry Harris, Trading and Exchanges:
Market Microstructure for Practitioners (2002).
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The Commission has long taken the position that the ``scope of
[the] duty of best execution must evolve as changes occur in the market
that give rise to improved executions for customer orders . . . [and
that] broker-dealers' procedures for seeking to obtain best execution
for customer orders also must be modified to consider price
[improvement] opportunities that become `reasonably available.' ''
\259\ Current SRO rules that specifically address broker-dealer best
execution policies and procedures requirements focus on a retrospective
``regular and rigorous'' review of execution quality. With limited
exceptions, such as those for orders involving foreign securities, and
securities for which there is limited pricing information or quotations
available, existing SRO rules do not establish specific standards
concerning a broker-dealer's policies and procedures for complying with
the best execution obligations in FINRA Rule 5310(a) and MSRB Rule G-
18(a).\260\
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\259\ See, e.g., Marc N. Geman, Securities Exchange Act Release
No. 43963 (Feb. 14, 2001) (Commission opinion) (citing Order
Execution Obligations Adopting Release, supra note 10, 61 FR 48322-
48323).
\260\ As discussed supra in note 129 and the accompanying text,
FINRA Rule 3110(b)(1) requires broker-dealers to have policies and
procedures for compliance with FINRA rules and Federal securities
laws and regulations. MSRB Rule G-18.08 requires broker-dealers to
have policies and procedures for determining the best available
market for the executions of their customers' transactions. MSRB
Rule G-28 requires broker-dealers to have procedures for compliance
with MSRB rules and the Exchange Act and rules thereunder. Unlike
these FINRA and MSRB rules, proposed Regulation Best Execution would
establish specific standards concerning the policies and procedures
for complying with the proposed best execution standard, as
discussed in sections IV.B.1 and 2 supra.
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The proposal would build on the existing regulatory framework,
codify in a Commission rule a best execution standard that is
consistent with how the Commission and the courts have described the
duty of best execution, enhance the Commission's ability to enforce
best execution, and impose detailed policies and procedures obligations
on broker-dealers' handling and execution of customer orders, including
documented incremental efforts required for a broker-dealer to obtain
the most favorable price in conflicted transactions for or with retail
customers.\261\ These requirements could further help enhance broker-
dealers' ability to maintain robust best execution practices, including
in situations where broker-dealers have order handling conflicts of
interest with retail customers.
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\261\ See supra section IV.
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The Commission estimates aggregate compliance costs of $165.4
million in one-time costs and $128.9 million in annual costs on broker-
dealers as they update, or establish, their policies and procedures for
the handling, execution, and review of customer orders. To the extent
that broker-dealers already have policies and procedures that are
consistent with the proposed rules, aggregate implementation costs
would be less than this estimate, and based on the Commission's
experience, the Commission preliminarily believes these estimates
overstate costs broker-dealers would bear in implementing the
proposal.\262\ Broker-dealers may also
[[Page 5483]]
incur indirect costs.\263\ Some of these costs could be passed through
to customers in the form of higher commissions or reduced services.
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\262\ See infra section V.C.2.
\263\ See infra section V.C.2.b).
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The Commission has considered the economic effects of proposed
Regulation Best Execution and, wherever possible, the Commission has
quantified the likely economic effects of proposed Regulation Best
Execution. The Commission is providing both a qualitative assessment
and quantified estimates of the potential economic effects of the
proposal where feasible. The Commission has incorporated data and other
information to assist it in the analysis of the economic effects of
proposed Regulation Best Execution. However, as explained in more
detail below, because the Commission does not have, and in certain
cases does not believe it can reasonably obtain, data that may inform
the Commission on certain economic effects, the Commission is unable to
quantify certain economic effects. Further, even in cases where the
Commission has some data, quantification is not practicable due to the
number and type of assumptions necessary to quantify certain economic
effects, which render any such quantification unreliable. Our inability
to quantify certain costs, benefits, and effects does not imply that
the Commission believes such costs, benefits, or effects are less
significant. The Commission requests that commenters provide relevant
data and information to assist the Commission in quantifying the
economic consequences of proposed Regulation Best Execution.
B. Baseline
Commission statements and SRO rules, including FINRA Rule 5310 and
MSRB Rule G-18, and related SRO interpretive notices and guidance
address broker-dealer best execution duties primarily through a broad,
principles-based approach. Differences in security characteristics and
market structure can cause broker-dealer order handling and execution
practices to vary significantly across different asset classes,
including the role that conflicts of interests play in the handling and
execution of a broker-dealer's retail customer orders. In addition,
policies related to the handling of customer orders can impact
competition among broker-dealers, trading venues, and broker-dealers
that offer order routing and execution services. The baseline against
which the costs, benefits, and the effects on efficiency, competition,
and capital formation of proposed Regulation Best Execution is measured
consists of the current regulatory requirements and SRO guidance for
broker-dealers concerning customer best execution, current broker-
dealer best execution review processes, the current market structure
and broker-dealer practices concerning handling and executing customer
orders that may be impacted by proposed Regulation Best Execution,\264\
and the structure of the market for broker-dealer services.
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\264\ While proposed Regulation Best Execution would apply to
all securities, the Commission preliminarily believes that the
proposal would not have economic effects on the market structure or
order handling practices in the markets for securities based swaps,
asset-backed securities, and repurchase and reverse repurchase
agreements because these markets are mostly dominated by
institutional investors that do their own order handling. Therefore,
the market structure and order handling practices in these markets
are not discussed in the economic baseline of this release.
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1. Current Legal and Regulatory Framework
Although FINRA and the MSRB have established rules and issued
guidance directly addressing the duty of best execution that are
applicable to their respective members, the Commission has never
established its own rule governing a broker-dealer's legal duty of best
execution. As described above in section II.A, the duty of best
execution that a broker-dealer has today was originally derived from an
implied representation that a broker-dealer makes to its customers when
it agrees to engage in certain transactions on their behalf. The common
law agency obligations of ``undivided loyalty and reasonable care''
that an agent owes to its principal require that a ``broker-dealer seek
to obtain for its customer orders the most favorable terms reasonably
available under the circumstances.'' \265\ Expressed in economic terms,
because a ``client-principal seeks his own economic gain and the
purpose of the agency is to help the client-principal achieve that
objective, the broker-dealer['s best execution obligation], absent
instructions to the contrary, [means that a broker-dealer] is expected
to use reasonable efforts to maximize the economic benefit to the
client in each transaction.'' \266\
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\265\ Newton v. Merrill, Lynch, Pierce, Fenner & Smith, Inc.,
135 F.3d at 270.
\266\ See id.
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In addition to the duty itself, the current framework consists of
examination and monitoring programs conducted by the Commission and
FINRA \267\ of Commission registrants and FINRA and MSRB members. Best
execution is and has been a priority item in these examinations.\268\
In addition, FINRA produces monthly status reports for members, known
as the best execution Outside-of-the-Inside report card, ``detailing
the number of transactions reported to a FINRA [trade reporting]
Facility, in which [a] firm participated that were executed Outside-of-
the-Inside market in apparent violation of the Best Execution Rule.''
\269\
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\267\ The MSRB does not conduct its own enforcement or
compliance examinations. MSRB, The Role and Jurisdiction of the
MSRB, at 2 (2021) (``the SEC and federal bank regulators [ ] share
responsibility for enforcement and compliance examinations''),
available at https://www.msrb.org/sites/default/files/2022-09/Role-and-Jurisdiction-of-MSRB.pdf.
\268\ The Division of Exams 2022 priorities note that best
execution in fixed-income securities, best execution obligations in
a zero commission environment, and possible effects of conflicts of
interest on best execution are focus points of its broker-dealer
exam program. Division of Examinations, 2022 Examination Priorities,
at 19 and 20, available at https://www.sec.gov/files/2022-exam-priorities.pdf. According to FINRA, ``[a]ssessing firms' compliance
with their best execution obligations under FINRA Rule 5310 (Best
Execution and Interpositioning) is one of the cornerstones of
FINRA's oversight activities.'' FINRA, 2022 Report on FINRA's
Examination and Risk Monitoring Program, at 2 (Feb. 2022), available
at https://www.finra.org/sites/default/files/2022-02/2022-report-finras-examination-risk-monitoring-program.pdf.
\269\ FINRA, Best Execution Outside-of-the-Inside Report Card,
available at https://www.finra.org/compliance-tools/report-center/equity/best-execution-outside-inside-report-card. Member firms are
told that they should ``make no inference . . . that FINRA staff has
or has not determined that the information contained on the Best
Execution Outside-of-the-Inside report cards does or does not
constitute rule violations.'' Id.
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(a) Commission and Court Statements, Agency Guidance, and Enforcement
Activities
In the context of agency rulemaking, adjudication, and Federal
court litigation, the Commission and various Federal courts of appeal
have articulated what the duty of best execution means and interpreted
how the duty applies in various circumstances. For example, the duty of
best execution requires a broker-dealer to ``execute customers' trades
at the most favorable terms reasonably available under the
circumstances, i.e., at the best reasonably available price.'' \270\
When considering what the
[[Page 5484]]
best reasonably available price means in the context of a broker-
dealers' best execution analysis, the Commission has articulated a non-
exhaustive list of factors that may be relevant to broker-dealers' best
execution analysis. These factors include the size of the order, speed
of execution, clearing costs, the trading characteristics of the
security involved, the availability of accurate information affecting
choices as to the most favorable market center for execution and the
availability of technological aids to process such information, and the
cost and difficulty associated with achieving an execution in a
particular market center.\271\
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\270\ Regulation NMS Adopting Release, supra note 21, at 37538.
See also Order Execution and Routing Practice Release, supra note
22, at 75418 (price is a critical concern for investors); Geman v.
SEC, 334 F.3d 1183, 1186 (10th Cir. 2003) (``[T]he duty of best
execution requires that a broker-dealer seek to obtain for its
customer orders the most favorable terms reasonably available under
the circumstances.'') (quoting Newton v. Merrill, Lynch, Pierce,
Fenner & Smith, Inc., 135 F.3d 266, 270 (3d Cir. 1998)); Kurz v.
Fidelity Management & Research Co., 556 F.3d 639, 640 (7th Cir.
2009) (describing the ``duty of best execution'' as ``getting the
optimal combination of price, speed, and liquidity for a securities
trade'').
\271\ See Order Execution and Routing Practice Release, supra
note 22, at 75422; Regulation NMS Adopting Release, supra note 21,
at 37538.
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Other Commission statements address what best execution means in
the context of various market practices and circumstances.
Interpositioning, which occurs when a broker-dealer places a third
party between itself and the best market for executing a customer trade
in a manner that results in a customer not receiving the best available
market price or paying unnecessary expenses, violates the broker-
dealer's duty of best execution.\272\ When a broker-dealer receives a
limit order, the duty of best execution requires the broker-dealer to
account for potential material differences in execution quality, such
as the likelihood of execution among the various securities markets or
market centers to which limit orders may be routed.\273\ The Commission
has also recognized that it may be impractical for a broker-dealer that
handles a heavy volume of orders to make individual determinations
regarding where to route each order \274\ and that the duty of best
execution requires a broker-dealer to assess periodically the quality
of competing markets to ensure that its customers' order flow is
directed to the markets providing the most beneficial terms.\275\
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\272\ See supra notes 29-30 listing Commission opinions. See
also SEC v. Ridenour, 913 F.2d 515 (8th Cir. 1990) (bond salesman's
interpositioning of personal trading between his customers'
securities transactions and the market violated the antifraud
provisions).
\273\ See Order Execution Obligations Adopting Release, supra
note 10, at 48323.
\274\ See Payment for Order Flow Release, supra note 33, at
55009.
\275\ See Regulation NMS Adopting Release, supra note 21, at
37516; Payment for Order Flow Release, supra note 33, at 55009.
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Although the Commission has not established a set of specific
minimum data elements that a broker-dealer would need to acquire to
achieve best execution \276\ and has acknowledged that it cannot
specify the data elements that may be relevant to every specific
situation,\277\ it has identified the various types of data needed by
broker-dealers to fulfill their duty of best execution. For example,
information contained in the public quotation system must be considered
in seeking best execution of customer orders.\278\ In adopting Rules
605 and 606,\279\ the Commission recognized that the reports required
of market centers would provide statistical disclosures regarding
certain factors, such as execution price and speed of execution,
relevant to a broker-dealer's order routing decisions and that these
public disclosures of execution quality should help broker-dealers
fulfill their duty of best execution.\280\ More recently, the
Commission emphasized that broker-dealers should consider the
availability of consolidated market data, including the various
elements of data content and the timeliness, accuracy, and reliability
of the data in developing and maintaining best execution policies and
procedures.\281\
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\276\ See MDI Adopting Release, supra note 38, at 18606.
\277\ Id.
\278\ See Order Execution and Routing Practice Release, supra
note 22, at 75418.
\279\ 17 CFR 242.605, 242.606.
\280\ See Order Execution and Routing Practice Release, supra
note 22, at 75418. See also, id. at 75420 (information provided by
these reports is not, by itself, sufficient to support conclusions
regarding the provision of best execution, and any such conclusions
would require a more in-depth analysis of the broker-dealer's order
routing practices than will be available from the disclosures
required by the rules).
\281\ See MDI Adopting Release, supra note 38, at 18605-06.
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The Commission has also emphasized the importance of price
improvement in considering whether a customer order received best
execution stating that ``notwithstanding any ambiguity that may have
once existed [ ], it should now be clear that a firm must consider the
potential for price improvement in carrying out its best execution
obligations.'' \282\ Relatedly, the Commission has taken the position
that simply routing customer order flow for automated executions or
internalizing customer orders on an automated basis at the best bid or
offer does not necessarily satisfy a broker-dealer's duty of best
execution for small orders in non-NMS stock equity securities (and NMS
stocks).\283\ Rather, broker-dealers handling small orders should look
for price improvement opportunities when executing these orders.\284\
And the expectation of price improvement for customer orders is
particularly important when broker-dealers receive payment for order
flow.\285\ According to the Commission, a broker-dealer's receipt of
payment for order flow is not a violation of its duty of best execution
as long as it periodically assesses the quality of the markets to which
it routes packaged order flow.\286\
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\282\ Marc N. Geman, Exchange Act Release No. 43963 (Feb. 14,
2001) (C'n opinion) (record did not support a finding that firm
fraudulently violated its duty of best execution), affirmed on other
grounds, 334 F.3d 1183, 1186 (10th Cir. 2003). See Order Execution
Obligations Adopting Release, supra note 10, at 48323. See also, id.
at 48323 n. 357
\283\ See id. at 48323.
\284\ See id.
\285\ See Payment for Order Flow Release, supra note 33, at
55008. See Exchange Act Rule 10b-10, 17 CFR 240.10b-10. See also
supra note 43 (reviewing the definition of payment for order flow).
\286\ See Payment for Order Flow Release, supra note 33, at
55009.
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An additional component of the best execution baseline for the
Commission is enforcement mechanisms. The Commission has broad
statutory authority under the Exchange Act to bring an injunctive
action in Federal district court under Exchange Act Section 21(d)(1)
whenever any person is engaged or is about to engage in acts or
practices constituting a violation of the Federal securities laws and
rules and regulations thereunder and, among other things, FINRA and
MSRB rules, including best execution rules. Exchange Act Section 21(f)
directs the Commission not to bring an injunctive action against any
person for a SRO rule violation ``unless . . . such self-regulatory
organization . . . is unable or unwilling to take appropriate action .
. ., or (2) such action is otherwise necessary or appropriate in the
public interest or for the protection of investors.'' \287\ The
Commission's authority to obtain monetary sanctions in Federal district
court actions for FINRA and MSRB rule violations is also not co-
extensive with its authority to obtain injunctive relief for violations
of the Federal securities laws. For example, while the Commission can
seek disgorgement and any equitable relief for Federal securities law
violations and SRO rule violations, the Commission's authority to
obtain civil penalties in a Federal district court action under Section
21(d) extends to violations of ``any provision of th[e
[[Page 5485]]
Exchange Act], the rules or regulations thereunder, or a cease-and-
desist order entered by the Commission . . . other than [ ] a violation
subject to a penalty pursuant to [the Exchange Act provision penalizing
insider trading violations].'' \288\ Section 21(d)(3) does not include
the language in Section 21(d)(1) regarding the ``rules of a registered
securities association'' or the ``rules of the Municipal Securities
Rulemaking Board.''
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\287\ Under Exchange Act Section 21(f), the Commission ``shall
not bring any action pursuant to subsection (d) or (e) of this
section against any person for violation of, or to command
compliance with, the rules of a self-regulatory organization . . .
unless it appears to the Commission that (1) such self-regulatory
organization . . . is unable or unwilling to take appropriate action
against such person in the public interest and for the protection of
investors, or (2) such action is otherwise necessary or appropriate
in the public interest or for the protection of investors.''
\288\ Exchange Act Section 21(d)(3)(A).
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The Commission's authority to obtain relief in administrative and
cease-and-desist proceedings is more limited. The Commission can
institute administrative proceedings pursuant to Exchange Act Sections
15(b)(4) and 15(b)(6), against broker dealers and their associated
persons respectively, and pursuant to Exchange Act Sections 15B(c)(2)
and 15B(c)(4) against municipal securities dealers and their associated
persons respectively, for willful violations, and willful aiding and
abetting violations of, among other things, the Federal securities
statutes, the rules and regulations thereunder, ``or the rules of the
Municipal Securities Rulemaking Board.'' \289\ There is no parallel
provision for the rules of an SRO or a registered securities
association such as FINRA. A cease-and-desist proceeding can be brought
only if ``any person is violating, has violated, or is about to violate
any provision of [the Exchange Act], or any rule or regulation
thereunder.'' \290\ There is no parallel provision for the rules of the
MSRB \291\ or the rules of a Federal securities association.\292\
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\289\ Exchange Act Section 15(b)(4)(D) and (E) and
15(b)(6)(A)(i). Where broker-dealer's best execution-related
misconduct has also involved fraud, the Commission may exercise its
discretion to bring best execution-based fraud charges pursuant to
the Exchange Act's and the Securities Act's antifraud provisions.
See, e.g., Linkbrokers Derivatives LLC, Exchange Act Rel. No. 72,846
(Aug. 14, 2014) (settled Section 15(b) and cease-and-desist
proceeding alleging antifraud violations of Exchange Act Section
15(c)(1)), available at https://www.sec.gov/litigation/admin/2014/34-72846.pdf.
\290\ Exchange Act Section 21C(a).
\291\ Where the Commission can institute an administrative
proceeding under both Sections 15B(c) and 21C, the Commission can
order remedies, including a cease-and-desist order, and other
sanctions against a municipal securities dealer. See, e.g., RBC
Capital Markets, LLC, Exchange Act Rel. No. 93,042 (Sept. 17, 2021)
(settled action) available at https://www.sec.gov/litigation/admin/2021/34-93042.pdf.
\292\ In situations where broker-dealer best execution-related
misconduct has involved fraud, the Commission can exercise its
discretion to bring best execution-based fraud charges pursuant to
the Exchange Act's or the Securities Act's antifraud provisions.
See, e.g., Robinhood SEC, supra note 69 (settled cease-and-desist
proceeding alleging antifraud violations of Securities Act Sections
17(a)(2) and 17(a)(3)) https://www.sec.gov/litigation/admin/2020/33-10906.pdf; Patrick R. Burke, Exchange Act Rel. No. 76,285 (Oct. 28,
2015) (settled cease-and-desist and Section 15(b) proceeding
alleging antifraud violations of Exchange Act Section 10(b) and Rule
10b-5 and Securities Act Section 17(a)), available at https://www.sec.gov/litigation/admin/2015/33-9968.pdf.
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(b) FINRA Rule 5310 Best Execution Rule and Related Information
As discussed in greater detail in Sections II.C and IV., FINRA has
a rule for its members that details their best execution
obligations.\293\ Specifically, Rule 5310(a)(1) states that ``[i]n any
transaction for or with a customer or 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.'' \294\ FINRA's rule applies ``not only where the member
acts as agent for the account of its customer but also where
transactions are executed as principal'' \295\ and cannot be
transferred to others.\296\ Interpositioning is expressly
prohibited.\297\ Like the position taken by the Commission,\298\
FINRA's rule lists a set of non-exclusive ``factors that will be
considered in determining whether a member has used `reasonable
diligence.'' The five factors listed are:
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\293\ Rule 5310, which first became effective in May 2012,
consolidated FINRA members' best execution requirements that were
based largely on NASD Rule 2320 and NASD Interpretive Guidance with
Respect to Best Execution Requirements, NASD IM-2320, as well as new
provisions. FINRA, Regulatory Notice 12-13, SEC Approves
Consolidated FINRA Best Execution Rule, available at https://www.finra.org/rules-guidance/notices/12-13. As previously noted
supra in note 129, in addition to FINRA's best execution rule, FINRA
Rule 3110(b)(1) requires broker-dealers to have procedures for
compliance with FINRA rules (including its best execution rule) and
Federal securities laws and regulations. Separately, FINRA Rules
3130(b) and (c) require the chief executive officer (or equivalent
officer) of a FINRA member to certify annually that the member has
in place processes to establish, maintain, review, test and modify
written compliance policies and written supervisory procedures
reasonably designed to achieve compliance with applicable FINRA
rules, MSRB rules, and Federal securities laws and regulations. See
also, FINRA Regulatory Notice 21-12, supra note 174, at 9 (``FINRA
has also advised Member firms should have effective procedures in
place to ensure they are fulfilling their best execution obligations
during extreme market conditions'').
\294\ FINRA Rule 5310(a)(1), available at https://www.finra.org/rules-guidance/rulebooks/finra-rules/5310. FINRA rule 5310
recodified FINRA's predecessor, the NASD, rule and interpretative
material (IM) governing best execution and interpositioning, NASD
Rule 2320 and IM-2320. FINRA's most recent regulatory guidance on
Rule 5310 is contained in Regulatory Notice 15-46, Best Execution:
Guidance on Best Execution Obligations in Equity, Options and Fixed
Income Markets (Nov. 2015) (``FINRA Regulatory Notice 15-46''),
available at https://www.finra.org/sites/default/files/notice_doc_file_ref/Notice_Regulatory_15-46.pdf; and Regulatory
Notice 21-23, Best Execution and Payment for Order Flow (June 23,
2021) (``FINRA Regulatory Notice 21-23'') available at https://www.finra.org/sites/default/files/2021-06/Regulatory-Notice-21-23.pdf.
\295\ FINRA Rule 5310(e). This paragraph also states that a
broker-dealer's duty of best execution is ``distinct from the
reasonableness of commission rates, markups, or markdowns, which are
governed by Rule 2121 and its Supplementary Material.'' Id.
\296\ FINRA Rule 5310.09(a).
\297\ FINRA Rule 5310(a)(2). This subparagraph is one of a
number of the rule's specific provisions addressing
interpositioning. For a discussion of the related burdens and
prohibitions imposed by FINRA in connection with interpositioning,
see the discussion of FINRA Rules 5310(b), (c), and (d) in Section
IV.A., including the text accompanying supra notes 149 and 150.
\298\ See Order Execution and Routing Practice Release, supra
note 22, at 75422, and the accompanying discussion.
i. the character of the market for the security (e.g., price,
volatility, relative liquidity, and pressure on available
communications);
ii. the size and type of transaction;
iii. the number of markets checked;
iv. accessibility of the quotation; and
v. the terms and conditions of the order which result in the
transaction, as communicated to the member and persons associated
with the member.\299\
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\299\ FINRA Rule 5310(a)(1).
FINRA's best execution rule and related guidance \300\ addresses
how its members' obligations and these factors are accounted for and
considered. For example, for debt securities, FINRA Rule 5310.03
explains that the term ``quotation'' in its ``accessibility of the
quotation'' factor ``refers to either dollar (or other currency)
pricing or yield pricing'' and that ``[i]n the absence of
accessibility, members are not relieved from taking reasonable steps
and employing their market expertise in achieving the best execution of
customer orders.'' \301\ FINRA Rule 5310.06 also states that FINRA
members ``must have written policies and procedures in place that
address how the member will determine the best inter-dealer market for
such a security in the absence of pricing information or multiple
quotations and must document its compliance with those policies and
procedures.''
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\300\ FINRA Rule 5310 includes supplementary material which
addresses: (i) the execution of marketable customer orders; (ii) the
definition of ``market;'' (iii) debt securities; (iv) executing
brokers; (v) the use of another broker, a broker's broker, to
execute a customer's orders; (vi) orders involving securities with
limited quotation or pricing information; (vii) orders involving
foreign securities; (viii) customer instructions for order handling;
and (ix) the regular and rigorous review of execution quality. The
text of FINRA Rule 5310 is available at https://www.finra.org/rules-guidance/rulebooks/finra-rules/5310. Regulatory Notices 15-46 and
21-23 are FINRA guidance documents for its best execution rule.
\301\ FINRA Rule 5310.03.
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FINRA Rule 5310.07 also addresses orders involving foreign
securities.
[[Page 5486]]
``Even though a security does not trade in the U.S., members still have
an obligation to seek best execution for customer orders involving any
foreign security.'' \302\ ``[A] member that handles customer orders
involving foreign securities that do not trade in the U.S. must have
specific written policies and procedures in place regarding its
handling of customer orders for these securities that are reasonably
designed to obtain the most favorable terms available for the customer,
taking into account differences that may exist between U.S. markets and
foreign markets.'' \303\ Referencing two of its factors to be
considered, FINRA Rule 5310.07 states that ``the character of the
particular foreign market and the accessibility of quotations in
certain foreign markets may vary significantly'' and that ``the
determination as to whether a member has satisfied its best execution
obligations necessarily involves a `facts and circumstances'
analysis.'' \304\ Further, for customer orders involving a foreign
security FINRA requires its members to ``have specific written policies
and procedures in place regarding its handling of customer orders for
these securities that are reasonably designed to obtain the most
favorable terms available for the customer.'' \305\
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\302\ FINRA Rule 5310.07.
\303\ Id.
\304\ Id. The rule also states that ``best execution obligations
also must evolve as changes occur in the market that may give rise
to improved executions [and] members also must regularly review
these policies and procedures to assess the quality of executions
received and update or revise the policies and procedures as
necessary.''
\305\ Id.
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FINRA rules address two situations where a member's best execution
obligation is modified or no longer applicable. If a broker-dealer
``receives an unsolicited instruction from a customer to route that
customer's order to a particular market for execution, the member is
not required to make a best execution determination beyond the
customer's specific instruction.'' \306\ FINRA Rule 5310.04 addresses a
specific situation where its best execution rule does not apply. The
rule ``does not apply in instances when another broker-dealer is simply
executing a customer order against the member's quote.'' The rule
explains that ``[t]he duty to provide best execution to customer orders
received from other broker-dealers arises only when an order is routed
from the broker-dealer to the member for the purpose of order handling
and execution.'' \307\
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\306\ FINRA Rule 5310.08. FINRA does require, however, that the
broker-dealer process the ``order promptly in accordance with [its]
terms . . . [and] where a customer has directed that an order be
routed to another specific broker-dealer,'' that broker-dealer
receiving the directed order would be subject to the duty of best
execution with respect to the customer's order. Id.
\307\ FINRA Rule 5310.04 (emphasis added).
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FINRA Rule 5310 addresses a broker-dealer's best execution-related
obligations to determine order execution quality. FINRA Rule 5310.09(a)
requires that ``[a] member that routes customer orders to other broker-
dealers for execution on an automated, non-discretionary basis, as well
as a member that internalizes customer order flow, must have procedures
in place to ensure the member periodically conducts regular and
rigorous reviews of the quality of the executions of its customers'
orders if it does not conduct an order-by-order review.'' \308\ This
``regular and rigorous'' review must be conducted at a minimum no less
frequently than quarterly unless, based on a member's business, ``more
frequent reviews are needed.'' Reviews are required to be done on a
security-by-security and type-of-order basis.\309\ Execution quality
reviews must compare customer execution quality to the execution
quality of other markets that are not used for customer order
execution.\310\ However, FINRA Rule 5310.09(c) allows a broker-dealer
to rely on another broker-dealer's regular and rigorous review if the
broker-dealer seeking to rely ``routes its order flow to another member
that has agreed to handle that order flow as agent for the customer
(e.g., a clearing firm or other executing broker-dealer)'' and ``as
long as the statistical results and rationale of the review are fully
disclosed to the member and the member periodically reviews how the
review is conducted, as well as the results of the review.'' \311\
Issues associated with payment for order flow are also addressed in
FINRA's best execution rule and guidance. FINRA recently issued best
execution guidance that stated that ``firms that provide payment for
order flow for the opportunity to internalize customer orders cannot
allow such payments to interfere with their best execution
obligations.'' \312\ For example, ``inducements such as payment for
order flow and internalization may not be taken into account in
analyzing market quality.'' \313\
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\308\ FINRA Rule 5310.09(a). FINRA has stated that there are two
situations where an order-by-order review would satisfy best
execution requirements when a ``regular and rigorous review alone .
. . may not'' do so. One involves certain larger-sized security
orders. See FINRA Regulatory Notice 15-46, supra note 294, at 3
(``when routing or internally executing larger-sized orders in any
security, regular and rigorous review alone (as opposed to an order-
by-order review) may not satisfy best execution requirements, given
that the execution of larger-size orders ``often requires more
judgment in terms of market timing and capital commitment'' (quoting
NASD Notice to Members 01-22 at n. 13)). The other circumstance
involves ``any orders that a member firm determines to execute
internally'' which, according to FINRA Regulatory Notice 21-23,
``are subject to an order-by-order best execution analysis.'' Id.,
supra note 294, at 3. FINRA guidance includes commentary that
advances in technology make ``order-by-order review of execution
quality [ ] increasingly possible for a range of orders in equity
securities and standardized options. Id. Although the text of FINRA
Rule 5310 and its interpretive guidance refer to an ``order-by-order
review'' in contrast to the ``regular and rigorous review'' detailed
in Rule 5310.09, it is our understanding that FINRA has not directly
addressed what an ``order-by-order review'' entails.
\309\ FINRA Rule 5310.09(a).
\310\ ``[A] member must determine whether any material
differences in execution quality exist among the markets trading the
security and, if so, modify the member's routing arrangements or
justify why it is not modifying its routing arrangements.'' FINRA
Rule 5310.09(b). FINRA has identified eight factors for members to
consider in order to assure that order flow is directed to markets
providing the most beneficial terms for a member's customers'
orders. These factors are discussed in the text accompanying supra
note 299.
\311\ FINRA Rule 5310.09(c).
\312\ FINRA Regulatory Notice 21-23, supra note 294, at 4.
\313\ Id. FINRA's guidance stated that ``the possibility of
obtaining price improvement is a heightened consideration when a
broker-dealer receives payment for order flow.'' Id. (citation
omitted).
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``In other words, . . . firms may not negotiate the terms of order
routing arrangements for those customer orders in a manner that reduces
the price improvement opportunities that otherwise would be available
to those customer orders absent payment for order flow.'' \314\
---------------------------------------------------------------------------
\314\ Id. (citing FINRA Regulatory Notice 15-46, supra note 294,
at n.25 (``For example, if a firm obtains price improvement at one
venue of $0.0005 per share, and it could obtain mid-point price
improvement at another venue of $0.025 per share, the firm should
consider the opportunity of such midpoint price improvement on that
other venue as part of its best execution analysis.'')).
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FINRA publishes reports that include the results of its examination
program's annual review of member best execution compliance. These
reports, covering examinations from 2017 through 2021, include a series
of findings and observations on various aspects of Rule 5310.\315\ In
each year, FINRA observed some noncompliance with Rule 5310. Among the
points made in each report, FINRA reported observing some firms that
did not: (1) assess execution in competing markets; (2) conduct an
adequate review on a type-of-order basis; (3) evaluate certain required
factors when conducting regular and rigorous review; and, in more
recent
[[Page 5487]]
years, (4) consider and address potential conflicts of interest in
conflicts of interest relating to routing of orders to affiliated
broker-dealers, ATSs, or market centers that provide payment for order
flow or other routing inducements.\316\
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\315\ Each of these reports is available at https://www.finra.org/media-center/reports-studies. For 2017 through 2019,
the reports are titled ``FINRA Report on Examination Findings.''
More recent reports are titled ``Report on FINRA's Examination and
Risk Monitoring Program.''
\316\ Id.
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(c) MSRB Rule G-18 Best Execution Rule and Guidance
The MSRB's adopted its best execution rule, Rule G-18, in 2015
which became effective on March 21, 2016.\317\ It is generally modeled
after and similar to FINRA Rule 5310.\318\ It extends the outline of
``reasonable diligence'' to include ``the information reviewed to
determine the current market for the subject security or similar
securities,'' provides more granular detail regarding transactions in
which the broker-dealer acts in a principal capacity, and directs at
least annual reviews of best execution (versus at least quarterly
reviews required by FINRA). Unlike FINRA Rule 5310, MSRB Rule G-48(e)
provides an exception from the requirements of Rule G-18 for all
transactions with sophisticated municipal market professionals, defined
in MSRB Rule D-15.\319\ According to FINRA and the MSRB, there are two
instances where ``material differences'' exist between the MSRB's best
execution guidance and FINRA's.\320\ They involve the regular and
rigorous review of execution quality required by members,\321\ and the
timeliness of executions consistent with reasonable diligence.\322\
MSRB Rule G-18.08(a) requires a broker-dealer to, at a minimum, conduct
annual reviews of its policies and procedures for determining the best
available market for the execution of its customers' transactions. MSRB
Rule G-18.08(b) provides that where a broker-dealer routes its
customers' transactions to another broker-dealer, and that broker-
dealer has agreed to handle those transactions as agent or riskless
principal for the customer, the routing broker-dealer may rely on the
other broker-dealer's periodic reviews as long as the results and
rationale of the reviews are fully disclosed to the broker-dealer and
the broker-dealer periodically reviews how the other broker-dealer's
reviews are conducted and the results of such reviews.\323\
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\317\ The full text of the MSRB rule is available at https://www.msrb.org/Rules-and-Interpretations/MSRB-Rules/General/Rule-G-18.aspx. The rule applies to brokers, dealers, and municipal
securities dealers. In addition, MSRB Rule G-28 requires broker-
dealers to have procedures for compliance with MSRB rules and the
Exchange Act and rules thereunder. As previously noted in supra note
48, for ease of discussion and consistency, when discussing the MSRB
rule, the release refers to these entities collectively as ``broker-
dealers.'' The MSRB issued ``Implementation Guidance on MSRB Rule G-
18, on Best Execution'' on November 20, 2015 (``MSRB 2015
Guidance''), available at https://www.msrb.org/~/media/Files/MISC/
Best-Ex-Implementation-Guidance.ashx. An updated version of portions
of that guidance from February 7, 2019 (``MSRB Notice 2019-05'') is
available at https://www.msrb.org/-/media/Files/Regulatory-Notices/Announcements/2019-05.ashx??n=1. The MSRB and FINRA coordinated
their issuance of independent guidance in 2015 with each notice
including a statement that the guidance being issued was
``consistent in all material respects with guidance on best
execution obligations [being published by the other SRO] . . .
except where the rule or context otherwise specifically requires.''
MSRB 2015 Guidance, at n. 1; FINRA Regulatory Notice 15-46, supra
note 294, at n. 1. The MSRB has also issued information for
investors available at https://www.msrb.org/msrb1/pdfs/Best-Execution-Investors-Perspective.pdf.
\318\ See sections II.C and IV for detailed discussions of Rule
G-18. The discussion in this section of the economic analysis is
largely limited to identifying the differences between Rule G-18 and
FINRA Rule 5310.
\319\ MSRB Rule G-48 and paragraph (e) provide that ``a broker,
dealer, or municipal securities dealer's obligations to a customer
that it reasonably concludes is a Sophisticated Municipal Market
Professional, or SMMP, as defined in Rule D-15, shall be modified''
such that ``[t]he broker, dealer, or municipal securities dealer
shall not have any obligation under Rule G-18 to use reasonable
diligence to ascertain the best market for the subject security and
buy or sell in that market so that the resultant price to the SMMP
is as favorable as possible under prevailing market conditions.''
See supra note 120.
\320\ FINRA Regulatory Notice 15-46, supra note 294, at 12 n. 1;
MSRB Notice 2019-05, supra note 317, at 4 n.1. In addition to these
``material differences,'' the MSRB guidance also expressly states
that the provisions of Rule G-18 do not apply to transactions in
municipal fund securities.'' MSRB Rule G-18.09. The FINRA guidance
has no comparable position.
\321\ The MSRB, ``[i]n adopting Rule G-18, and paragraph .08 of
the Supplementary Material specifically, [ ] did not include
provisions that are contained in FINRA Rule 5310 pertaining to
``regular and rigorous review of execution quality,'' to tailor the
rule to the characteristics of the municipal securities market.''
MSRB Notice 2019-05, supra note 317, at 7 n.12.
\322\ FINRA Regulatory Notice 15-46, supra note 294, at 12 n. 1.
\323\ For a discussion of how the MSRB has interpreted the
obligations of introducing brokers, see supra note 229.
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The other material difference between FINRA and MSRB best execution
rules can be found in MSRB Rule G-18.03. According to this rule, ``[a]
dealer must make every effort to execute a customer transaction
promptly, taking into account prevailing market conditions. In certain
market conditions a dealer may need more time to use reasonable
diligence to ascertain the best market for the subject security.''
\324\ FINRA Rule 5310 has no similar provision noting the potential
need for more time.
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\324\ MSRB Rule G-18.03.
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MSRB does not have authority to bring enforcement actions itself.
Rather, FINRA and the Commission may enforce MSRB rules.
2. Best Execution Review Processes
Policies and procedures for reviewing the execution quality of
customer orders vary across broker-dealers. Under the existing SRO
rules and guidance, broker-dealers \325\ that route to clearing or
executing brokers on an agency basis may rely on the best execution
review of their clearing firm or executing brokers. Other broker-
dealers may use third-party transactions costs analysis (TCA) services
and internal review systems, including best execution committees.
Currently, broker-dealers review best execution to standards set by
FINRA Rule 5310 or MSRB Rule G-18, as applicable.\326\ FINRA Rule 5310
requires at least a quarterly review of execution quality. MSRB Rule G-
18 requires an annual review of best execution policies and procedures
that takes into account execution quality obtained under those policies
and procedures, among other things. In performing reviews of customers'
order execution quality, broker-dealers compare the execution actually
achieved to the execution quality in other markets that were not used.
Overall, these processes help broker-dealers to evaluate whether or not
access to a specific market will improve customer execution quality
given cost of access. FINRA Rule 5310.02 provides a ``market''
definition and states that broker-dealers must not mandate that
``certain trading venues have less relevance than others in the course
of determining a firm's best execution obligations.'' What constitutes
a relevant/material market to access varies based on the needs of the
individual customer order and estimated changes in their transaction
costs. A best execution policy including a documented process of venue
selection aids this decision.
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\325\ These broker-dealers can include introducing brokers as
proposed to be defined by this rule, but FINRA's rule applies more
generally.
\326\ See supra Section II.C for a detailed discussion of FINRA
and MSRB best execution review requirements.
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Introducing brokers perform best execution reviews by evaluating
the execution quality achieved by brokers to which they route their
customers' orders. As discussed above in this section, introducing
brokers \327\ may rely on the best execution review processes of their
routing or executing brokers and use these to evaluate the execution
[[Page 5488]]
quality of orders by comparing execution statistics of executing
brokers, with which the introducing broker has a relationship. The
Commission believes this is currently done by comparing execution
statistics in aggregate, rather than on an order-by-order basis, except
where an introducing broker is following FINRA's statements in its
regulatory notice regarding order-by-order best execution reviews.\328\
Introducing brokers typically have pre-arranged agreements with a small
number of executing brokers, which vary by introducing broker.\329\
This may lead to introducing brokers principally relying on execution
statistics from these executing brokers to determine whether customers'
orders are receiving best execution. While the FINRA rule requires
introducing brokers to review the methodology and results of its
executing broker's regular and rigorous review of its execution quality
on a quarterly basis, it does not specifically require the introducing
broker to compare the execution quality of its executing broker(s) to
what it would have received from other executing brokers.\330\
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\327\ All broker-dealers who route to executing or clearing
brokers on an agency basis may use this reliance, per FINRA Rule
5310, for the purposes of best execution.
\328\ See supra note 308 for further discussion on FINRA's rules
and guidance related to broker-dealers reviewing the execution
quality of customer orders.
\329\ See Henry F. Minnerop, The Role and Regulation of Clearing
Brokers-Revisited, 75 Bus. Lawyer 2201 (Summer 2020), available at
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3663233
(retrieved from Elsevier database).
\330\ See FINRA Rule 5310.09(c), Regular and Rigorous Review of
Execution Quality.
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Executing brokers are able to conduct a more thorough review of
execution quality of the orders they receive. Executing brokers review
execution quality by comparing execution statistics of executions
received given particular execution methods, e.g., routing to a
particular market center or internalization. The Commission
preliminarily believes this review is highly heterogeneous among
executing brokers (i.e., some use third party transaction cost analysis
(``TCA'') services exclusively while others supplement and verify their
own analysis with third party TCA statistics), with some brokers
performing very rigorous comparisons of executions using various
methods, and other brokers performing a more cursory review.
Some brokers may utilize third-party analysis in their execution
quality reviews. In order to evaluate their execution quality, some
brokers may send information on their orders to third parties TCA
services to produce independent order execution quality statistics. TCA
components may include, but are not necessarily limited to, fees,
taxes, rebates, spreads, delay costs, price appreciation, market
impact, timing risk, and opportunity costs. For example, TCA service
providers in the NMS stock and options markets may produce execution
quality reports for their clients which contain, in addition to other
metrics, information on the percentage of trades receiving price
improvement, percentage of trades at or within the NBBO, average
savings per share from price improvement, liquidity multiple (i.e.,
average size of order execution at or better than the NBBO at the time
of order routing, divided by average quoted size), execution speed, and
effective to quoted spread ratios. In NMS Stocks, broker-dealers may
also utilize Rule 605 reports to help evaluate execution quality at
different market centers, including market to which they may not route
orders.\331\
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\331\ See supra note 223 and accompanying discussion for more
information on Rule 605 reports.
---------------------------------------------------------------------------
Some broker-dealers use best execution committees (BECs) to
evaluate their execution quality and establish their best execution
policies and procedures. Order-by-order reviews are typically reserved
for large orders, which likely leaves the execution quality review of
retail orders as a task to be done in aggregate. BECs meet
periodically, as often as monthly, to review execution quality of all
applicable order types, compare order routing practices, policies, and
procedures to industry standards, and maintain written documentation
for order execution and evaluation. BEC members may consist of senior
trading representatives along with members of the broker-dealer's
compliance, legal, and operational risk departments.
3. Description of Markets and Broker-Dealer Order Handling and
Execution Practices
Broker-dealers execute orders from their customers in a variety of
ways, which may depend on the nature of the market, broker-dealer, or
customer, or characteristics of the order such as size. Some broker-
dealers may act on a purely agency basis by routing orders to the best
available quotes set by other broker-dealers or third-party market
makers on exchanges and ATSs or at other OTC market centers, some
broker-dealers may choose to execute the orders on a principal basis,
and some may do both.
Certain conflicts of interest may arise in the handling and
execution of customer orders that exacerbate the principal-agent
problem between the customer and broker-dealer. Common types of
conflicts of interest that may exacerbate the principal-agent problem
can involve: (1) a broker-dealer routing a customer order in exchange
for a payment or a lower fee; or (2) a broker-dealer seeking to
transact in a principal capacity with a customer order, which involves
trading off the spread the broker-dealer can earn on the transaction vs
the price the customer must pay; or (3) a broker-dealer routing a
customer order to a trading venue or broker-dealer with which it may
have a relationship, such as a broker-dealer routing a customer order
to an affiliated ATS.\332\ However, SRO rules address the extent to
which certain specific situations presenting conflicts of interest are
prohibited from influencing a broker-dealer's duty of best execution.
For example FINRA rules and guidance (e.g., FINRA Regulatory Notice 21-
23) require that ``member firms may not let payment for order flow
interfere with their duty of best execution.'' \333\
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\332\ See supra Section III.A.
\333\ See supra Section III.A.2.
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The below sections discuss in more detail the trading environment
and broker-dealer order handling and execution practices in different
asset classes. They also discuss the role that certain conflicts of
interest such as PFOF and principal trading play in the handling and
execution of retail orders in different asset classes.
(a) NMS Securities
i. NMS Stocks
a. NMS Stocks Trading Services Overview
Market centers compete to attract order flow in NMS stocks. At the
same time, market participants compete to provide liquidity in NMS
stocks within market centers. As shown in Table 1, in Q1 of 2022, NMS
stocks were traded on 16 registered securities exchanges \334\
[[Page 5489]]
and off-exchange at 32 NMS Stock ATSs and at over 230 other FINRA
members, including OTC market makers.\335\ OTC market markers include 6
wholesalers that internalize the majority of individual investor
marketable orders.\336\ These numerous market centers match traders
with counterparties, provide a framework for price negotiation and/or
provide liquidity to those seeking to trade.
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\334\ Most of these 16 registered securities exchanges are owned
by three exchange families. Currently, CBOE Global Markets owns:
Cboe BYX Exchange, Inc., Cboe BZX Exchange, Inc. (``Cboe BZX''),
Cboe EDGA Exchange, Inc., and Cboe EDGX Exchange, Inc. (``Cboe
EDGX''); the Nasdaq Inc. owns: Nasdaq BX, Inc. (``Nasdaq BX''),
Nasdaq PHLX LLC (``Nasdaq Phlx''), and The Nasdaq Stock Market LLC
(``Nasdaq''); and the Intercontinental Exchange Inc. owns: NYSE,
NYSE American LLC (``NYSE American''), NYSE Arca, Inc. (``NYSE
Arca''), NYSE Chicago, Inc., and NYSE National, Inc. Other
registered securities exchanges that trade NMS stocks and do not
belong to one of these exchange groups include: Investors Exchange
LLC (``IEX''), Long-Term Stock Exchange, Inc., MEMX LLC, and MIAX
Pearl, LLC (``MIAX PEARL''). Among these exchanges, eight trade only
equities and eight trade both equities and options. The Commission
has approved BOX Exchange LLC (``BOX'') to trade certain equity
securities that would be NMS stocks on a facility, BSTX LLC
(``BSTX''), but BSTX is not yet operational. See Securities Exchange
Act Release Nos. 94092 (Jan. 27, 2022), 87 FR 5881 (Feb. 2, 2022)
(SR-BOX-2021-06) (approving the trading of equity securities on the
exchange through a facility of the exchange known as BSTX); 94278
(Feb. 17, 2022), 87 FR 10401 (Feb. 24, 2022) (SR-BOX-2021-14)
(approving the establishment of BSTX as a facility of BOX). BSTX
cannot commence operations as a facility of BOX until, among other
things, the BSTX Third Amended and Restated Limited Liability
Company Agreement approved by the Commission as rules of BOX is
adopted. Id. at 10407.
\335\ See Concept Release on Equity Market Structure, Exchange
Act Release No. 61358 (Jan. 14, 2010), 75 FR 3593 (Jan. 21, 2010) at
3598-3560 (for a discussion of the types of trading centers); see
also Form ATS-N Filings and Information, available at https://www.sec.gov/divisions/marketreg/form-ats-n-filings.htm. Some
academic studies attribute the fragmented nature of this market, in
part, to certain provisions of Regulation NMS. See, e.g., Maureen
O'Hara & Mao Ye, Is Market Fragmentation Harming Market Quality?,
100 J. Fin. 459 (2011); Amy Kwan, et. al., Is Market Fragmentation
Harming Market Quality?, 115 J. Fin. 330 (2015).
\336\ The six OTC market makers that are classified as
wholesalers for purposes of this release are the OTC market makers
to which the majority of marketable orders originating from retail
brokers were routed as identified from information from retail
broker Rule 606(a)(1) reports from Q1 2022. Rule 606(a)(1) requires
broker-dealers to produce quarterly public reports containing
information about the venues to which the broker-dealer regularly
routed non-directed orders for execution, including any payment
relationship between the broker-dealer and the venue, such as any
PFOF arrangements. See 17 CFR 242.606(a)(1).
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Market centers' primary customers are broker-dealers that route
their own orders or their customers' orders for execution. Market
centers may compete with each other for these broker-dealers' order
flow on a number of dimensions, including execution quality. They also
may innovate to differentiate themselves from other trading centers to
attract more order flow. While registered exchanges cater to a broader
spectrum of investors, ATSs and OTC market makers, including
wholesalers, tend to focus more on providing trading services to either
institutional or individual investor orders.
Table 1--Q1 2022 NMS Stock Share Volume Percentage by Market Center Type
----------------------------------------------------------------------------------------------------------------
Percentage of Percentage of
Market center type Venue count total share off- exchange
volume share volume
----------------------------------------------------------------------------------------------------------------
Exchanges....................................................... 16 59.7 ..............
NMS Stock ATSs.................................................. 32 10.2 25.2
Wholesalers \a\................................................. 6 23.9 59.4
Other FINRA Members............................................. 232 6.3 15.6
----------------------------------------------------------------------------------------------------------------
This table reports for Q1 2022 the percentage of NMS stock share volume executed by market center type and the
percentage of off-exchange share volume by market centers type. Venue Count lists the number of venues in each
market center category. Percentage of Total Share Volume is the percentage of all NMS stock share volume (on-
exchange plus off-exchange) executed by the type of market center. Percentage of off-Exchange Share Volume is
the percentage of off-exchange share volume executed by the type of market center. Exchange share volume and
total market volume are based on CBOE Market Volume Data on monthly share volume executed on each exchange and
share volume reported in FINRA Trade Reporting Facilities (TRFs).\b\ NMS Stock ATSs, wholesalers and Other
FINRA members share volume are based on monthly FINRA OTC Transparency data on aggregated NMS stock trading
volume executed on individual ATSs and over-the-counter at Non-ATS FINRA members.\c\ The Percentage of Off-
Exchange Share Volume is calculated by dividing the NMS Stock ATS, wholesaler and FINRA member share volume
from the FINRA Transparency Data by the total TRF share volume reported in CBOE Market Volume Data.
Percentages do not add up to 100 percent due to rounding.
\a\ See supra note 336 for details regarding how FINRA member OTC market makers are classified as wholesalers
for purposes of this release.
\b\ Cboe, U.S. Historical Market Volume Data, available at https://cboe.com/us/equities/market_statistics/historical_market_volume/. Trade Reporting Facilities (TRFs) are facilities through which FINRA members report
off-exchange transactions in NMS stocks, as defined in SEC Rule 600(b)(47) of Regulation NMS. See generally
FINRA, Trade Reporting Facility, available at https://www.finra.org/filing-reporting/trade-reporting-facility-trf trf.
\c\ FINRA OTC (Non-ATS) Transparency Data, Monthly Statistics, available at https://otctransparency.finra.org/otctransparency/OtcData otctransparency/OtcData; FINRA OTC (ATS Block)Transparency Data, Monthly Statistics, available at https://otctransparency.finra.org/otctransparency/AtsBlocksDownload. The FINRA OTC (Non-ATS) Transparency Data may not
contain all share volume transacted by a wholesaler or FINRA member because FINRA aggregates ``[s]ecurity-
specific information for firms with `de minimis' volume outside of an ATS'' and ``publishe[s it] on a non-
attributed basis.'' FINRA, OTC (ATS & Non-ATS) Transparency, Overview, available athttps://www.finra.org/
filing-reporting/otc-transparency.
Table 1 displays NMS stock share volume percentage by market center
type for Q1 2022. Exchanges execute approximately 60% of total share
volume in NMS stocks, while off-exchange market centers execute
approximately 40%. The majority of off-exchange share volume is
executed by wholesalers, who execute almost one quarter of total share
volume (23.9%) \337\ and about 60% of off-exchange share volume.\338\
NMS Stock ATSs execute approximately 10% of total NMS stock share
volume and 25% of off-exchange share volume. Other FINRA members,
besides wholesalers and ATSs, execute approximately 15% of off-exchange
share volume. Wholesalers and other OTC market makers also operate
single dealer platforms (``SDPs'') where they operate as dealers to
internalize marketable institutional orders.\339\ One study found that
SDPs accounted for approximately 10% of off-exchange
[[Page 5490]]
trading volume in Q1 2022.\340\ Exchanges (via their rules) and ATSs
determine how orders compete with each other, wherein liquidity
suppliers set prices and wait for execution at their prices by
liquidity demanders. This interaction between liquidity providers and
demanders encompasses order-by-order competition. Unlike exchanges, for
which each exchange's rules determine competition in a non-
discretionary fashion, wholesalers execute or route orders in a
discretionary fashion.\341\ While some orders may be routed to a
central limit order book against which institutional investors may
execute (on the discretion of the wholesaler), institutional investors
generally consider order flow routed to a wholesaler to be
``inaccessible.'' \342\
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\337\ Of the six wholesalers identified in Q1 2022, two
accounted for approximately 66% of wholesalers' total executed share
volume of NMS stocks. This result suggests that just two wholesalers
account for a very large percentage of order flow coming from
individual investors. One study finds that the concentration of
wholesaler internalization, as measured by the Herfindahl-Hirschman
Index (HHI) of share volume executed across wholesalers, has
increased from 2018 to 2021. See Edwin Hu & Dermot Murphy,
Competition for Retail Order Flow and Market Quality (Working paper,
June 2022), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4070056 (retrieved from Elsevier database).
\338\ The share volume reported for wholesalers in FINRA OTC
Transparency Data includes both individual investor orders executed
by wholesalers in a principal capacity, as well as other orders
executed by wholesalers in a principal capacity, such as
institutional orders executed on their single dealer platforms. It
does not include share volume that they executed in a riskless
principal capacity or share volume that was routed and executed at
another market center.
\339\ Wholesalers and OTC market makers can execute orders
itself or instead further route the order to other venues. An SDP
always acts as the counterparty to any trade that occurs on the SDP.
See, e.g., FINRA, Investor Insights, Where Do Stocks Trade? (Dec. 3,
2021), available at https://www.finra.org/investors/insights/where-do-stocks-trade .
\340\ See Rosenblatt Securities, US Equity Trading Venue Guide
(May 24, 2022), available at https://www.rblt.com/market-reports/rosenblatts-2021-us-equity-trading-venue-guide-2. SDP trading volume
would be included in the share volume percentage estimates for
wholesalers and other FINRA members in Table 1.
\341\ A study estimates that the volume of individual investor
orders executed by wholesalers accounted for approximately 16% to
17% of consolidated share volume during Q1 2022. See Rosenblatt
Securities, An Update on Retail Market Share in US Equities (June
24, 2022), available at https://www.rblt.com/market-reports/trading-talk-an-update-on-retail-market-share-in-us-equities. However,
wholesalers are not completely focused on individual investor order
flow and some do offer services to institutional order flow.
\342\ See, e.g., Jennifer Hadiaris, Cowen Market Structure:
Retail Trading -- What's going on, what may change, and what can you
do about it?, Insights (Mar. 23, 2021), available at https://www.cowen.com/insights/retail-trading-whats-going-on-what-may-change-and-what-can-institutional-traders-do-about-it/ (``Market
makers print most of these shares internally at their firm, so they
trade off-exchange. One way we have for isolating retail volume is
to look at the share of volume that trades off-exchange, but not in
a dark pool. We refer to this as `inaccessible liquidity.' This is
because most institutional orders--whether they are executed via
algos directly or by high touch desks--primarily go to exchanges and
dark pools.'').
---------------------------------------------------------------------------
As a proxy for expected execution quality, quoted prices are a
dimension on which exchanges compete to attract order flow.
Specifically, exchanges are required to post the best bid and ask
prices available on the exchange at that time \343\ and broker-dealers
can observe those prices and choose to route orders to the exchange
posting the best prices at a given point in time. However, others who
provide trading services, such as ATSs and OTC market makers, do not
compete on this dimension.\344\ In other words, wholesalers generally
do not compete for order flow by posting competitive prices the way
exchanges do. They do not display or otherwise advertise the prices at
which they are willing to internalize individual investor orders at a
given point in time. This suggests that wholesalers attract order flow
by offering retail brokers more than just competitive price
improvement.\345\ In particular, wholesalers bundle their market access
services with execution services, thereby fully vertically integrating
order handling and execution services for their retail broker
customers.
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\343\ See Rule 602 of Regulation NMS.
\344\ ATSs typically compete for institutional order flow by
offering innovative trading features such as distinct trading
protocols and segmentation options. They may also compete on fees.
In addition, they could include their ATS access in the broader set
of bundled services that the broker-dealer operator of the ATS
offers to its institutional investors.
\345\ Wholesalers do not compete by quoting price at a given
point in time, but instead generally attract order flow by offering
prices that are on average better than displayed prices.
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b. Rules Addressing Consolidated Market Data
In 2020, the Commission adopted a new rule and amended existing
rules to establish a new infrastructure for consolidated market data
(``MDI Rules''),\346\ and the regulatory baseline for NMS stocks
includes these changes to the current arrangements for consolidated
market data. However, as discussed in more detail below, the MDI Rules
have not been implemented, and so they have not yet affected market
practice. As a result, the data used to measure the baseline below
reflects the regulatory structure in place for consolidated market data
prior to the implementation of the MDI Rules. Accordingly, this section
first will briefly summarize the regulatory structure for consolidated
market data prior to the implementation of the MDI Rules. It then will
discuss the current status of the implementation of the MDI Rules and
provide an assessment of the potential effects that the implementation
of the MDI Rules could have on the baseline estimations.
---------------------------------------------------------------------------
\346\ See supra note 38, discussing MDI Adopting Release.
---------------------------------------------------------------------------
Regulatory Structure for Consolidated Market Data Prior to the MDI
Rules
Consolidated market data are made widely available to investors
through the national market system, a system set forth by Congress in
section 11A of the Exchange Act \347\ and facilitated by the Commission
in Regulation NMS.\348\ Market data are collected by exclusive SIPs,
who consolidate that information and disseminate an NBBO and last sale
information. For quotation information, only the 16 exchanges that
currently trade NMS stocks provide quotation information to the SIPs
for dissemination in consolidated market data.\349\ FINRA has the only
SRO display-only facility (the ADF). No broker-dealer, however,
currently uses it to display quotations in NMS stocks in consolidated
market data. Disseminated quotation information includes each
exchange's current highest bid and lowest offer and the shares
available at those prices, as well as the NBBO.
---------------------------------------------------------------------------
\347\ See supra note 13.
\348\ 17 CFR 242.600 through 242.614.
\349\ See supra note 334.
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For transaction information, currently all of the national
securities exchanges that trade NMS stocks and FINRA provide real-time
transaction information to the SIPs for dissemination in consolidated
market data. Such information includes the symbol, price, size, and
exchange of the transaction, including odd-lot transactions.
Unimplemented Market Data Infrastructure Rules
Among other things, the unimplemented MDI Rules update and expand
the content of consolidated market data to include: (1) certain odd-lot
information; \350\ (2) information about certain orders that are
outside of an exchange's best bid and best offer (i.e., certain depth
of book data); \351\ and (3) information about orders that are
participating in opening, closing, and other auctions.\352\ The MDI
Rules also introduced a four-tiered definition of round lot that is
tied to a stock's average closing price during the previous month.\353\
For stocks with prices greater than $250, a round lot is defined as
consisting of between 1 and 40 shares, depending on the tier.\354\ The
MDI Rules also introduce a decentralized consolidation model under
which competing consolidators, rather than the existing exclusive SIPs,
will collect, consolidate, and disseminate certain NMS
information.\355\
---------------------------------------------------------------------------
\350\ See 17 CFR 242.600(b)(59); MDI Adopting Release, supra
note 38, 86 FR at 18613. The Commission outlined a phased transition
plan for the implementation of the MDI Rules, including the
implementation of odd-lot order information. See MDI Adopting
Release, 86 FR at 18698-701.
\351\ See MDI Adopting Release, supra note 38, 86 FR 18596.
\352\ See id. at 18630.
\353\ See id. at 18617.
\354\ See id. The Commission adopted a four-tiered definition of
round lot: 100 shares for stocks priced $250.00 or less per share,
40 shares for stocks priced $250.01 to $1,000.00 per share, 10
shares for stocks priced $1,000.01 to $10,000.00 per share, and 1
share for stocks priced $10,000.01 or more per share.
\355\ See id. at 18637.
---------------------------------------------------------------------------
In the MDI Adopting Release, the Commission established a
transition period for implementation of the MDI Rules.\356\ The ``first
key milestone'' for
[[Page 5491]]
the transition period was to be an amendment of the effective national
market system plan(s), which ``must include the fees proposed by the
plan(s) for data underlying'' consolidated market data (``Proposed Fee
Amendment'').\357\ The compliance date for the MDI Rules was set with
reference to the date that the Commission approved the Proposed Fee
Amendment.\358\ The end of the transition period was to be at least two
years after the date the Commission approved the Proposed Fee
Amendment.\359\
---------------------------------------------------------------------------
\356\ Id. at 18698-18701.
\357\ Id. at 18699.
\358\ See, e.g., id. at 18700 n. 355 (compliance date for
amendment to Rule 603(b) to be 180 calendar days from the date of
the Commission's approval of the amendments to the effective
national market system plan(s)).
\359\ Id. at 18700-18701 (specifying consecutive periods of 90
days, 90 days, 90 days, 180 days, 90 days, a period for filing and
approval of another national market system plan amendment to
effectuate the cessation of the operations of the SIPs (with a 300-
day maximum time for Commission action after filing to approve or
disapprove the filing).
---------------------------------------------------------------------------
The MDI Adopting Release did not specify a process for continuing
the transition period if the Commission disapproved the Proposed Fee
Amendment. On September 21, 2022, the Commission disapproved the
Proposed Fee Amendment, because the Participants had not demonstrated
that the proposed fees were fair, reasonable and not unreasonably
discriminatory.\360\ Accordingly, there currently is no date to begin
the at-least-two-year period for implementation of the MDI Rules, and
there is no date that can be reasonably estimated for the
implementation of the MDI Rules to be completed.
---------------------------------------------------------------------------
\360\ Securities Exchange Act Release No. 95851 (Sept. 21, 2022)
(Order Disapproving the Twenty-Fifth Charges Amendment to the Second
Restatement of the CTA Plan and Sixteenth Charges Amendment to the
Restated CQ Plan).
---------------------------------------------------------------------------
Given that the MDI Rules have not yet been implemented, they have
not affected market practice and therefore data that would be required
for a comprehensive quantitative analysis of a baseline that includes
the effects of the MDI Rules is not available. It is possible that the
baseline (and therefore the economic effects relative to the baseline)
could be different once the MDI Rules are implemented. The following
discussion reflects the Commission's assessment of the anticipated
economic effects of the MDI Rules as described in the MDI Adopting
Release.\361\
---------------------------------------------------------------------------
\361\ See MDI Adopting Release, supra note 38, 86 FR 18741-
18799.
---------------------------------------------------------------------------
The Commission anticipated that the new round lot definition will
result in narrower NBBO spreads for most stocks with prices greater
than $250 because, for these stocks, fewer odd-lot shares will need to
be aggregated together (possibly across multiple price levels) \362\ to
form a round lot and qualify for the NBBO.\363\ The reduction in
spreads will be greater in higher-priced stocks because the definition
of a round lot for these stocks will include fewer shares, such that
even fewer odd-lot shares will need to be aggregated together.\364\
This could cause statistics that are measured against the NBBO to
change because they will be measured against the new, narrower NBBO.
For example, execution quality statistics on price improvement for
higher-priced stocks may show a reduction in the number of shares of
marketable orders that received price improvement because price
improvement will be measured against a narrower NBBO. In addition, the
Commission anticipated that the NBBO midpoint in stocks priced higher
than $250 could be different under the MDI Rules than it otherwise
would be, resulting in changes in the estimates for statistics
calculated using the NBBO midpoint, such as effective spreads. In
particular, at times when bid odd-lot quotations exist within the
current NBBO but no odd-lot offer quotations exist (and vice versa),
the midpoint of the NBBO resulting from the rule will be higher than
the current NBBO midpoint.\365\ More broadly, the Commission
anticipated that the adopted rules will have these effects whenever the
new round lot bids do not exactly balance the new round lot offers.
However the Commission stated that it does not know to what extent or
direction such odd-lot imbalances in higher priced stocks currently
exist, so it is uncertain of the extent or direction of the
change.\366\
---------------------------------------------------------------------------
\362\ The calculation of the NBBO includes odd-lots that, when
aggregated, are equal to or greater than a round lot. As stated in
CFR 242.600(b)(21)(ii), ``such aggregation shall occur across
multiple prices and shall be disseminated at the least aggressive
price of all such aggregated odd-lots.'' For example, if there is
one 50-share bid at $25.10, one 50-share bid at $25.09, and two 50-
share bids at $25.08, the odd-lot aggregation method would show a
protected 100-share bid at $25.09.
\363\ For example, if there is one 20-share bid at $250.10, one
20-share bid at $250.09, and two 50-share bids at $250.08, prior to
MDI the NBB would be $250.08, as even aggregated together the odd
lot volume would not add up to at least a round lot. After MDI, the
NBB would be $25.09, as the odd-lot aggregation method would show a
protected 40-share round lot bid at $25.09.
\364\ See supra note 354. An analysis in the MDI Adopting
Release showed that the new round lot definition caused a quote to
be displayed that improved on the current round lot quote 26.6% of
the time for stocks with prices between $250.01 and $1,000, and
47.7% of the time for stocks with prices between $1,000.01 and
$10,000. See MDI Adopting Release, supra note 38, 86 FR 18743.
\365\ For example, if the NBB is $260 and the NBO is $260.10,
the NBBO midpoint is $260.05. Under the adopted rules a 40 share buy
quotation at $260.02 will increase the NBBO midpoint to $260.06.
Using this new midpoint, calculations of effective spread will be
lower for buy orders, but will be higher for sell orders.
\366\ See MDI Adopting Release, 86 FR 18750.
---------------------------------------------------------------------------
The Commission also anticipated that the MDI Rules could result in
a smaller number of shares at the NBBO for most stocks in higher-priced
round lot tiers.\367\ To the extent that this occurs, there could be an
increase in the frequency with which marketable orders must walk the
book to execute. This would affect statistics that are calculated using
consolidated depth information, such as measures meant to capture
information about whether orders received an execution of more than the
displayed size at the quote, i.e., ``size improvement.''
---------------------------------------------------------------------------
\367\ However, this effect will depend on how market
participants adjust their order submissions. See id. at 18746, for
further discussion.
---------------------------------------------------------------------------
The MDI Rules may also result in a higher number of odd-lot trades,
as the inclusion of odd-lot quotes that may be priced better than the
current NBBO in consolidated market data may attract more trading
interest from market participants that previously did not have access
to this information.\368\ However, the magnitude of this effect depends
on the extent to which market participants who rely solely on SIP data
and lack information on odd-lot quotes choose to receive the odd-lot
information and trade on it. The Commission states in the MDI Adopting
Release that it believes it is not possible to observe this willingness
to trade with existing market data.\369\
---------------------------------------------------------------------------
\368\ See id. at 18754.
\369\ See id.
---------------------------------------------------------------------------
The MDI Rules may have implications for broker-dealers' order
routing practices. For those market participants that rely solely on
SIP data for their routing decisions and that choose to receive the
expanded set of consolidated market data, the Commission anticipated
that the additional information contained in consolidated market data
will allow them to make more informed order routing decisions. This in
turn would help facilitate best execution, which would reduce
transaction costs and increase execution quality.\370\
---------------------------------------------------------------------------
\370\ See id. at 18725.
---------------------------------------------------------------------------
The MDI Rules may also result in differences in the baseline
competitive standing among different trading venues, for several
reasons. First, for stocks with prices greater than $250, the
Commission anticipated that the new definition of round lots may affect
order flows as market participants who rely on consolidated data will
be aware of
[[Page 5492]]
quotes at better prices that are currently in odd-lot sizes, and these
may not be on the same trading venues as the one that has the best 100
share quote.\371\ Similarly, it anticipated that adding information on
odd-lot quotes priced at or better than the NBBO to expanded core data
may cause changes to order flow as market participants take advantage
of newly visible quotes.\372\ However, the Commission stated that it
was uncertain about the magnitude of both of these effects.\373\ To the
extent that it occurs, a change in the flow of orders across trading
venues may result in differences in the competitive baseline in the
market for trading services.
---------------------------------------------------------------------------
\371\ See id. at 18744.
\372\ See id. at 18754.
\373\ See id. at 18745, 18754.
---------------------------------------------------------------------------
Second, national securities exchanges and ATSs have a number of
order types that are based on the NBBO, and so the Commission
anticipated that the changes in the NBBO caused by the new round lot
definitions may affect how these order types perform and could also
affect other orders with which they interact.\374\ The Commission
stated that these interactions may affect relative order execution
quality among different trading platforms, which may in turn affect the
competitive standing among different trading venues, with trading
venues that experience an improvement/decline in execution quality
attracting/losing order flow.\375\ However, the Commission stated that
it was uncertain of the magnitude of these effects.\376\
---------------------------------------------------------------------------
\374\ See id. at 18748.
\375\ See id.
\376\ See id.
---------------------------------------------------------------------------
Third, the Commission anticipated that, as the NBBO narrows for
securities in the smaller round lot tiers, it may become more difficult
for the retail execution business of wholesalers to provide price
improvement and other execution quality metrics at levels similar to
those provided under a 100 share round lot definition.\377\ To the
extent that wholesalers are held to the same price improvement
standards by retail brokers in a narrower spread environment, the
wholesalers' profits from executing individual investor orders might
decline,\378\ and to make up for lower revenue per order filled in a
narrower spread environment, wholesalers may respond by changing how
they conduct their business in a way that may affect retail brokers.
However, the Commission stated that it was uncertain as to how
wholesalers may respond to the change in the round lot definition, and,
in turn, how retail brokers may respond to those changes, and so was
uncertain as to the extent of these effects.\379\ If wholesalers do
change how they conduct business, it may impact wholesalers'
competitive standing in terms of the execution quality offered,
particularly to individual investor orders.
---------------------------------------------------------------------------
\377\ See id. at 18747.
\378\ Individual investor orders typically feature lower adverse
selection than other types of orders, such as institutional orders.
It is generally more profitable for any liquidity provider,
including wholesalers, to execute against orders with lower adverse
selection risk. See, e.g., David Easley, Nicholas M. Kiefer &
Maureen O'Hara, Cream-skimming or profit-sharing? The curious role
of purchased order flow, 51 J. Fin. 811 (1996).
\379\ See id. at 18748.
---------------------------------------------------------------------------
Where implementation of the above-described MDI Rules may affect
certain numbers in the baseline, the description of the baseline below
notes those effects.
c. Market Access
Some broker-dealers that connect directly to one or more exchanges
and other trading centers offer order routing to smaller broker-dealers
that may not directly connect to exchanges. This is, in part, driven by
the requirement that in order to directly route orders to an exchange,
broker-dealers need to be a member of that exchange.\380\ It is also
driven by economies of scale in being able to distribute high fixed
costs related to exchange connectivity and proprietary market data
feeds.\381\ Most large broker-dealers connect to multiple
exchanges.\382\ These broker-dealers may use their connections to
provide order-routing and execution services, such as access to smart
order routers (SORs), to smaller broker dealers who may find direct
connections to exchanges prohibitively expensive.\383\ To this end,
such smaller broker-dealers access exchanges through intermediaries,
i.e., larger broker-dealers, allowing these intermediaries to compete
with exchanges in the trade execution and order-routing markets.\384\
These intermediaries often compete on both the quality of their order
execution and the fees they charge.\385\
---------------------------------------------------------------------------
\380\ Membership on an exchange also gives the broker-dealer
access to exchange-provided order routers that re-route orders to
other exchanges at a per-order fee.
\381\ Broker-dealers may choose to incur these costs in order to
gain faster access through direct exchange connectivity as well as
proprietary exchange data feeds, both of which may improve order
handling and execution capabilities, and thus their competitive
position. See Section V.B.3.(e) of Market Data Infrastructure
Adopting Release (for discussions on broker-dealer competitive
trading strategies).
\382\ See MDI Adopting Release, supra note 38, at 86 FR 18740
(for analysis indicating that 50 firms connected to all but one of
the exchanges in a sample of FINRA audit trail data from December
2016), available at https://www.govinfo.gov/content/pkg/FR-2021-04-09/pdf/2020-28370.pdf.
\383\ The number of broker-dealers providing access is thus
limited due to the expenses of being an exchange member and ATS
subscriber. In addition, membership on an exchange also gives the
broker-dealer access to exchange-provided order routers that re-
route orders to other exchanges at a per-order fee. Thus, membership
on one exchange can effectively provide access, though not directly,
to all exchanges.
\384\ Providing market access can mean rerouting customer orders
and it can also involve sponsoring access for the broker to send
customer orders directly to a market center.
\385\ The types of fees charged by routing brokers can vary,
some charge a per-order/share fee or a fee that is part of other
bundled services they may offer.
---------------------------------------------------------------------------
d. Retail Order Handling in NMS Stocks
The Commission estimates that in 2021 approximately 1,037 retail
brokers originated orders from retail investors in NMS stocks.\386\
Retail brokers route most of their customers' marketable order flow to
wholesalers.\387\ Wholesalers do not typically directly charge retail
brokers for their order routing and execution services. In fact, they
may pay some retail brokers for the opportunity to handle their order
flow with PFOF. Wholesalers' vertical integration of routing and
execution services for the orders of individual investors provides them
flexibility with regard to their handling of order flow. They utilize
sophisticated algorithmic trading technology to deliver their
services.\388\ In particular, wholesalers determine which orders to
internalize (i.e., execute in a principal capacity) and which to
execute in a riskless principal or agency capacity. Commission analysis
indicates that wholesalers
[[Page 5493]]
internalize over 90% of the executed dollar volume from individual
investor marketable orders that are routed to them and executed.\389\
---------------------------------------------------------------------------
\386\ This number is estimated using CAT data for broker-dealers
that originated an order from an ``Individual Customer'' CAT account
type in 2021. See infra note 422 for more info CAT account types.
\387\ Commission analysis of broker-dealer Rule 606 report order
routing data in infra Table 3 indicates that retail brokers route
over 90% of their marketable orders to wholesalers.
\388\ Wholesalers, similar to other market makers, must
establish connections with the numerous venues in which they wish to
operate and provide liquidity. They also must design smart order
routers that can locate and provide liquidity in real time, as well
as maintain fast data processing capabilities that enable them to
respond to market conditions while abiding by the relevant trade
execution regulations. Wholesalers also face the costs associated
with price risk. As wholesalers trade against market participants,
they take positions at the opposite side, accumulating inventory.
Holding inventory exposes wholesaler profits to inventory (price)
risk, where the value of inventory, and hence, that of the
wholesaler's holdings, may fluctuate as security prices vary.
Scaling up the size of the business to ensure steady incoming flow
from opposite sides of the markets is a common strategy pursued by
wholesalers. This strategy enables them to execute buy and sell
transactions, offsetting order flow from opposite sides, reducing
the possibility of accumulating prolonged, unwanted inventory.
However, among other costs, scaling up requires more comprehensive,
efficient connectivity networks, and adds to the costs of
establishing and maintaining such networks.
\389\ See analysis in infra Table 7.
---------------------------------------------------------------------------
One aspect of the wholesaler business model is the segmentation of
the order flow of individual investors, which typically have lower
adverse selection risk than the orders of other types of market
participants.\390\ Wholesalers are market makers that can identify
orders with low adverse selection risk.\391\ Through segmentation,
wholesalers typically internalize marketable orders with lower adverse
selection risk and generally execute them at prices better than the
current NBBO, i.e., because of segmentation, wholesalers are typically
able to execute the marketable orders of individual investors at better
prices than they would receive if they were routed to an exchange. An
analysis of marketable NMS stock orders presented below indicates that
the orders that wholesalers internalize present lower adverse selection
risk and receive higher execution quality relative to marketable orders
wholesalers receive and execute in a riskless principal or agency
capacity.\392\ Additional results \393\ show that, relative to orders
executed on exchanges, orders internalized by wholesalers are
associated with lower price impacts (i.e., lower adverse selection
risk),\394\ lower effective half-spreads (i.e., higher price
improvement),\395\ and higher realized half-spreads (i.e., higher
potential profitability).\396\ Academic studies have also found that
retail orders in NMS stocks benefit from being segmented and
internalized by wholesalers, because wholesalers can offer the
segmented retail orders more price improvement due to their lower
adverse selection risk.\397\
---------------------------------------------------------------------------
\390\ Wholesalers and other liquidity providers face adverse
selection risk when they accumulate inventory, for example, by
providing liquidity to more informed traders, because of the risk of
market prices moving away from market makers before they are able to
unwind their positions. Wholesalers and other market makers are
usually not privy to the motives or information of the investors
they are trading with. As such, should the liquidity provider trade
with an investor possessing short-lived price information about the
security price, it is exposing its inventory to adverse selection
risk. Hence, liquidity providers normally choose their trading
strategies to minimize their interaction with order flow with
increased adverse selection risk. Wholesalers do this by attracting
marketable orders of individual investors, known to be the order
flow with the lowest adverse selection risk. Pursuing this strategy
also requires scaling up the part of the business that interacts
with retail order flow.
\391\ See infra Table 7 and corresponding discussion. Adverse
selection is based on various characteristics of the order,
including the identity of the originating broker.
\392\ See analysis in infra Table 7.
\393\ See infra Table 5 and Table 6 for a comparison of exchange
and wholesaler execution quality.
\394\ ``Price impact'' is the extent to which the NBBO midpoint
moves against the liquidity provider for a marketable order in a
short time period after the order execution. For Rule 605 reporting,
the time period is five minutes after the time of order execution.
For the analyses of CAT data provided later in this section, the
time period is one minute after the time of order execution, which
was chosen to reflect the increase in trading speed in the years
since Rule 605 was adopted. By measuring the difference between the
transaction price and the prevailing market price for some fixed
period of time after the transaction (e.g., one minute), price
impact measures the extent of adverse selection costs faced by a
liquidity provider. For example, if a liquidity provider provides
liquidity by buying shares from a trader who wants to sell, thereby
accumulating a positive inventory position, if the liquidity
provider wants to unwind this inventory position by selling shares
in the market, it will incur a loss if the price has fallen in the
meantime. In this case, the price impact measure will be positive,
reflecting the liquidity provider's exposure to adverse selection
costs.
\395\ The effective half-spread is calculated by comparing the
trade execution price to an estimate of the stock's value (i.e., the
midpoint of the prevailing NBBO at the time of order receipt) and
thus captures how much more than the stock's estimated value a
trader has to pay for the immediate execution of their order. The
effective spread will be smaller (or less positive) when it is
closer to the NBBO midpoint, reflecting the order receiving a
greater amount of price improvement. See, e.g., Bjorn
Hagstr[ouml]mer, Bias in the Effective Bid-Ask Spread, 142 J. Fin.
Econ. 314 (2021). For the remainder of this analysis, we will use
the term ``effective spread'' to refer to the ``effective half-
spread.'' See also results in Thomas Ernst & Chester S. Spatt, supra
note 77. Rule 600(b)(8) of Regulation NMS defines ``average
effective spread'' as the share-weighted average of effective
spreads for order executions calculated, for buy orders, as double
the amount of difference between the execution price and the
midpoint of the NBB and NBO at the time of order receipt and, for
sell orders, as double the amount of difference between the midpoint
of the NBB and NBO at the time of order receipt and the execution
price.
\396\ The realized half-spread is calculated similarly to the
effective half-spread, but, instead of using the NBBO midpoint at
the time of order receipt, the realized spread calculation uses the
NBBO midpoint a short time period after the execution of a
marketable order. For Rule 605 reporting, the time period is five
minutes after the time of order execution. For the analyses of CAT
data provided later in this section, the time period is one minute
after the time of order execution. The realized half-spread proxies
for the potential profitability of trading for liquidity providers
after accounting for the adverse selection risk (i.e., price impact)
of the trade. See, e.g., Securities Exchange Act Release No. 43590
(Nov. 17, 2000), 65 FR 75423-75424 (Dec. 1, 2000) (Disclosure of
Order Execution and Routing Practices) (``The smaller the average
realized spread, the more market prices have moved adversely to the
market center's liquidity providers after the order was executed,
which shrinks the spread `realized' by the liquidity providers. In
other words, a low average realized spread indicates that the market
center was providing liquidity even though prices were moving
against it for reasons such as news or market volatility.''); See
also Larry Harris, Trading and Exchanges: Market Microstructure for
Practitioners at 286 (Oxford University Press 2003) (``Informed
traders buy when they think that prices will rise and sell
otherwise. If they are correct, they profit, and whoever is on the
other side of their trade loses. When dealers trade with informed
traders, prices tend to fall after the dealer buys and rise after
the dealer sells. These price changes make it difficult for dealers
to complete profitable round-trip trades. When dealers trade with
informed traders, their realized spreads are often small or
negative. Dealers therefore must be very careful when trading with
traders they suspect are well informed.''). See also Joel Hasbrouck,
Empirical Market Microstructure: The Institutions, Economics, and
Econometrics of Securities Trading at 147 (Oxford University Press
2007) (``The execution cost based on the pretrade bid-ask midpoint
(BAM) is also known as the effective cost. Since 2001, the U.S. SEC
has required U.S. equity markets to compute effective costs and make
summary statistics available on the Web . . . The rule . . . also
requires computation of the realized cost . . . . The difference
between effective and realized costs is sometimes used as an
estimate of the price impact of the trade. The realized cost can
also be interpreted as the revenue of the dealer who sold to the
customer . . . and then covered his position at the subsequent
BAM.''). For the remainder of this analysis, we will use the term
``realized spread'' to refer to the realized half-spread. Rule
600(b)(9) of Regulation NMS generally defines ``average realized
spread'' as the share-weighted average of realized spreads for order
executions calculated, for buy orders, as double the amount of
difference between the execution price and the midpoint of the NBB
and NBO five minutes after the time of order execution and, for sell
orders, as double the amount of difference between the midpoint of
the NBB and NBO five minutes after the time of order execution and
the execution price.
\397\ See Ernst & Spatt, supra note 77 and Kothari, S.P., So,
E., & Johnson, T. Commission Savings and Execution Quality for
Retail Trades (Working paper, 2021). See also Adams, Kasten, &
Kelley, Do investors save when market makers pay? Retail Execution
costs under PFOF models (Working paper, 2021), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3975667 (retrieved from
Elsevier database).
---------------------------------------------------------------------------
[[Page 5494]]
Segmentation and Routing of Individual Investor Orders in NMS Stocks
Most individual investor orders are non-directed, so individual
investor order routing choices are largely made by retail brokers.
Specifically, retail brokers choose how to access the market in order
to fill their individual investor customers' orders. Wholesalers are
the dominant providers of market access for retail brokers and bundle
their market access services with execution services.
Retail brokers may route to wholesalers because the cost of sending
orders to wholesalers is lower than the various alternatives available
to their customers for market access. While some broker-dealers have
SORs,\398\ exchange memberships, and ATS subscriptions, and are thus
able to provide market access to retail brokers, other broker-dealers
incur costs in handling order flow for retail brokers in the form of
exchange access fees, ATS access fees, and administrative and
regulatory costs such as recordkeeping and the risk management controls
of Rule 15c3-5. While wholesalers could incur some of these marginal
costs as well, they benefit on the margin from individual investor
order flow because it gives them the option to internalize the most
profitable of that order flow, i.e., the individual investor orders
with the lowest adverse selection risk.\399\ This ability to capture,
identify, and internalize profitable orders from individual investors
allows wholesalers to provide market access to retail brokers at low
explicit cost, either by providing PFOF or by not charging retail
brokers explicitly for market access. This service of obtaining market
access on behalf of retail brokers assists retail brokers by allowing
them to avoid routing expenses (even in cases where the wholesaler
further routes the order instead of internalizing) or costly liquidity
searches, and may increase retail brokers' reliance on wholesalers
beyond any payment they receive for routing their order flow to
wholesalers.
---------------------------------------------------------------------------
\398\ Individual investors and professional traders relying on
displayed screens to access financial markets generally do not have
access to these low-latency (algorithmic, high speed) technologies.
\399\ See infra Table 7 and corresponding discussion.
---------------------------------------------------------------------------
Indeed, Table 2 shows that retail brokers who accept PFOF (``PFOF
brokers'') pay less to route their orders to wholesalers than to route
them elsewhere.\400\ In fact, they are paid to route their order flow
to wholesalers for every order type reported in the table. On average,
rates paid by wholesalers for both market and marketable limit orders
are higher than those paid by alternative venues, with wholesalers
paying an average of 13 cents per 100 shares for market orders and 12.6
cents for marketable limit orders across S&P 500 and non-S&P 500 stocks
during Q1 2022. In contrast, exchanges, on average, charged PFOF
brokers when they routed their marketable order flow to exchanges. This
likely indicates that most of the volume that PFOF brokers sent to
exchanges was routed to maker-taker exchanges (where fees are assessed
on marketable orders).\401\ Furthermore, since retail brokers that do
not accept PFOF (``non-PFOF brokers'') also incur fees when they route
marketable orders to exchanges, they are incentivized to route their
marketable order flow to wholesalers, who do not charge them explicit
costs to route and execute their orders.
---------------------------------------------------------------------------
\400\ In Table 2, average payment rates reported in Rule 606
reports for PFOF brokers in S&P 500 stocks and non-S&P 500 stocks in
Q1 2022 are broken down by trading venue and order type, with rates
given in cents per 100 shares.
\401\ Furthermore, wholesaler rates for non-marketable orders
are more than double the rates for marketable orders, averaging 27.1
cents per hundred shares compared to 13 cents for market orders and
12.6 cents for marketable limit orders. Additionally, Table 2 shows
that the average payment rates PFOF brokers receive from routing
non-marketable limit orders to wholesalers is greater than the
average rates they receive from routing them to exchanges. This may
be driven by wholesalers passing through exchange rebates for these
orders, for which they may receive higher volume-based tiering rates
compared to retail brokers, back to broker-dealers.
Table 2--Average Rule 606 Payment Rates for Q1 2022 to PFOF Brokers by Trading Venue Type
----------------------------------------------------------------------------------------------------------------
Non-
Market orders Marketable marketable Other orders
limit orders limit orders
----------------------------------------------------------------------------------------------------------------
S&P 500....................... Exchange........ -5.9 -23.9 30.9 20.8
OMM--Wholesaler. 15.2 21.8 41.1 24.1
Other........... 4.5 -0.6 -0.6 7.5
Non-S&P 500................... Exchange........ -14.9 -15.3 17.9 16.5
OMM--Wholesaler. 12.5 11.8 24.6 10.1
Other........... 1.5 -3.7 -4.6 1.5
Combined...................... Exchange........ -12.4 -15.7 19.3 17.1
OMM--Wholesaler. 13.0 12.6 27.1 11.9
Other........... 1.7 -3.7 -4.5 2.0
----------------------------------------------------------------------------------------------------------------
This table shows the average payment rates (in cents per 100 shares) made from different types of trading venues
in Q1 2022 to 14 retail PFOF brokers from wholesalers based on their Rule 606 reports. The table breaks out
average rates from exchanges, wholesalers, and other trading venues for market orders, marketable limit
orders, non-marketable limit orders, and other orders in S&P 500 stocks and non-S&P 500 stocks. Other venues
include any other venue to which a retail broker routes an order other than a wholesaler or an exchange. The
43 broker-dealers were identified from the 54 retail brokers used in the CAT retail analysis (see infra note
422). This analysis uses the retail broker's Rule 606 report if it publishes one or the Rule 606 report of its
clearing broker if it did not publish a Rule 606 report itself (the sample of 43 broker-dealer Rule 606
reports include some broker-dealers that were not included in the CAT analysis because some clearing broker
Rule 606 reports are included). Some broker-dealers reported handling orders only on a not held basis and did
not have any Rule 606.
[[Page 5495]]
Table 3 confirms that wholesalers dominate the business of
providing market access for retail brokers and that PFOF is a factor in
retail broker routing decisions.\402\ Data from Table 3 indicates that
orders of individual investors for NMS stocks are primarily routed to
wholesalers, although, a small fraction of individual investor orders
are routed to exchanges and other broker-dealers providing market
access or other market centers (i.e., ATSs), some of which may be
affiliated with the broker that received the original order.
---------------------------------------------------------------------------
\402\ Table 3 summarizes order routing decisions of 43 of the
most active retail brokers about non-directed orders. Table 4
repeats the analysis but separately summarizes routing choices for
14 retail brokers who accept PFOF in equity markets and 29 who do
not. Note that some brokers do not accept PFOF for orders in
equities but do accept PFOF for orders in options. Consistent with
Rule 606, routing statistics are aggregated together in Rule 606
reports based on whether the stock is listed in the S&P500 index.
Rule 606 reports collect routing and PFOF statistics based on four
different order types for NMS stocks: (1) market orders, resulting
in immediate execution at the best available price; (2) marketable
limit orders, resulting in immediate execution at the best price
that is not worse that the order's quoted limit price; (3) non-
marketable limit orders whose quoted limit price less aggressive
than the NBBO, often preventing immediate execution; and (4) all
other orders. See supra note 336 for a summary of the requirements
of Rule 606(a)(1) of Regulation NMS.
Table 3--Retail Broker Order Routing in NMS Stocks for Q1 2022, Combining PFOF and Non-PFOF Brokers
----------------------------------------------------------------------------------------------------------------
Non-
Market Marketable marketable Other Total
Venue type (percent) limit limit (percent) (percent)
(percent) (percent)
----------------------------------------------------------------------------------------------------------------
Panel A: Non S&P 500 Stocks
----------------------------------------------------------------------------------------------------------------
Other........................... 6.0 4.7 3.1 1.5 3.6
Exchange........................ 0.2 5.5 22.5 0.8 8.5
Wholesaler...................... 93.9 89.8 74.4 97.6 87.9
-------------------------------------------------------------------------------
Total....................... 26.5 12.6 33.6 27.3 100.0
----------------------------------------------------------------------------------------------------------------
Panel B: S&P 500 Stocks
----------------------------------------------------------------------------------------------------------------
Other........................... 6.6 5.9 1.8 1.7 3.6
Exchange........................ 0.2 4.6 25.1 0.8 9.1
Wholesaler...................... 93.3 89.6 73.1 97.5 87.3
-------------------------------------------------------------------------------
Total....................... 30.6 9.6 33.5 26.4 100.0
----------------------------------------------------------------------------------------------------------------
This table aggregates Rule 606 reports from retail brokers and shows the percentage of market orders, marketable
limit orders, non-marketable limit orders, and other orders that retail brokers route to different types of
venues in Q1 2022. Other venues include any other venue to which a retail broker routes an order other than a
wholesaler or an exchange. Order type classifications are based on the order types broker-dealers are required
to include in their Rule 606 reports.
This table aggregates routing information from 43 broker-dealer Rule 606 reports from Q1 2022. The 43 broker-
dealers were identified from the 54 retail brokers used in the CAT retail analysis (see infra note 422). This
analysis uses the retail broker's Rule 606 report if it publishes one or the Rule 606 report of its clearing
broker if it did not publish a Rule 606 report itself (the sample of 43 broker-dealer Rule 606 reports include
some broker-dealers that were not included in the CAT analysis because some clearing broker Rule 606 reports
are included). Some broker-dealers reported handling orders only on a not held basis and did not have any Rule
606 reports. Because Rule 606 only include percentages of where there order flow is routed and not statistics
on the number of orders, the reports are aggregated together using a weighting factor based on an estimate of
the number of non-directed orders each broker-dealer routes each month. The number of orders is estimated by
dividing the number of non-directed market orders originating from a retail broker in a given month (based on
estimates from CAT data) by the percentage of market orders as a percent of non-directed orders in the retail
broker's Rule 606 report (the weight for a clearing broker consists of the aggregated orders from the
introducing brokers in the CAT retail analysis that utilize that clearing broker).
Table 4--Retail Broker Order Routing in NMS Stocks for Q1 2022
----------------------------------------------------------------------------------------------------------------
Non-
Market Marketable marketable Other Total
Venue type (percent) limit limit (percent) (percent)
(percent) (percent)
----------------------------------------------------------------------------------------------------------------
Panel A: Non-S&P 500 Stocks
Non-PFOF Brokers
----------------------------------------------------------------------------------------------------------------
Other........................... 24.1 22.3 4.2 41.6 16.0
Exchange........................ <0.1 25.3 80.8 19.7 39.8
Wholesaler...................... 76.0 52.4 15.0 38.8 44.2
-------------------------------------------------------------------------------
Total....................... 38.4 12.4 44.2 5.0 100.0
----------------------------------------------------------------------------------------------------------------
PFOF Brokers
----------------------------------------------------------------------------------------------------------------
Other........................... <0.1 1.2 2.8 0.3 1.1
Exchange........................ 0.2 1.5 5.8 0.2 2.1
Wholesaler...................... 99.7 97.3 91.4 99.5 96.8
-------------------------------------------------------------------------------
Total....................... 24.1 12.7 31.5 31.8 100.0
----------------------------------------------------------------------------------------------------------------
[[Page 5496]]
Panel B: S&P 500 Stocks
Non-PFOF Brokers
----------------------------------------------------------------------------------------------------------------
Other........................... 24.8 27.0 3.2 23.4 15.4
Exchange........................ <0.1 19.6 83.2 8.2 39.0
Wholesaler...................... 75.2 53.4 13.6 68.3 45.6
-------------------------------------------------------------------------------
Total....................... 39.0 9.2 43.8 8.0 100.0
----------------------------------------------------------------------------------------------------------------
PFOF Brokers
----------------------------------------------------------------------------------------------------------------
Other........................... <0.1 0.5 1.3 0.3 0.6
Exchange........................ 0.2 0.9 3.4 0.3 1.3
Wholesaler...................... 99.8 98.6 95.3 99.5 98.2
-------------------------------------------------------------------------------
Total....................... 28.4 9.7 30.7 31.2 100.0
----------------------------------------------------------------------------------------------------------------
This table aggregates Rule 606 reports from PFOF and non-PFOF retail brokers and separately shows the percentage
of market orders, marketable limit orders, non-marketable limit orders, and other orders PFOF brokers and non-
PFOF brokers route to different types of venues in Q1 2022. PFOF brokers are retail brokers that receive
payments for routing marketable orders to wholesalers. Other venues include any other venue to which a retail
broker routes an order other than a wholesaler or an exchange. Order type classifications are based on the
order types broker-dealers are required to include in their Rule 606 reports.
This table aggregates routing information from PFOF and non-PFOF broker-dealer Rule 606 reports from Q1 2022.
Fourteen retail brokers are identified as PFOF brokers that receive payments for routing orders in NMS stocks
to wholesalers. Twenty-nine non-PFOF brokers are identified as retail brokers that do not receive monetary
compensation when they route orders in NMS stocks to wholesalers. The 43 broker-dealers were identified from
the 54 retail brokers used in the CAT retail analysis (see infra note 422). This analysis uses the retail
broker's Rule 606 report if it publishes one or the Rule 606 report of its clearing broker if it did not
publish a Rule 606 report itself (the sample of 43 broker-dealer Rule 606 reports include some broker-dealers
that were not included in the CAT analysis because some clearing broker Rule 606 reports are included). Some
broker-dealers reported handling orders only on a not held basis and did not have any Rule 606 reports.
Because Rule 606 only include percentages of where there order flow is routed and not statistics on the number
of orders, the reports are aggregated together using a weighting factor based on an estimate of the number of
non-directed orders each broker-dealer routes each month. The number of orders is estimated by dividing the
number of non-directed market orders originating from a retail broker in a given month (based on estimates
from CAT data) by the percentage of market orders as a percent of non-directed orders in the retail broker's
Rule 606 report (the weight for a clearing broker consists of the aggregated orders from the introducing
brokers in the CAT analysis that utilize that clearing broker).
CAT data analysis indicates that about 80% of the share volume and
about 74% of the dollar volume of individual investor marketable orders
that were routed to wholesalers and executed comes from PFOF
brokers.\403\ Data from Table 4 indicates that, while retail brokers
who accept PFOF from wholesalers tend to send more of their orders to
those wholesalers, wholesalers even dominate the market access services
for non-PFOF brokers, though non-PFOF brokers route a significantly
lower fraction (i.e., 75.2% to 76%) of their market orders to
wholesalers, compared to 99.7% to 99.8% of market orders for PFOF
brokers. Moreover, non-PFOF brokers route 24.1% to 24.8% of their
market orders to other non-exchange market centers, e.g., ATSs, while
PFOF brokers route less than 1% of their market orders to these market
centers. However, regardless of whether the retail broker accepts PFOF,
the order type, or the S&P500 index inclusion of the stock,\404\ Table
3 shows that retail brokers route over 87% of their customer orders to
wholesalers.
---------------------------------------------------------------------------
\403\ See infra Table 15.
\404\ Rule 606 reports require that broker-dealers separate
their disclosure information for S&P 500 stocks, non-S&P 500 stocks,
and options.
---------------------------------------------------------------------------
This result suggests that, while PFOF may be a factor in retail
brokers' routing decisions, wholesalers likely also compare favorably
to other market access (including retail brokers pursuing their own
market access) along other dimensions. The routing behavior in Table 4
may, in part, reflect a tendency of non-PFOF brokers to route customer
orders to market centers such as their own ATSs for mid-point execution
and the lack of an affiliated ATS for PFOF brokers. However, even
broker-dealers with their own ATSs do not route the majority of their
individual investor order flow to those ATSs and typically do not
internalize order flow. Further, retail brokers with membership on
multiple exchanges primarily route their marketable orders to
wholesalers. These results could point to a lower marginal costs of
routing to wholesalers relative to other routing and execution
alternatives. Table 5 shows that wholesalers appear to compare
favorably to exchanges in the execution quality of orders routed to
them, suggesting that execution quality could be another key factor in
the decision of retail brokers to route to wholesalers.\405\ In
particular, marketable orders routed to wholesalers appear to have
higher fill rates, lower effective spreads, and lower E/Q ratios.\406\
These orders are also more likely to receive price improvement and,
conditional on receiving price improvement, receive greater price
improvement when routed to wholesalers as compared to exchanges.
---------------------------------------------------------------------------
\405\ See infra Table 5 and corresponding discussions.
\406\ The E/Q ratio is the ratio of a stock's effective spread
over quoted spread. A lower value indicates smaller effective
spreads (i.e., trading costs) as a percentage of the quoted spread.
---------------------------------------------------------------------------
In addition, wholesalers may provide additional valuable services
to retail brokers that route order flow to them. Based on staff
experience, the Commission understands that wholesalers are more
responsive to retail brokers that provide them with order flow,
including, for example, following customer instructions not to
internalize particular orders. More broadly, wholesalers appear to
provide retail brokers with a high degree of consistency with regard to
execution quality. More specifically, wholesalers receive order flow
from retail brokers
[[Page 5497]]
that contains orders that vary with regard to quoted spreads and
adverse selection risk. While wholesalers receive order flow from
retail brokers that contains variation in quoted spreads and adverse
selection risk, wholesalers could target an average level of price
improvement across this heterogeneous order flow, resulting in a
relatively consistent degree of execution quality.
When wholesalers do not internalize an order, they obtain an
execution from another market center by either routing in an agency
capacity or using what is known as a riskless principal transaction. In
a riskless principal transaction, after receiving an order from a
retail broker, a wholesaler may send a principal marketable order
similar to the retail broker order to an exchange and, upon execution
of the principal order at the exchange, execute the original retail
broker order at the same price.\407\
---------------------------------------------------------------------------
\407\ See supra note 182 for further discussions on riskless
principal transactions.
---------------------------------------------------------------------------
Commission analysis shows that wholesalers internalize over 90% of
the executed dollar value in NMS stocks from the marketable order flow
routed to them by retail brokers, which amounts to more than 80% of
share volume.\408\ Results also show that the marketable NMS stock
orders wholesalers choose to internalize have less adverse selection
risk: orders that wholesalers execute in a principal capacity have a
price impact of 0.9 bps, compared to a price impact of 4.6 bps for
those executed via other methods. This is consistent with the dealer
incentive to hold inventory that is less likely to experience adverse
changes in price.\409\
---------------------------------------------------------------------------
\408\ See analysis in infra Table 7.
\409\ See, e.g., David Easley, et. al. supra note 378.
---------------------------------------------------------------------------
Fractional Share Orders
A number of retail brokers allow individual investors to trade and
enter orders for fractional shares of a security, e.g., an individual
investor could submit an order to buy 0.2 shares of a stock.\410\ This
type of trading has grown dramatically since 2019, with an increasing
number of broker-dealers offering this functionality. Evidence suggests
that this growth is in great part due to the rise in direct retail
participation in equity markets.\411\ It is the Commission's
understanding that retail or executing brokers generally trade in a
principal capacity against their customers' fractional share orders and
in turn, send out principal orders that are in a whole number of shares
(i.e., not containing a fractional share component) for execution to
manage their inventory risk.
---------------------------------------------------------------------------
\410\ Fractional shares often arise from retail brokers allowing
individual investors to submit orders for a fixed dollar value.
\411\ See, Zhi Da, et. al., Fractional Trading (working paper,
November 18, 2021), available at https://ssrn.com/abstract=3949697
(retrieved from SSRN Elsevier database). Also see Rick Steves,
Fractional Shares Experts Weigh In Amid Exploding Retail Trading
Volumes, FinanceFeeds (Jun. 7, 2021), available at https://financefeeds.com/fractional-shares-experts-weigh-in-amid-exploding-retail-trading-volumes/, which shows that trading volume increased
substantially (in one case, more than 1,400%) for brokers after they
introduced the use of fractional shares.
---------------------------------------------------------------------------
An analysis using CAT data reveals that more than 46 million
fractional share orders were executed in March 2022, originating from
more than 5 million unique accounts. Over 31 million of these orders
were for less than 1 share, and they originated from more than 3.3
million accounts. The overwhelming majority (92%) of fractional share
orders were attributed to natural persons, (i.e., individual
investors). While fractional shares orders only represented a small
fraction (2.1%) of total executed orders, they represent a much higher
fraction (15.3%) of executions received by individual investors.
Execution Quality of Individual Investor Marketable Orders
The wholesaler business model relies on segmentation and
internalization of marketable order flow of individual investors, which
is characterized by low adverse selection risk. An analysis of the
execution quality of market and marketable limit orders handled by
wholesalers retrieved from Rule 605 reports \412\ and presented in
Table 5 \413\ shows that orders in NMS stocks handled by wholesalers
are associated with lower price impact \414\ compared to those executed
on exchanges, indicating that orders handled by wholesalers on average
have lower adverse selection costs.\415\ This lower adverse selection
[[Page 5498]]
cost allows wholesalers to provide these orders with better execution
quality, manifested in lower effective spreads \416\ and E/Q ratios
compared to exchanges.\417\ The higher realized spreads \418\
associated with orders handled by wholesalers observed in Table 5
suggest that wholesalers have an opportunity to earn higher economic
profits than liquidity suppliers on exchanges after accounting for
adverse selection costs (i.e., after adjusting for price impact).\419\
This is despite the finding that the orders handled by wholesalers
eventually execute at better prices than those received by and executed
on exchanges, as observed by the lower effective spreads shown in Table
5 for marketable orders handled by wholesalers.
---------------------------------------------------------------------------
\412\ Rule 605 requires market centers to make available, on a
monthly basis, standardized information concerning execution quality
for covered orders in NMS stocks that they received for execution.
See 17 CFR 242.605. Covered orders are defined in 17 CFR
242.600(b)(22) to include orders (including immediate-or-cancel
orders) received by market centers during regular trading hours at a
time when a national best bid and national best offer is being
disseminated, and, if executed, is executed during regular trading
hours, and excludes orders for which the customer requests special
handling for execution (such as not held orders). Rule 605 reports
contain a number of execution quality metrics for covered orders,
including statistics for all non-marketable limit orders with limit
prices within ten cents of the NBBO at the time of order receipt as
well as separate statistics for market orders and marketable limit
orders. Under the Rule, the information is categorized by individual
security, one of five order type categories (see 17 CFR
242.600(b)(14)), and one of four order size categories, which does
not include orders for less than 100 shares or orders greater than
or equal to 10,000 shares (see 17 CFR 242.600(b)(11)). As such, Rule
605 does not require reporting for orders smaller than 100 shares,
including odd-lot orders. Rule 605 requires market centers to report
execution quality information for all covered orders that the market
center receives for execution, including orders that are executed at
another venue (i.e., because they are effectively rerouted to
another trading center by the market center).
\413\ The following filters were applied to the Rule 605 data to
remove potential data errors. Observations where the total shares in
covered orders were less than the sum of the canceled shares, share
executed at the market center, and share executed away from the
market center were deleted. Observations with missing order size
code, order type code, total covered shares, or total covered orders
were deleted. Realized and effective spread values are set to
missing values if the total shares executed at and away from the
market center are zero. Per share dollar realized spreads, per share
dollar effective spreads, and per share dollar price improvements
were winsorized at 20% of the volume weighted average price of the
stock for the month as calculated from NYSE Daily TAQ data.
\414\ See supra note 394 and accompanying text for a definition
and discussion of price impact. Table 5 estimates the average price
impact associated with marketable orders routed to wholesalers to be
1.2 bps. This means that for a $10 stock the NBBO midpoint would
move up (down) by an average of 0.12 cents in the five minutes
following the execution of marketable buy (sell) order.
\415\ Once implemented, the changes to the current arrangements
for consolidated market data in the MDI Adopting Release, 86 FR
18621 may impact the numbers in Table 5, including by reducing those
for realized spread, effective spread, and amount of price
improvement. The NBBO will narrow in stocks priced greater than $250
because it will be calculated based off a smaller round lot size.
This narrower NBBO will decrease price improvement statistics in
Rule 605 reports, which is measured against the NBBO. The effects on
effective and realized spreads is more uncertain, because they are
measured against the NBBO midpoint, which may not change if both the
NBB and NBO decrease by the same amount. However, if marketable
orders are more likely to be submitted when there are imbalances on
the opposite side of the limit order book (i.e., more marketable buy
orders are submitted when there is more size on the offer side of
the limit order book than the bid side), then the NBBO midpoint may
change such that it is closer to the quote the marketable order
executes against, which may decrease the effective and realized
spreads in stocks above $250 when Market Data Infrastructure is
implemented. It is uncertain how likely this NBBO midpoint is to
change. It is also uncertain how or to what degree these changes
would differ between exchange and wholesaler Rule 605 reports. If
both changed similarly, then there would not be changes in relative
differences between their reported spread measures. See supra
section V.B.3.a).i.b.
\416\ See supra note 395 for a definition and discussion of
effective spreads.
\417\ The E/Q ratio is the ratio of a stock's effective spread
over quoted spread. A lower value indicates that smaller effective
spreads (i.e., trading costs) as a percentage of the quoted spread.
\418\ See supra note 396 and accompanying text for a definition
and discussion of realized spreads as a measure of the economic
profits earned by liquidity providers. Realized spreads do not
measure the actual trading profits that market makers earn from
supplying liquidity. In order to estimate the trading profits that
market makers earn, we would need to know at what times and prices
the market maker executed the off-setting position for a trade in
which it supplied liquidity (e.g., the price at which the market
maker later sold shares that it bought when it was supplying
liquidity). If market makers offset their positions at a price and
time that is different from the NBBO midpoint at the time lag used
to compute the realized spread measure (Rule 605 realized spread
statistics are measured against the NBBO midpoint 5 minutes after
the execution takes place), then the realized spread measure is an
imprecise proxy for the profits market makers earn supplying
liquidity. Additionally, realized spread metrics do not take into
account any transaction rebates or fees, including PFOF, that a
market maker might earn or pay, which would also affect the profits
they earn when supplying liquidity. Furthermore, realized spreads
also do not account for other costs that market makers may incur as
part of their business, such as fixed costs for setting up their
trading infrastructure and costs for connecting to trading venues
and receiving market data.
\419\ The execution quality information in Rule 605 combines
information about orders executed at a market center with
information on orders received for execution at a market center but
executed by another market center; see supra note 412. As such, the
execution quality statistics presented in Table 5 include orders
that are effectively rerouted by wholesalers. Furthermore, note that
Rule 605 does not specifically require market centers to prepare
separate execution quality reports for their SDPs, and as such these
calculations reflect all covered market and marketable limit orders
in NMS stocks received and executed by wholesalers, including those
on SDPs.
---------------------------------------------------------------------------
Additionally, the results in Table 5 show that approximately 79% of
the executed dollar volume in marketable orders handled by wholesalers
are market orders. The Commission believes that these outcomes reflect
the heavy utilization of market orders for NMS stocks by individual
investors whose orders are primarily handled by wholesalers, contrary
to the heavy utilization of limit orders by other market participants.
Table 5 also highlights significantly higher fill rates, i.e., the
percentage of the shares in an order that execute in a trade, for
marketable orders sent to wholesalers as compared to exchanges.\420\
Wholesalers execute the vast majority of orders that they receive
against their own capital, i.e., they internalize the vast majority of
orders they receive.\421\ Wholesalers expose themselves to inventory
risk when internalizing order flow, but mitigate this risk by
internalizing orders that possess low adverse selection risks.
---------------------------------------------------------------------------
\420\ Marketable orders may not fully execute if there isn't
sufficient liquidity on the exchange to fill the order within its
limit price and/or if it contains other instructions that limit
their execution, such as if they are designated as IOC orders or
their instructions not to route the order to another exchange.
\421\ See analysis in infra Table 7 and corresponding
discussion.
Table 5--Comparison of Rule 605 Execution Quality Statistics Between Exchanges and Wholesalers for NMS Common Stocks and ETFs in Q1 2022
--------------------------------------------------------------------------------------------------------------------------------------------------------
Combined marketable orders Market Marketable limit
-----------------------------------------------------------------------------------------------
WH EX WH EX WH EX
--------------------------------------------------------------------------------------------------------------------------------------------------------
Average Price........................................... $47.89 $58.14 $56.19 $85.45 $30.66 $58.08
Share Volume (billion shares)........................... 106.97 179.49 72.20 0.39 34.77 179.10
Dollar Volume (billion $)............................... $5,122.91 $10,436.02 $4,056.85 $33.53 $1,066.06 $10,402.49
Fill Rate (%)........................................... 69.32% 25.77% 99.79% 58.08% 34.81% 25.77%
Effective Spread (bps).................................. 1.81 2.06 1.47 3.29 3.11 2.06
Realized Spread (bps)................................... 0.61 -0.38 0.39 2.40 1.43 -0.39
Price Impact (bps)...................................... 1.20 2.44 1.08 0.90 1.68 2.45
E/Q ratio............................................... 0.48 1.01 0.40 1.65 0.83 1.01
Pct of Shares Price Improved............................ 83.17% 8.78% 88.99% 15.95% 61.01% 8.75%
Constrained Amount of Price Improvement (bps)........... 2.17 1.50 2.33 1.92 1.24 1.50
--------------------------------------------------------------------------------------------------------------------------------------------------------
This table computes aggregated execution quality statistics for marketable orders covered orders received by exchanges and wholesalers from Rule 605
reports for Q1 2022 for NMS common stocks and ETFs. See supra note 412 for a definition of covered orders. Individual wholesaler and exchange Rule 605
reports are aggregated together at the stock-month level, into two categories, WH and EX, such that aggregate execution quality data is averaged for,
a) wholesalers (WH) and, b) exchanges (EX), for each stock during each month.
The following metrics were calculated: Average Price is the stock's average execution price from the Rule 605 data (Dollar Volume/Share Volume), Share
Volume is the total executed shares (in billions) from the Rule 605 data. Dollar Volume is the total executed dollar volume (in billions), calculated
as the executed share volume from the Rule 605 data multiplied by the stock's monthly VWAP price, as derived from NYSE Daily Trade and Quote data
(TAQ). Fill Rate is the weighted average of the stock-month total executed share volume/total covered shares from the Rule 605 data. Effective Spread
is the weighted average of the stock-month percentage effective half spread in basis points (bps). Realized Spread is the weighted average of the
stock-month percentage realized half spread in basis points (bps). Price Impact is the weighted average of the stock-month percentage price impact in
basis points (bps). E/Q ratio is the weighted average of the stock-month ratio of the effective spread/quoted spread. Pct of Shares Price Improved is
the weighted average of the stock-month ratio of shares executed with price improvement/total executed share volume. Conditional Amount of Price
Improvement is the weighted average of the stock-month of the amount of percentage price improvement in basis points (bps), conditional on the
executed share receiving price improvement.
[[Page 5499]]
Aggregated effective and realized percentage spreads are measured in half spreads in order to show the average cost of an individual investor order and
are calculated by dividing the aggregated Rule 605 reported per share dollar amount by twice the stock's monthly volume weighed average price (VWAP),
as derived from NYSE Daily Trade and Quote data (TAQ), for trades executed during regular market hours during the month. Percentage price impact is
calculated as the aggregated Rule 605 reported per share dollar effective spreads minus per share dollar realized spreads divided by twice the stock's
monthly volume weighed average price (VWAP), as derived from NYSE Daily Trade and Quote data (TAQ). Percentage amount of price improvement is
calculated as the aggregated Rule 605 reported per share dollar amount of price improvement divided by the stock's monthly volume weighed average
price (VWAP), as derived from NYSE Daily Trade and Quote data (TAQ). Percentage spreads and amount of price improvement percentages are reported in
basis points (bps). The Combined Market and Marketable Limit order type category is constructed for each security-month-order size category by
combining the market and marketable limit order categories and computing the total and share weighted average metrics for the order size category for
each security-month.
The sample includes NMS common stocks and ETFs that are present in the CRSP 1925 US Stock Database, Ctr. Rsch. Sec. Prices, U. Chi. Booth Sch. Bus.
(2022). The CRSP 1925 US Indices Database, Ctr. Rsch. Sec. Prices, U. Chi. Booth Sch. Bus. (2022), was used to identify if a stock was a member of the
S&P 500. The stock did not have to be in the CRSP 1925 US Indices Database to be included in the analysis. NMS Common stocks and ETFs are identified,
respectively, as securities in TAQ with a Security Type Code of `A' and `ETF'. For each stock-month-order-type (such that aggregate execution quality
data is averaged for, (a) wholesalers and, (b) exchanges, for each stock during each month) the per dollar share weighted measures from Rule 605
reports are aggregated together by share-weighting across different trading venues and order-size categories within the stock-month-order-type and
venue type (i.e. trading venue Rule 605 reports for exchanges and wholesalers are aggregated into different categories). Percent values are then
calculated for each stock month by dividing by the stock's monthly volume weighed average price (VWAP). These percentage stock-month values are
averaged together into order-type categories (market orders, marketable limit orders, and the combined market and marketable limit order type
category, for both wholesalers and exchanges) based on weighting by the total dollar trading volume for the wholesaler or exchange category in that
stock-month-order type, where dollar trading volume is estimated by multiplying the Rule 605 report total executed share volume, i.e., the share
volume executed at market center + share volume executed away from the market center, for the stock-month-order type by the stock's monthly VWAP). See
supra note 413 for a discussion of filters that were applied to the Rule 605 data in this analysis. This analysis uses data from prior to the
implementation of the MDI Rules and specific numbers may be different following the implementation of the MDI Rules. See supra note 415.
To supplement the analyses using Rule 605 data and test for the
robustness of the results that it generated, CAT data \422\ was
analyzed to look at the execution quality of marketable orders of
individual investors in NMS Common Stocks and ETFs that were less than
$200,000 in value and that executed and were handled by wholesalers
during Q1 2022 (``CAT retail analysis'').\423\ This was compared to a
sample of CAT data examining the execution quality of executed market
and marketable limit orders in NMS Common Stocks and ETFs received by
exchanges that were less than $200,000 in value over the same time
period (``CAT exchange analysis'').\424\
---------------------------------------------------------------------------
\422\ This analysis used CAT data to examine the execution
quality of marketable orders in NMS Common stocks and ETFs that
belonged to accounts with a CAT account type of ``Individual
Customer'' and that originated from a broker-dealer MPID that
originated orders from 10,000 or more unique ``Individual Customer''
accounts during January 2022. The number of unique ``Individual
Customer'' accounts associated with each MPID was calculated as the
number of unique customer account identifiers with an account
customer type of ``Individual Customer'' that originated at least
one order during the month of January 2022. The Commission found
that 58 broker-dealer MPIDs associated with 54 different broker-
dealers originated orders from 10,000 or more unique Individual
Customer accounts in January 2022. For the Consolidated Audit Trail,
account type definitions are available in Appendix G to the CAT
Reporting Technical Specifications for Industry Members (https://catnmsplan.com/), for the field name ``accountHolderType.'' Account
types represent the beneficial owner of the account for which an
order was received or originated, or to which the shares or
contracts are allocated. Possible types are: Institutional Customer,
Employee, Foreign, Individual Customer, Market Making, Firm Agency
Average Price, Other Proprietary, and Error. An Institutional
Customer account is defined by FINRA Rule 4512(c) as a bank,
investment adviser, or any other person with total assets of at
least $50 million. An Individual Customer account means an account
that does not meet the definition of an ``institution'' and is also
not a proprietary account. Therefore, the CAT account type
``Individual Customer'' includes natural persons as well as
corporate entities that do not meet the definitions for other
account types. The Commission restricted that analysis to MPIDs that
originated orders from 10,000 or more ``Individual Customer''
accounts in order to ensure that these MPIDs are likely to be
associated with retail brokers to help ensure that the sample is
more likely to contain marketable orders originating from individual
investors. NMS Common stocks and ETFs are identified, respectively,
as securities in TAQ with a Security Type Code of `A' and `ETF'.
\423\ Fractional share orders with share quantity less than one
share were excluded from the analysis. The analysis included market
and marketable limit orders that originated from one the 58 retail
broker MPIDs and were received by a market center that was
associated with one of the six wholesalers CRD numbers (FINRA's
Central Registration Depository number) during some point in the
order's lifecycle. Orders that were received by the wholesaler or
executed outside of normal market hours were excluded. Orders were
also excluded if they had certain special handling codes so that
execution quality statistics would not be skewed by orders being
limited in handling by special instructions (e.g., pegged orders,
stop orders, post only orders). Orders identified in CAT as Market
and Limit orders with no special handling codes or one of the
following special handling codes were included in the analysis: NH
(not held), CASH (cash), DISQ (display quantity), RLO (retail
liquidity order), and DNR (do not reduce). These special handling
codes were identified based on their common use by retail brokers
and descriptions of their special handling codes. The marketability
of a limit order was determined based on the consolidated market
data feed NBBO at the time a wholesaler first receives the order.
Limit orders that were not marketable were excluded. The dollar
value of an order was determined by multiplying the order's number
of shares by either its limit price, in the case of a limit order,
or by the far side quote (i.e., NBO for a market buy order and NBB
for a market sell) of the consolidated market data feed NBBO at the
time the order was first received by a wholesaler, in the case of a
market order. Orders with dollar values greater than or equal to
$200,000 were excluded from the analysis. The analysis includes NMS
Common Stocks and ETFs (identified by security type codes of `A' and
`ETF' in NYSE TAQ data) that are also present in CRSP data. Price
improvement, effective spreads, realized spreads, quoted spreads,
and price impacts were winsorized if they were greater than 20% of a
stock's VWAP during a stock-week. See Table 6 for a detailed
description of the analysis.
\424\ The Commission analysis used CAT data to examine the
execution quality of market and marketable limit orders in NMS
Common Stocks and ETFs that were under $200,000 in value that were
received and executed by exchanges during normal market hours in Q1
2022. The analysis employed filters to clean the data and account
for potential data errors. The analysis is limited to orders
identified in CAT as market and limit orders accepted by exchanges.
Orders were excluded from the analysis if they had certain special
handling codes, such as post or add-liquidity only orders, midpoint
orders, orders that can only execute in opening and closing
auctions, orders with a minimum execution quantity, pegged orders,
or stop order or stop-loss orders. Orders were also required to
execute in normal trades during normal trading hours to be included
in the analysis. Normal trades are identified in CAT data by sale
conditions ``blank, @, E, F, I, S, Y'' which correspond to regular
trades, intermarket sweep orders, odd lot trades, split trades, and
yellow flag regular trades. For orders submitted to exchanges, the
NBBO the exchange records seeing at the time of order receipt is
used to measure the NBBO and NBBO midpoint for calculating
statistics that are based on the time of order receipt (e.g.,
effective spreads, price improvement, quoted spreads, etc.). The
marketability of exchange orders was determined based on the NBBO
observed by the exchange at the time of order receipt. The dollar
value for a market order was calculated as the price of the far side
NBBO quote (NBO for a market buy order and NBB for a market sell)
times the shares in the order. The dollar value for a limit order
was calculated as the price of the limit order times the number of
shares in the order. Orders with dollar values greater than or equal
to $200,000 were excluded from the analysis. The consolidated market
data feed NBBO was used to calculate statistics that use the NBBO or
NBBO one minute after execution (e.g., realized spreads, price
impacts, etc.). The analysis includes NMS Common Stocks and ETFs
(identified by security type codes of `A' and `ETF' in NYSE TAQ
data) that are also present in CRSP data. Price improvement,
effective spreads, realized spreads, quoted spreads, and price
impacts were winsorized if they were greater than 20% of a stock's
VWAP during a stock-week. See Table 6 for a detailed description of
the analysis.
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[[Page 5500]]
Table 6 reports the results from CAT data analysis.\425\ In
addition to reporting results for all stocks, it also breaks out
results based by if a stock is an ETF or is in the S&P 500 or not.
Generally, the results from this analysis are consistent with results
from the analysis of Rule 605 data from Table 5. Specifically,
wholesalers display lower price impacts (WH Price Impact) and E/Q
ratios (WH E/Q Ratio), indicating that orders internalized by
wholesalers receive better execution quality relative to order executed
on exchanges (EX Price Impact and EX E/Q Ratio containing the
corresponding statistics for exchanges). Despite this enhanced
execution quality, realized spreads of wholesalers (WH Realized Spread)
exceed those produced by exchanges (EX Realized Spread).
---------------------------------------------------------------------------
\425\ Certain items in Table 6 may also be affected by the MDI
rules once they are implemented. See supra note 415.
---------------------------------------------------------------------------
Table 6 also reports some statistics for wholesalers that are not
available in Rule 605 reports, including statistics on midpoint
executions (WH Pct Shares Executed at Midpoint) and sub-penny trades
(WH Pct of Shares Executed as Subpenny Prices). In all NMS common stock
and ETF orders, wholesalers execute approximately 44% of shares at
prices at or better than the NBBO midpoint (WH Pct Shares Executed at
Midpoint or Better). However, wholesalers also offer less than 0.1
cents price improvement to approximately 18.6% of shares that they
execute (WH Pct Shares Executed with <0.1 cent Price Improvement).
Wholesalers execute more than 65% of shares at sub-penny prices (WH Pct
of Shares Executed as Subpenny Prices), with over 40% of shares being
executed at prices with four decimal points (i.e., the fourth decimal
place is not equal to zero, which is measured by the WH Pct of Shares
Executed at Subpenny Prices with 4 Decimals variable).
Table 6--Wholesaler CAT Analysis of Exchange Individual Investor Order Execution Quality for Marketable Orders
in NMS Common Stocks and ETFs by Type of Stock
----------------------------------------------------------------------------------------------------------------
Variable All SP500 NonSP500 ETF
----------------------------------------------------------------------------------------------------------------
Panel A: Wholesaler and Exchange Execution Quality
----------------------------------------------------------------------------------------------------------------
Average Price................................... $29.87 $110.31 $10.52 $53.14
WH Principal Execution Rate..................... 90.44% 93.07% 87.66% 88.12%
WH Share Volume (billion shares)................ 87.11 11.63 63.17 12.31
EX Share Volume (billion shares)................ 281.90 66.98 140.82 74.10
WH Dollar Volume (billion $).................... $2,601.44 $1,282.62 $664.41 $654.41
EX Dollar Volume (billion $).................... $16,194.84 $6,479.89 $3,246.09 $6,468.85
WH Effective Spread (bps)....................... 2.11 0.67 6.23 0.76
EX Effective Spread (bps)....................... 3.18 1.52 8.11 1.42
WH Realized Spread (bps)........................ 0.85 0.42 2.00 0.51
EX Realized Spread (bps)........................ -1.22 -0.28 -3.90 -0.34
WH Price Impact (bps)........................... 1.26 0.25 4.22 0.25
EX Price Impact (bps)........................... 4.40 1.80 12.00 1.75
WH E/Q Ratio.................................... 0.39 0.32 0.50 0.41
EX E/Q Ratio.................................... 1.04 1.01 0.98 1.17
----------------------------------------------------------------------------------------------------------------
Panel B: Wholesaler Price Improvement
----------------------------------------------------------------------------------------------------------------
WH Pct Executed with Price Improvement.......... 89.95% 93.33% 85.43% 87.93%
WH Conditional Amount Price Improvement (bps)... 2.54 1.47 6.16 0.99
WH Pct Shares Executed at Midpoint or Better.... 44.57% 47.37% 39.76% 43.97%
WH Pct Shares Executed at Midpoint.............. 31.69% 32.47% 28.46% 33.44%
WH Pct Shares Executed at NBBO.................. 8.38% 5.86% 10.97% 10.69%
WH Pct Shares Executed Outside NBBO............. 1.67% 0.81% 3.61% 1.38%
WH Pct Shares Executed with <0.1 cent Price 18.64% 16.62% 20.58% 20.64%
Improvement....................................
WH Pct of Shares Executed as Subpenny Prices.... 66.98% 65.10% 64.16% 73.55%
WH Pct of Shares Executed at Subpenny Prices 47.60% 46.82% 47.03% 49.68%
without Midpoint Trades........................
WH Pct of Shares Executed at Subpenny Prices 41.36% 40.80% 41.76% 42.06%
with 4 Decimals................................
----------------------------------------------------------------------------------------------------------------
This table uses CAT data to compare aggregated execution quality statistics for Q1 2022 broken out for different
security types for executed marketable orders with order size under $200,000 in NMS Common Stocks and ETFs
received by wholesalers from individual investors to similar orders received by exchanges. Aggregated
statistics in the table labeled WH are based on analysis of CAT data of executed marketable orders in NMS
Common Stocks and ETFs from individual investors for under $200,000 in value belonging to one of 58 retail
broker MPIDs that were handled by one of 6 wholesalers during normal market hours in Q1 2022 (see supra note
423 for additional discussions on the CAT data used in the CAT retail analysis). Aggregated statistics in the
table labeled EX are based on a corresponding analysis of CAT data of executed marketable orders in NMS Common
Stocks and ETFs receive by exchanges that were under $200,000 in value and received and executed during normal
market hours in Q1 2022 (see supra note 424 for additional discussions on the CAT data used in CAT exchange
analysis).
[[Page 5501]]
The following metrics are calculated for all stocks and for each of the stock-types. EX indicates aggregated
statistics for executed marketable orders routed to exchanges and WH indicates aggregated statistics for
executed marketable orders from individual investors that were routed to wholesalers. Average Price is the
average execution price. WH Principal Execution Rate is the percentage of dollar volume of individual investor
trades that a wholesaler executed in a principal capacity. Share Volume is the total executed share volume.
Dollar Volume is the total executed dollar volume. Effective Spread is the weighted average of the percentage
effective half spread in basis points (bps) (measured as average (execution price--NBBO midpoint at time of
order receipt) * average transaction price). Realized Spread is the weighted average of the percentage one
minute realized spread in bps (measured as average (execution price--NBBO midpoint one minute after execution)
* average transaction price). Price Impact is the weighted average of the percentage one-minute price impact
spread in bps (measured as average (NBBO midpoint one minute after execution--NBBO midpoint at time of order
receipt)/average transaction price). E/Q Ratio is the weighted average of the ratio of the effective dollar
spread divided by its quoted spread at the time of order receipt. WH Pct Executed with Price Improvement is
the weighted average of the percentage of share volume that is routed to wholesalers and executed at a price
better than the NBBO. WH Conditional Amount Price Improvement is the weighted average amount of percentage
price improvement given by wholesalers conditional on the order receiving price improvement in bps (measured
for a marketable buy order as average (NBO at time of order receipt--execution price) and measured for a
marketable sell order as average (execution price--NBB at time of order receipt) and then dividing the
difference by the average transaction price). WH Pct Share Executed at Midpoint or Better is the weighted
average of the percentage of shares that are routed to a wholesaler and executed at prices equal to or better
than the NBBO midpoint at the time of order receipt. WH Pct Share Executed at Midpoint is the weighted average
of the percentage of shares that are routed to a wholesaler and executed at a price equal to the NBBO midpoint
at the time of order receipt. WH Pct Shares Executed at NBBO is the weighted average of the percentage of
share volume routed to a wholesaler and executed at the NBBO at the time of order receipt (executed at the NBB
for marketable sell orders and the NBO for marketable buy orders). WH Pct Shares Executed Outside NBBO is the
weighted average of the percentage of share volume routed to wholesalers and executed at prices outside the
NBBO at the time of order receipt (executed a price less than the NBB for marketable sell orders and a price
greater than the NBO for marketable buy orders). WH Pct Shares Executed with <0.1 cent Price Improvement is
the weighted average of the percentage of shares that are executed with an amount of price improvement less
than 0.1 cents measured against the NBBO at the time of order receipt. WH Pct Shares Executed Subpenny Prices
is the weighted average of the percentage of shares that execute at a subpenny price (a dollar execution price
with a non-zero value in the third or fourth decimal place). WH Pct Shares Executed at Subpenny without
Midpoint Trades is the weighted average of the percentage of shares that execute at a subpenny price (an
dollar execution price with a non-zero value in the third or fourth decimal place), excluding executions with
subpenny prices that occur at the NBBO midpoint. WH Pct Shares Executed at Subpenny Prices with 4 Decimals is
the weighted average of the percentage of shares that execute at a subpenny price where there is a dollar
execution price with a non-zero value in the fourth decimal place. Average transaction prices used in
calculating the metrics are calculated as the total dollar trading volume divided by the total share trading
volume in the category and time period.
For the wholesaler (WH) CAT metrics used in the sample, the analysis includes marketable orders for under
$200,000 in value that originate from a customer with a CAT account type of ``individual'' at one of the 58
retail broker MPIDs and are routed to a wholesaler (see supra note 422 for more info on CAT account types and
retail broker identification methodology and supra note 423 for more details on how the CAT retail analysis
sample was constructed). Fractional share orders with share quantity less than one share were excluded from
the analysis. Orders were also excluded if they had certain special handling codes. The marketability of a
limit order is determined based on the consolidated market data feed NBBO at the time a wholesaler first
receives the order.
For the exchange (EX) CAT metrics, executed market and marketable limit orders received by exchanges during
normal market hours were over the same period were used to calculate the exchange execution quality statics
(see supra note 424 for more details on how the CAT exchange sample was constructed). Exchange orders were
filtered if they had certain special handling codes. The marketability of exchange orders was determined based
on the NBBO observed by the exchange at the time of order receipt.
The dollar value of an order was determined by multiplying the order's number of shares by either its limit
price, in the case of a limit order, or by the far-side quote of the NBBO at the time of order receipt, in the
case of a market order. The analysis includes NMS Common Stocks and ETFs (identified by security type codes of
`A' and `ETF' in NYSE TAQ data) that are also present in CRSP data from CRSP 1925 US Stock Database, Ctr.
Rsch. Sec. Prices, U. Chi. Booth Sch. Bus. (2022). The CRSP 1925 US Indices Database, Ctr. Rsch. Sec. Prices,
U. Chi. Booth Sch. Bus. (2022), was used to identify if a stock was a member of the S&P 500. The stock did not
have to be in the CRSP 1925 US Indices Database to be included in the analysis. Time of order receipt is
defined as the time the wholesaler or exchange first receives the order. Wholesaler metrics based on the time
of order receipt are measured against the NBBO from the consolidated market data feed. Exchange metrics based
on time of order receipt are measured against the NBBO the exchange reports observing. Realized spreads for
both exchange and wholesaler metrics are calculated with respect to the NBBO midpoint from the consolidated
market data feed observed one minute after the time of order execution.
Separately, for both the exchange and wholesaler samples, total share volume, total dollar volume, average
transaction price, percentage volume metrics, and share weighted average dollar per share spread, price
impact, and price improvement metrics were calculated at a stock-week-order size category level by aggregating
together execution quality statistics calculated for individual orders. The order-size categories were defined
as orders less than 100 shares, 100-499 shares, 500-1,999 shares, 2,000-4,999, 5,000-9,999 shares, and 10,000+
shares. For each stock-week-order size category, percentage spread, price impact, and price improvement
metrics were calculated by dividing the average dollar per share metric by the average transaction price
calculated for each stock-week-order size category. E/Q ratios were calculated for each stock-week-order size
category by dividing the average dollar per share effective spread by the average dollar per share quoted
spread.
Exchange sample metrics for E/Q ratios and percentage spread, price impact, and price improvement metrics for a
for each stock-week-order size category were then merged with the corresponding stock-week-order size category
in the wholesaler sample. Weighted averages for both wholesaler and exchange metrics and the wholesaler
percentage volume metrics are then calculated for the security type in the sample by averaging across stock-
week-order size category levels based on their total dollar transaction volume during the sample period in the
wholesaler CAT sample (i.e., for both exchanges and wholesalers, using the stock's total dollar trading volume
in wholesaler executed transactions as the weight when averaging the share weighted average stock-week- size
category values). Weighting the exchange and wholesaler execution metrics by the same weights helps to ensure
the samples are comparable across stocks. Total dollar volume and share volume for the exchange and wholesaler
samples are calculated by summing across all executions in a security type in each sample. The wholesaler
Principal Execution Rate is calculated for a security type in the wholesaler sample by summing the total
dollar volume in trades wholesalers executed in a principal capacity across the security type in the
wholesaler sample and dividing by the total dollar volume in traded in the security type in the wholesaler
sample.
This analysis uses data from prior to the implementation of the MDI Rules and specific numbers may be different
following the implementation of the MDI Rules. See supra note 415.
Table 7 uses CAT data to summarize how individual investor
marketable NMS stock order execution quality varies based on whether
the wholesaler executes the order in a principal capacity (i.e.,
internalizes the order) or effectively reroutes the order (i.e.,
executes in a riskless principal or handles it in an agency capacity).
This analysis supports the interpretation that wholesalers identify and
tend to internally execute individual investor orders associated with
the lower adverse selection costs.\426\ Internalized orders have a
lower price impact (0.91 bps as compared to 4.63 bps for those
effectively rerouted, measured by WH Price Impact), and lower effective
[[Page 5502]]
spreads (1.77 compared to 5.36 for other transactions, measured by WH
Effective Spread). Wholesalers also earn higher realized spreads on the
orders they execute as principal (0.86 bps for principal transactions
compared to 0.72 bps earned by those providing liquidity for the
riskless principal or agency transactions, measured by WH Realized
Spread), despite executing them at lower effective spreads.
---------------------------------------------------------------------------
\426\ Certain items in Table 7 may also be affected by the MDI
Rules once they are implemented. See supra note 415.
Table 7--Wholesaler CAT Analysis of Individual Investor Order Execution
Quality by Wholesaler Execution Capacity
------------------------------------------------------------------------
Effectively
Variable Internalized rerouted
------------------------------------------------------------------------
Average Price........................... $33.48 $14.78
WH Orders (million)..................... 236.95 34.36
WH Trades (millions).................... 251.32 74.36
WH Share Volume (billion shares)........ 70.28 16.83
WH Pct of Executed Share Volume......... 80.68% 19.32%
WH Dollar Volume (billion $)............ $2,352.80 $248.64
WH Pct of Executed Dollar Volume........ 90.44% 9.56%
WH Effective Spread (bps)............... 1.77 5.36
WH Realized Spread (bps)................ 0.86 0.72
WH Price Impact (bps)................... 0.91 4.63
WH E/Q Ratio............................ 0.35 0.70
WH Pct Executed with Price Improvement.. 93.37% 57.65%
WH Conditional Amount Price Improvement 2.45 3.74
(bps)..................................
WH Pct Shares Executed at Midpoint or 46.05% 30.65%
Better.................................
WH Pct Shares Executed at Midpoint...... 32.23% 26.53%
WH Pct Shares Executed at NBBO.......... 5.51% 35.49%
WH Pct Shares Executed Outside NBBO..... 1.12% 6.86%
WH Pct Shares Executed with <0.1 cent 20.38% 2.22%
Price Improvement......................
------------------------------------------------------------------------
The table summarizes execution quality statistics from the CAT retail
analysis based on whether the wholesaler executed the individual
investor NMS stock order in a principal capacity or in another
capacity (i.e., in an agency or riskless principal capacity). The
majority of the other transactions are executed by the wholesaler in a
riskless principal capacity. See supra Table 6 for additional details
on the sample and metrics used in the analysis. Share-weighted
percentage metrics are averaged together at the individual execution
capacity-stock-week-order-size category level for the wholesaler
sample using the methodology in Table 6. Weighted averages for the
metrics are then calculated for each execution capacity by averaging
across execution capacity-stock-week-order size category levels based
on their total dollar transaction volume during the sample period in
the wholesaler CAT sample. This analysis uses data from prior to the
implementation of the MDI Rules and specific numbers may be different
following the implementation of the MDI Rules. See supra note 415.
The analysis in Table 7 presents evidence that wholesalers execute
46% of the shares they internalize at prices equal to or better than
the midpoint. However, additional analysis of CAT data indicates that
there is often midpoint liquidity on exchanges and NMS Stock ATSs when
wholesalers internalize individual investor orders at prices worse than
the midpoint.
Table 8 uses CAT data from March 2022 to examine the non-displayed
liquidity available at the NBBO midpoint on exchanges and NMS Stock
ATSs at a moment in time when a wholesaler internalizes an individual
investor marketable order at a price less favorable (to the customer)
than the NBBO midpoint.\427\ The results indicate that, on
average,\428\ 51% of the shares internalized by wholesalers are
executed at prices less favorable than the NBBO midpoint (Wholesaler
Pct Exec Shares Worse Than Midpoint). Out of these individual investors
shares that were executed at prices less favorable than the midpoint,
on average, 75% of these shares could have hypothetically executed at a
better price against the non-displayed liquidity resting at the NBBO
midpoint on exchanges and NMS Stock ATSs. Under the current market
structure, this liquidity is not displayed, so wholesalers may not have
been aware of this liquidity and able to execute the individual
investor marketable orders against it. Currently, if wholesalers wanted
to detect this hidden liquidity, they would have had to ping each
individual exchange or NMS Stock ATS to see if midpoint liquidity was
available on that venue.\429\
---------------------------------------------------------------------------
\427\ More specifically, the analysis uses CAT data to look at
the total shares available at the NBBO midpoint that originate from
hidden midpoint pegged orders on exchanges and NMS Stock ATSs. The
analysis compares the size of an individual investor marketable
order that was internalized in a principal capacity by a wholesaler
at a price less favorable than the NBBO midpoint (measured at the
time the wholesaler received the order) to the total shares of
midpoint liquidity (originating from midpoint peg orders) at the
NBBO midpoint on exchanges and NMS Stock ATSs at the time the
individual investor order is executed in order to hypothetically see
how many additional shares could have gotten price improvement if
they had executed against the hidden liquidity available at the NBBO
midpoint. A midpoint peg order is a type of hidden order whose price
automatically adjusts with the NBBO midpoint. The analysis looks at
midpoint peg orders on exchanges and ATSs during normal market hours
(midpoint peg orders with an Immediate or Cancel or Fill or Kill
modifier are excluded). The total potential shares in orders that
were available at the NBBO midpoint from midpoint peg orders on
exchanges and ATSs was calculated each stock day by adding shares
when midpoint peg orders were received by an exchange or ATS and
subtracting shares in these orders that were canceled or traded.
Shares were also subtracted from the total when a wholesaler
internalized an individual investor marketable order at a price
worse than the NBBO midpoint and shares were available at the
midpoint on exchanges and ATSs that the order could have
hypothetically executed against. This ensures that that analysis is
not overestimating the available midpoint liquidity (i.e., it
ensures that we do not estimate two individual investor 100 share
orders could have executed against the same resting 100 share
midpoint order). The analysis also kept track of the total amount of
dollars of additional price improvement that individual investors
would have received if their orders had hypothetically executed
against the liquidity available at the NBBO midpoint instead of
being internalized by the wholesaler. Note that this analysis might
underestimate the total non-displayed liquidity available at the
NBBO midpoint because it only looks at orders that pegged to the
midpoint and not other orders, such as limit orders with a limit
price equal to the NBBO midpoint.
\428\ As discussed in Table 8, percentages were computed at a
stock-week level and then averaged across stock-weeks by weighting
by the total dollar volume the wholesaler internalized during that
stock-week.
\429\ Pinging for midpoint liquidity at multiple venues could
increase the risk of information leakage or that prices may move,
possibly resulting in some market participants canceling midpoint
orders they posted.
---------------------------------------------------------------------------
Table 8 also estimates that the additional dollar price improvement
that these individual investor marketable orders would have received
[[Page 5503]]
if they had executed against the available midpoint liquidity instead
of being internalized. The total amount of additional price improvement
that all of these individual investor orders would have received was
about 51% of the total dollar price improvement provided by wholesalers
to all of the individual investor marketable orders that they
internalized (i.e., the marketable orders internalized at prices better
or equal to the midpoint plus marketable orders internalized at prices
worse than the midpoint).\430\
---------------------------------------------------------------------------
\430\ This estimate of the potential additional price
improvement if orders are executed against midpoint liquidity only
accounts for differences in the potential execution prices of the
order and does not account for any other differences in costs of
executing the order at different venues, such as differences in PFOF
or access fees and rebates.
---------------------------------------------------------------------------
In addition, the results in Table 8 also indicate the availability
of NBBO midpoint liquidity is only slightly lower for less liquid (non-
S&P 500 stocks) as liquid (S&P500) stocks. That is, while about 57% of
the shares in individual investor marketable orders in non-S&P500
stocks internalized by wholesalers received executions at less
favorable prices than the NBBO midpoint, there was nevertheless hidden
liquidity available at the NBBO midpoint for about 68% of these non-
S&P500 shares. Moreover, the potential additional price improvement
that could have been gained by if these individual investor orders had
executed against this NBBO midpoint liquidity is almost 55% of the
total price improvement provided by wholesalers in these stocks.
Table 8--Available Midpoint Liquidity When Wholesaler Internalizes a Retail Trade
--------------------------------------------------------------------------------------------------------------------------------------------------------
Wholesaler Additional
Pct exec Pct shares MP dollar price
Stock type Price group Liquidity bucket shares worse price improvement
than midpoint improvement Pct
--------------------------------------------------------------------------------------------------------------------------------------------------------
All.................................... All.............................. ............................ 51.05 74.60 51.05
SP500.................................. All.............................. ............................ 48.41 72.32 41.43
SP500.................................. (1) <$30......................... ............................ 64.36 60.08 50.00
SP500.................................. (2) $30-$100..................... ............................ 47.82 60.36 29.29
SP500.................................. (3) $100+........................ ............................ 47.69 75.69 43.27
NonSP500............................... All.............................. ............................ 57.45 68.10 54.51
NonSP500............................... (1) <$30......................... Low......................... 73.30 49.52 67.63
NonSP500............................... (1) <$30......................... Medium...................... 71.30 60.25 82.85
NonSP500............................... (1) <$30......................... High........................ 66.77 52.18 59.74
NonSP500............................... (2) $30-$100..................... Low......................... 63.60 80.69 68.88
NonSP500............................... (2) $30-$100..................... Medium...................... 57.71 85.24 61.80
NonSP500............................... (2) $30-$100..................... High........................ 50.24 71.79 44.58
NonSP500............................... (3) $100+........................ Low......................... 61.62 84.32 61.49
NonSP500............................... (3) $100+........................ Medium...................... 55.40 93.29 55.96
NonSP500............................... (3) $100+........................ High........................ 47.15 90.99 45.57
ETF.................................... All.............................. ............................ 49.93 86.06 58.28
ETF.................................... (1) <$30......................... Low......................... 66.58 39.75 31.61
ETF.................................... (1) <$30......................... Medium...................... 57.95 54.91 38.35
ETF.................................... (1) <$30......................... High........................ 62.24 78.47 88.70
ETF.................................... (2) $30-$100..................... Low......................... 61.01 62.00 41.78
ETF.................................... (2) $30-$100..................... Medium...................... 53.94 77.54 46.85
ETF.................................... (2) $30-$100..................... High........................ 49.87 84.09 49.56
ETF.................................... (3) $100+........................ Low......................... 52.45 72.28 40.13
ETF.................................... (3) $100+........................ Medium...................... 47.51 87.20 45.35
ETF.................................... (3) $100+........................ High........................ 46.93 90.28 48.33
--------------------------------------------------------------------------------------------------------------------------------------------------------
This table summarizes midpoint liquidity available on exchanges and ATSs during March 2022 when a wholesaler internalizes an individual investor
marketable order less than $200,000 in an NMS common stock or ETF on a principal basis at a price less favorable than the NBBO midpoint (at the time
of the wholesaler receives the order) from one of the 58 retail broker MPIDs in the CAT retail analysis. Stocks are broken out into buckets based on
their security type, price, and liquidity. Stock type is based on whether a security is an ETF, or a common stock in the S&P 500 or Non-S&P 500. Price
buckets are based on a stock's weekly average VWAP price as estimated from TAQ. Stocks within each security type-price bucket, except S&P 500 stocks,
are sorted into three equal liquidity buckets based on the stock's total share trading volume during the week estimated using TAQ data. See supra
Table 6 for additional details on the sample and CAT analysis of wholesaler executions of the orders of individual investors.
Wholesaler Pct Exec Shares Worse Than Midpoint is the average percentage of individual investor shares that wholesalers executed on a principal basis at
a price less favorable than the NBBO midpoint (measured at the time the wholesaler receives the order). Pct Shares MP Price Improvement is the average
percentage of shares that the wholesaler executed at a price less favorable than the NBBO midpoint that could have executed at a better price against
resting liquidity available at the NBBO midpoint on exchanges and NMS Stock ATSs at the time the wholesaler executed the order. Additional Dollar
Price Improvement Pct is the ratio of the total additional dollars of price improvement of the sample period that individual investors whose orders
were executed at a price less favorable than midpoint would have received if their orders would have executed against available midpoint liquidity,
divided by the total dollars in price improvement (measured relative to the NBB or NBO at the time of order receipt) that wholesalers provided over
the sample period when they internalized individual investor orders (i.e. the total price improvement for orders wholesalers internalized at prices
less favorable than the midpoint plus the total price improvement for orders wholesalers internalized at prices more favorable than the midpoint).
[[Page 5504]]
Midpoint liquidity is measured based on resting midpoint peg orders on exchanges and NMS Stock ATSs during normal market hours identified from CAT data.
Midpoint peg orders with an Immediate or Cancel or Fill or Kill modifier are excluded. The total potential shares in orders that were available at
midpoint on exchanges and ATSs at a point in time were calculated keeping a running total each stock day by adding shares when midpoint peg orders
were received by an exchange or NMS Stock ATS and subtracting shares when shares in these midpoint peg orders were canceled or traded. When a
wholesaler executes an order at a price less favorable than the NBBO midpoint (at the time the wholesaler receives the order), then the executed
shares are compared to the available resting liquidity at the NBBO midpoint. If the NBBO midpoint at the time the order is executed would provide
price improvement over the price the wholesaler would have executed the order at, then the shares executed by the wholesaler are subtracted from the
total resting shares available at the NBBO midpoint, up to the lesser of the number of shares executed by the wholesaler or the total resting shares
available (i.e. the total resting shares will not drop below zero). These are counted as the total shares that would have received additional price
improvement at the midpoint. This methodology ensures that that analysis is not overestimating the available midpoint liquidity (i.e. it ensures that
we do not estimate two individual investor 100 share orders could have executed against the same resting 100 share midpoint order). NBBO midpoints for
both time of order receipt and time of execution are estimated from the consolidated market data feed.
The additional dollars of price improvement individual investors whose orders were executed at a price less favorable than the midpoint would have
received if their orders would have executed against available midpoint liquidity was calculated as the difference between the price the wholesaler
executed the order at and the NBBO midpoint at the time the wholesaler executed the order (i.e., executed price--NBBO midpoint at the time of
execution for a marketable buy order and midpoint--executed price for a marketable sell order ) times the number of shares that would have received
the additional price improvement.
Weighted averages are calculated for the variables Wholesaler Pct Exec Shares Worse Than Midpoint and Pct Shares MP Price Improvement using the
following methodology. Percentages based on share volume are calculate for each stock-week (e.g., total shares executed at a price worse than the
midpoint during a stock-week divided by the total shares of individual investor marketable orders executed by a wholesaler in a principal capacity
during the stock-week). Weighted averages are then calculated for each stock-type-price-liquidity bucket by averaging these stock-week percentages
over the month by weighting each stock-week by the total dollar trade volume internalized by the wholesaler during the stock-week (i.e., using the
stock's total dollar trading volume internalized by the wholesaler as the weight when averaging the stock-week percentage values).
The Additional Dollar Price Improvement Pct is not weighted and is calculated as the ratio of the month's total additional dollar price improvement
orders executed at a price less favorable than the NBBO would have received if their orders would have executed against available midpoint liquidity,
divided by the month's total dollars in price improvement (measured relative the NBBO at the time of order receipt) that wholesalers provided when
they executed individual investor orders (i.e. the total price improvement for orders wholesalers internalized at prices less favorable than the
midpoint plus the total price improvement for orders wholesalers internalized at prices more favorable than the midpoint.
ii. Listed Options
a. Options Trading Services Overview
Registered exchanges are the sole providers of trading services in
the market for listed options, and the Options Clearing Corporation
(OCC) is the sole entity clearing trades for exchange-listed options
and security futures.\431\ All listed options trading occurs on
exchanges. Exchanges compete with each other by offering different cost
structures to participate on the exchange, and offering differing order
types to allow customers advanced trading strategies. Options exchanges
offer the ability to route orders to competing options exchanges in the
event of a competing option exchange having the best price for a given
options order.\432\
---------------------------------------------------------------------------
\431\ See What Is OCC?, The Options Clearing Corporation,
available at https://www.theocc.com/Company-Information/What-Is-OCC.
Listed options can only be traded on a registered options exchange.
See By-Laws of The Options Clearing Corporation, Article I, Section
1(C)(28) (defining ``confirmed trade'') and Article VI, Section 1.
\432\ See e.g., Securities Exchange Act Release No. 60405 (July
30, 2009), 74 FR 39362 (August 6, 2009) (approving the national
market system plan relating to options order protection and locked/
crossed markets) (File No. 4-546).
---------------------------------------------------------------------------
There are sixteen options exchanges \433\ in the U.S. options
market. Each of the sixteen exchanges is operated by one of five
exchange groups.\434\ Table 9 presents the market share, as measured by
contract volume, for each option exchange and each exchange group based
on OPRA data from 2022/01/01 to 2022/03/31. Cboe is the exchange with
the largest market share,\435\ at close to 15%. However, on the
exchange group level, the Nasdaq group, with its six exchanges, has the
highest market share.
---------------------------------------------------------------------------
\433\ Eight exchanges trade only options. Eight trade both
options and equities.
\434\ Exchange groups are collection of exchanges operated by
one parent entity.
\435\ This is in part due to the fact that there are several
very liquid Cboe-listed only products such as SPX and SPXW.
Table 9--U.S. Options Exchange Market Share
------------------------------------------------------------------------
Market
Group Exchange share
(percent)
------------------------------------------------------------------------
BOX................................. BOX.................... 5.78
Cboe................................ Cboe................... 14.81
C2..................... 3.66
EDGX................... 4.86
BZX.................... 7.91
Nasdaq.............................. Nasdaq................. 7.93
BX..................... 2.01
PHLX................... 10.91
GEMX................... 2.32
ISE.................... 5.63
MRX.................... 1.69
NYSE................................ AMEX................... 6.68
Arca................... 12.54
MIAX................................ MIAX................... 5.39
PEARL.................. 4.26
EMERALD................ 3.61
------------------------------------------------------------------------
There is one ATS in the market for listed options.\436\ As the
Commission understands, this ATS offers subscribers an RFQ
protocol.\437\ A customer may accept the quote the ATS returns from the
RFQ protocol, after which the order is sent to an exchange for
execution.
---------------------------------------------------------------------------
\436\ In contrast to the market for NMS Stocks, ATS trades in
NMS Options are still executed on an exchange.
\437\ See, DASH Financial Technologies, Execution Services: Dash
ATS available at https://dashfinancial.com/execution-services/dash-ats/.
---------------------------------------------------------------------------
Most option exchanges do not provide midpoint liquidity, and
marketable orders routed to the limit order book can only be executed
at the NBBO prices when there is no price improvement order present.
The Nasdaq Option Exchange first introduced an order type called price
improvement order which allows market participants to enter the order
at a non-displayed limit price within the NBBO spread at 1 cent
increments regardless of the tick size of the option series. Marketable
customer orders are able interact with the resting price improving
orders and receive better prices than the prevailing NBBOs.
b. Retail Order Handling in Options
The Commission understands the majority of retail orders for
options are handled by wholesalers.\438\ Rule 606 data from Q1 2022
show that all but one of the top 15 retail options brokers routed all
of their non-directed \439\ orders from customers to wholesalers. Some
of this flow is routed directly to wholesalers, while some goes through
a third-party clearing firm, but is at some point handled by at least
one wholesaler. Sometimes retail brokers do route to exchanges, either
directly or through a third-party firm.
---------------------------------------------------------------------------
\438\ See supra section III.A.
\439\ According to the Rule 606 filings for the top 15 retail
brokers for listed options, on average non-directed orders made up
around 99.13% of all retail orders in Q1 of 2022.
---------------------------------------------------------------------------
Table 10 summarizes order routing choices of 45 major retail
brokers for non-directed orders for listed options. Routing decisions
are summarized
[[Page 5505]]
separately for 23 retail brokers who accept PFOF from wholesalers or
clearing firms in option markets (PFOF brokers) and those who do not
(non-PFOF brokers). Within each category of brokers, routing statistics
for each order type \440\ is reported separately.
---------------------------------------------------------------------------
\440\ See supra section V.C.2.e.i.
---------------------------------------------------------------------------
Similar to results for NMS stocks, the composition of order types
differ between non-PFOF and PFOF brokers. Market orders and marketable
limit orders comprise a smaller proportion of orders routed by non-PFOF
brokers than PFOF brokers. For example, market orders make up 9.97% and
14.60% of non-directed orders of non-PFOF and PFOF brokers,
respectively. Consequently, the non-marketable limit order type and
other order type make up smaller shares of orders routed by PFOF
brokers.
Non-PFOF brokers route a significantly lower fraction, 46%, of
their customer orders to wholesalers, compared to over 99% of customer
orders that PFOF brokers route to wholesalers. Additionally, Non-PFOF
brokers also route 17% of customer orders to clearing firms, whereas
essentially no orders from PFOF brokers are routed in this manner.
Finally, as an alternative to the previously mentioned routing choices,
Non-PFOF brokers route a significantly higher fraction, 38%, of
customers' orders directly to the exchanges than PFOF brokers, which
route less than 0.1% of the order flow to the exchanges.
Table 10--Retail Broker Order Routing in Listed Options for March 2022
----------------------------------------------------------------------------------------------------------------
Non-
Market Marketable marketable Other Total
Venue type (percent) limit limit (percent) (percent)
(percent) (percent)
----------------------------------------------------------------------------------------------------------------
Non-PFOF Retail Brokers
----------------------------------------------------------------------------------------------------------------
Clearing firm................... 4.49 1.46 10.62 0.27 16.84
Exchange........................ 0.01 0.44 5.47 31.70 37.61
Wholesaler...................... 5.48 7.88 47.14 35.01 45.55
-------------------------------------------------------------------------------
Total....................... 9.97 9.25 51.18 20.66 100.00
----------------------------------------------------------------------------------------------------------------
PFOF Retail Brokers
----------------------------------------------------------------------------------------------------------------
Clearing firm................... 0.00 0.00 0.02 0.01 0.04
Exchange........................ 0.00 0.00 0.06 0.01 0.07
Wholesaler...................... 14.59 8.19 44.71 32.41 99.90
-------------------------------------------------------------------------------
Total....................... 14.60 8.20 44.78 32.42 100.00
----------------------------------------------------------------------------------------------------------------
This table shows the percentage of market orders, marketable limit orders, non-marketable limit orders, and
other orders that retail brokers route to different types of venues in March 2022. Other venues include any
other venue to which a retail broker routes an order other than a wholesaler or an exchange. Twenty-three
retail brokers are identified as PFOF retail brokers that receive payments for routing orders in listed
options to wholesalers or clearing firms. Twenty-two non-PFOF retail brokers are identified as retail brokers
that do not receive monetary compensation when they route orders in listed options to wholesalers. The reports
are aggregated together using a weighting factor based on an estimate of the number of orders non-directed
orders each broker-dealer routes each month. The number of orders is estimated by dividing the number of
market orders a retail broker routes according to a CAT analysis by the percentage of market orders the retail
broker routes for March 2022.
Similar market forces that drive internalization of orders in the
equity markets exist in option markets as well.\441\ In the options
market, internalization \442\ can occur on the limit order book or
through price improvement auction mechanisms.\443\ Internalization on
the limit order book requires the wholesalers' own quotes to be at the
NBBOs, and some exchanges develop certain features (e.g., specialist
model) \444\ to facilitate and improve the internalization rate. From
the Consolidated Audit Trail data for March 2022, the Commission
estimates that wholesalers internalize 70.6% of the single-leg orders
routed to the price improvement auctions and 19.1% of the single-leg
orders routed to the limit order books.\445\ For multi-leg orders, the
internalization rates are 82.4% and 9.27% respectively.\446\ Combining
single-leg and multi-leg orders, the Commission estimates wholesalers
internalize around 31% of the executed orders routed to the option
exchange: 73% of orders routed to price improvement auctions and 17% of
orders routed to the limit order book.\447\
---------------------------------------------------------------------------
\441\ See supra section V.B.3.i.(d).
\442\ In contrast to the market for NMS Stocks, NMS options are
typically internalized after being sent to an exchange. Broker-
dealers wishing to internalize orders are able to use the rules of
exchanges to internalize some orders completely, through routing to
affiliated market makers (partial internalization), or through price
improvement auctions (partial internalization), which offer
competition advantages over competing market participants.
\443\ Price improvement auctions can be used by institutional
broker-dealers to seek price improvement opportunities for their
institutional clients' orders as well. Some exchanges have developed
auctions for large orders with an ``all-or-none'' feature.
\444\ ``Specialist model'' is a general term. The term to
describe a ``specialist'' varies by exchange. Some exchanges may
formally call this ``Designated Market Marker,'' or other similar
terms.
\445\ A single-leg order involves buying or selling a single
options series. For example, buying a call option on XYZ stock with
a strike price of $5.00.
\446\ A multi-leg order involves buying or selling multiple
options series simultaneously. For example, buying a call option on
XYZ stock with a strike price of $5.00, and, in the same order,
selling a call option on XYZ stock with a strike price of $10.00.
\447\ The internalization rate measure throughout this paragraph
is based on the contract volume. A given customer's order can be
partially internalized. For example, suppose a wholesaler routes an
order with 10 contracts to a price improvement auction and is
allocated 7 contracts after the auction concludes, then the
wholesaler is deemed as internalizing 70% of the order.
[[Page 5506]]
Table 11--Execution Protocol and Allocation of Limit Order
[Book by options exchange]
----------------------------------------------------------------------------------------------------------------
Group Exchange Specialist Auction Pro-rata
----------------------------------------------------------------------------------------------------------------
BOX................................. BOX.................... Y Y Y
CBOE................................ CBOE C2................ N N Y
CBOE................... Y Y Y
CBOE BZX............... N N N
CBOE EDGX.............. N Y Y
MIAX................................ MIAX................... Y Y Y
MIAX Emerald........... Y N Y
MIAX PEARL............. N N N
Nasdaq.............................. Nasdaq BX.............. Y Y Y
Nasdaq GEMX............ Y Y Y
Nasdaq ISE............. Y Y Y
Nasdaq MRX............. Y Y Y
Nasdaq NOM............. N N N
Nasdaq PHLX............ Y N Y
NYSE................................ NYSE American.......... Y Y Y
NYSE Arca.............. N Y N
----------------------------------------------------------------------------------------------------------------
To internalize a given customer's marketable order on the exchange
limit order book, the wholesaler needs to provide a quote that is at
the NBBO.\448\ This form of internalization may not yield complete
internalization of the order because there could be quotes from other
market makers, some of whom are quoting at the same price and may have
priority over the wholesaler (e.g., the other market makers will have
priority if the wholesaler joins the NBBO set by other market makers in
a price-time priority exchange or they quote with a larger trading
interest than the wholesaler in a pro-rata exchange). Being a
specialist enables the wholesaler to further internalize more orders
more than a pro-rata allocation model would allow.\449\ Some exchanges
appoint a firm to be the specialist for each equity option class.
According to Table 11, 10 out of 16 option exchanges adopt the
specialist model for quoting and executing single-leg orders on the
limit order book. The specialist has greater quoting requirements than
other exchange members or market makers. To compensate specialists for
continuous provision of two-sided quotes to match buyers and sellers,
the exchanges reward specialists by allowing the specialist to receive
a greater allocation (40%+) of incoming orders if they are at the NBBO
and/or provide them with a guarantee of 100% allocation of orders of 5
contracts or less (the ``five-lot rule''). Some exchanges allow
executing brokers to route customers' orders in the form of directed
orders to the affiliated market makers with heightened allocation
(40%+) and small order guarantees with 100% of the orders of one
contract. According to the table, all exchanges that adopted the
specialist model are pro-rata exchanges, meaning that trading interests
are allocated based on the size of the quote in proportion to the total
depth on the NBBO. Therefore, when wholesalers are also specialists,
wholesalers may receive a disproportionate allocation of the customer
order, even though, as the specialist, the wholesaler might not be
providing the most depth at the best prices. A recent academic study
\450\ shows that the execution quality is worse for specialists who pay
PFOF than the specialists who do not: the realized spreads for the 400
to 500 share orders, which can be fully internalized by the
specialists, are 3 basis points higher when the specialists pay PFOF
compared to when the specialists do not pay PFOF, suggesting that the
process is not fully efficient.
---------------------------------------------------------------------------
\448\ Internalizing a customer's non-marketable limit order with
a price between the prevailing NBBO spread would require the
wholesaler to route the customer's order to the limit order book
first and then submit an immediate-or-cancel order to fill the limit
order. The internalization rate may not be 100% since other market
makers can react to the limit order after the exchange books the
book in the limit order book.
\449\ All the exchanges that appoint specialists are pro-rata
exchanges. In a pro-rata exchange, allocations are proportional to
the trading interests at the best prices for each options series.
\450\ See Ernst & Spatt, supra note 77.
---------------------------------------------------------------------------
Another way to internalize customer orders without being a
specialist is through price improvement auctions. Some option exchanges
\451\ provide two-sided price improvement mechanisms for both single-
leg and multi-leg orders originated from customers. To start a price
improvement auction (PIA), the affiliated market maker (``MM'') of an
executing broker usually submits a two-sided order representing a
customer's order and its own ``contra'' order, which is on the opposite
side of the customer's order, to the exchange. The PIA usually lasts
for 0.1 seconds, during which time, the exchange would expose and
broadcast the customer order to other exchange members (competing
market participants) for price improvement opportunity over the current
NBBO price, and the competing market participants then submit
responding orders to the auction to the exchange. After the PIA
concludes, the allocation of the execution will begin with the best
price received from the contra order and responding orders and end with
the price where the remaining volume of the customer's order will be
filled. In addition to the previously mentioned benefits to
specialists, option exchanges have developed certain arrangements or
schedules to give wholesalers advantages to conduct operations on the
exchange by further facilitating the ability of wholesalers to
internalize the customer orders they receive through the auctions. Such
preferential advantages include, but are not limited to the following:
(1) asymmetric fee schedule in which initiating MMs pay a much smaller
transaction fee than competing market participants, (2) price auto-
match in which the exchanges allow the PIA initiating exchange members
to match the best price among the responding orders from the competing
market participants, and (3) guaranteed allocation in which the
initiating exchange members are allowed to execute at least 40% of the
customer's order exposed in a PIA. Academic studies suggest that the
preferential treatment of wholesalers provided by the exchanges leads
to less
[[Page 5507]]
than fully competitive liquidity provision in auctions.\452\
---------------------------------------------------------------------------
\451\ According to Table 11, 10 out of 16 option exchanges
provide price improvement auction mechanisms to wholesalers and
other executing brokers.
\452\ See supra note 450 and see also Terrance Hendershott, Saad
Khan, & Ryan Riordan, Option Auctions, (Working paper, May 15, 2022)
available at https://papers.ssrn.com/sol3/Papers.cfm?abstract_id=4110516 (retrieved from Elsevier database).
---------------------------------------------------------------------------
iii. Payment for Order Flow in NMS Securities \453\
---------------------------------------------------------------------------
\453\ See infra section V.B.3.(c) for a discussion of PFOF in
the market for crypto asset securities.
---------------------------------------------------------------------------
Rule 10b-10(d)(8) defines payment for order flow as any monetary
payment, service, property, or other benefit that results in
remuneration, compensation, or consideration to a broker or dealer from
any broker or dealer, national securities exchange, registered
securities association, or exchange member in return for the routing of
customer orders by such broker or dealer to any broker or dealer,
national securities exchange, registered securities association, or
exchange member for execution.\454\ PFOF includes any payments from a
wholesaler to a retail broker-dealer in return for order flow. It also
includes any exchange rebates paid to a broker-dealer in return for
sending orders to the exchange. PFOF has the potential to adversely
affect routing decisions to the extent it is not directly passed on to
the customer.\455\ However, it is also possible that there is a
tradeoff between PFOF and execution quality that does not adversely
affect order routing decisions.
---------------------------------------------------------------------------
\454\ See supra note 43 for discussion of payment for order flow
definition under Rule 10b-10(d)(8). In certain circumstances,
broker-dealers are required to disclose their PFOF arrangements. For
example. Rule 10b-10 requires extensive disclosures in
confirmations, including specific disclosures about PFOF.
Additionally, Rule 606 reports require the disclosure of PFOF
arrangements and the average PFOF rates broker-dealers receive on
non-directed orders in NMS stocks and options for routing orders to
a trading venue.
\455\ FINRA has stated that obtaining price improvement is a
heightened consideration when a broker-dealer receives payment for
order flow and it is especially important to determine that
customers are receiving the best price and execution quality
opportunities notwithstanding the payment for order flow. See FINRA
Regulatory Notice 21-23, supra note 294.
---------------------------------------------------------------------------
Studies have found that PFOF may adversely affect order execution
quality. For example, one study looked at the effect of exchange
rebates in the routing of non-marketable limit orders in the equities
markets and found evidence that broker-dealers tend to route customer
orders to the venues that pay high rebates, but offer lower execution
quality in the form of lower fill rates and longer times to order
execution.\456\ Similarly, in the options market, a study \457\ finds
that some brokers tend to route non-marketable limit orders for listed
options to exchanges that offer large rebates. The study's analysis
indicates that non-marketable limit orders routed to exchanges that pay
higher liquidity rebates receive worse execution quality than non-
marketable limit orders routed to exchanges that do not offer liquidity
rebates. One study finds no relation, potentially as a result of low
statistical power.\458\ Evidence on the potential adverse effects
appears stronger in the options market than in the equity market.\459\
Section V.B.3.(a).iii.a presents Commissions analysis.
---------------------------------------------------------------------------
\456\ See, e.g., Robert H. Battalio, Shane A. Corwin & Robert H.
Jennings, Can Brokers Have It All? On the Relation Between Make-Take
Fees and Limit Order Execution Quality, 71 J. Fin. 2193 (2016),
available at https://onlinelibrary.wiley.com/doi/10.1111/jofi.12422/full (``We identify retail brokers that seemingly route orders to
maximize order flow payments by selling market orders and sending
limit order to venues paying large liquidity rebates. . . . [W]e
document a negative relation between limit order execution quality
and rebate/fee level. This finding suggests that order routing
designed to maximize liquidity rebates does not maximize limit order
execution quality. . . .'').
\457\ See, e.g., Robert Battalio, Todd Griffith & Robert Van
Ness, Do (Should) Brokers Route Limit Orders to Options Exchanges
That Purchase Order Flow?, 56 J. Fin. Quan. Anal. 183 (2020).
\458\ See Christopher Schwarz, et. al., The `Actual Retail
Price' of Equity Trades (Working paper, September 14, 2022)
(``Schwarz''), available at https://ssrn.com/abstract=4189239
(retrieved from Elsevier database) do not find a relationship
between the amount of PFOF a retail broker receives and the amount
of price improvement their customers' orders receive. However, see
infra note 466 for a discussion comparing the results in Table 16.
\459\ See Ernst & Spatt, supra note 77, at 1 (``We exploit
variation in the Designated Market Maker (DMM) assignments at option
exchanges to show that retail traders receive less price
improvement, and worse prices, from those DMMs who pay PFOF to
brokers.''). The paper also finds PFOF amounts from wholesalers in
the NMS stock market are small (compared to the options market) and
that individual investor orders executed at wholesalers receive
meaning price improvement.
---------------------------------------------------------------------------
a. PFOF Amounts and Rates
Table 12 summarizes information on PFOF payments in NMS Stocks and
Options for Q1 2022 received by 52 retail broker-dealers and aggregated
based on the order type and type of trading venue.\460\ Wholesalers
paid more than $750 million dollars, about 94% of the total PFOF
payments of approximately $850 million. Note also that PFOF for options
represent the largest share of these payments (70%), equal to more than
$550 million. In addition, PFOF for non-S&P 500 orders was about 24% of
total wholesale PFOF disbursements, substantially larger than the 6%
share of PFOF paid for S&P 500 orders. Finally, note that wholesaler
PFOF for marketable orders (market and marketable limit orders) was
equal to 51% of all wholesaler PFOF, while PFOF for non-marketable
limit orders equaled about 38% of wholesaler PFOF disbursements.
---------------------------------------------------------------------------
\460\ The PFOF data was aggregated from Rule 606 reports from
the 52 retail brokers. The order types are based on those included
in Rule 606 reports. Other Trading Venues includes any other trading
center to which a retail broker routes an order other than a
wholesaler or an exchange, including ATSs. See supra note 404 for
more details on what is included in Rule 606 reports.
Table 12--Aggregated 606 Payments for Q1 2022 to Retail Broker-Dealers by Venue Type, Asset Class, and Order
Type
----------------------------------------------------------------------------------------------------------------
Non-
Market orders Marketable marketable Other orders Total
limit orders limit orders
----------------------------------------------------------------------------------------------------------------
Wholesalers:
S&P 500..................... $20,169,292 $6,861,406 $15,675,087 $4,963,329 $47,669,114
Non-S&P 500................. 74,313,900 45,711,676 53,253,329 14,502,924 187,781,828
Options..................... 69,221,438 185,987,581 235,507,979 70,361,954 561,078,951
-------------------------------------------------------------------------------
Total................... 163,704,629 238,560,663 304,436,395 89,828,206 796,529,894
National Securities Exchanges:
S&P 500..................... -2,883 -1,600,326 4,151,796 -1,058,038 1,490,549
Non-S&P 500................. -14,624 -13,794,526 24,538,646 -2,224,848 8,504,649
Options..................... -54,106 4,838,611 19,019,112 13,334,942 37,138,559
-------------------------------------------------------------------------------
Total................... -71,613 -10,556,240 47,709,554 10,052,056 47,133,756
Other Trading Venues:
[[Page 5508]]
S&P 500..................... -14,335 -87,299 514,713 16,715 429,794
Non-S&P 500................. 41,513 -1,397,974 1,736,516 -5,007 375,049
Options..................... 185,367 -305,579 4,740,343 649,611 5,269,742
Total................... 212,545 -1,790,852 6,991,572 661,319 6,074,585
Grand Total............. 163,845,562 226,213,571 359,137,521 100,541,581 849,738,235
----------------------------------------------------------------------------------------------------------------
This table shows the aggregate payments made from different types of venues in Q1 2022 to 52 broker-dealer based
on their Rule 606 reports. The table breaks out payments from exchanges, wholesalers, and other trading venues
for market orders, marketable limit orders, non-marketable limit orders, and other orders in S&P 500 stocks,
Non-S&P 500 stocks and Options. Other Trading Venues includes any other trading center to which a retail
broker routes an order other than a wholesaler or an exchange, including ATSs.
Table 13, Panel A summarizes the total PFOF dollars paid to the 52
broker-dealers in Q1 2022 based on their total assets. The majority of
payments, more than 750 million dollars, went to broker-dealers with
more than 1 billion dollars in assets. As shown earlier, most of this
payment came from the options market.
Table 13, Panel B summarizes the distribution of total PFOF dollars
paid to the 52 broker-dealers as a percentage of their total revenue in
Q1 2022. On average, the payments reported on Rule 606 reports
accounted for 21% of the broker-dealer's total revenue. However, there
was considerable variation across broker-dealers. Rule 606 reported
payments accounted for less than 5.9% of total revenue for over 50% of
the broker-dealers in the sample. However, for the top 10% of broker-
dealers by revenue, Rule 606 reported payments accounted for more than
74% their total revenue in Q1 2022.
Table 13--Rule 606 Report Broker-Dealer Sample and Payments by Asset Size and Distribution of Payments as Percent of Broker-Dealer Total Revenue
--------------------------------------------------------------------------------------------------------------------------------------------------------
Size of Broker-Dealer (Total Assets)
Variable ---------------------------------------------------------------------------------------------------------------
>50bn 1bn-50bn 500mn-1bn 100mn-500mn 10mn-100mn 1mn-10mn <1mn
--------------------------------------------------------------------------------------------------------------------------------------------------------
Panel A: Broker-Dealers and Payments in Rule 606 Sample by Asset Size
--------------------------------------------------------------------------------------------------------------------------------------------------------
Number of Firms in 606 Sample........... 10 20 2 13 7 0 0
Number of Firms with Positive 606 5 11 1 5 4 0 0
Payments...............................
606 Total Dollar Payments............... $323,768,783 $437,613,668 $4,122 $72,400,510 $15,951,151 $0 $0
606 Total Equity Payments............... $112,360,651 $108,639,249 $4,122 $23,525,311 $1,721,651 $0 $0
606 Total Options Payments.............. $211,408,132 $328,974,419 $0 $48,875,200 $14,229,501 $0 $0
--------------------------------------------------------------------------------------------------------------------------------------------------------
Panel B: Distribution of Firm Payments Reported in Rule 606 as Percentage of Broker-Dealers' Total Revenue
--------------------------------------------------------------------------------------------------------------------------------------------------------
Mean Std Dev 10th Pctl 25th Pctl 50th Pctl 75th Pctl 90th Pctl
--------------------------------------------------------------------------------------------------------------------------------------------------------
606 Total Payments % of Total Revenue... 20.94% 32.31% 0.02% 0.08% 5.82% 28.66% 74.29%
606 Equity Payments % of Total Revenue.. 6.67% 11.57% 0.00% 0.02% 1.24% 7.70% 16.23%
606 Options Payments % of Total Revenue. 14.28% 27.52% 0.00% 0.02% 2.52% 17.50% 49.96%
--------------------------------------------------------------------------------------------------------------------------------------------------------
This table summarizes total payments from the Q1 2022 Rule 606 Reports for 52 broker-dealers based on their total assets and total revenue. Panel A
shows how many broker-dealers fall within each asset size category and the total payments reported on their Rule 606 Reports that they received in the
equity and options markets from venues to which they routed orders in Q1 2022. Panel B shows the distribution of the equity and options payments as a
percentage of a firm's total revenue for Q1 2022. Total Assets are estimated by Total Assets (allowable and non-allowable) from Part II of the FOCUS
filings (Form X-17A-5 Part II) from Q4 2021 and correspond to balance sheet total assets for the broker-dealer. Total Revenue is reported by each
broker-dealer during Q1 2022 in their FINRA Supplemental Statement of Income Form.
From the Rule 606 reports of 15 major retail brokers for listed
options, we can infer that as of Q4 of 2020, 11 of them had PFOF
arrangements with wholesalers, one firm routed the orders directly to
the exchanges, one firm routed the orders to its parent firm, and the
remaining two firms routed the orders to wholesalers but did not have
PFOF arrangements. According to the Rule 606 reports, wholesalers paid
$560 million in PFOF to the 11 retail brokers for non-directed orders
in listed options in Q1 2022.
Table 14 presents the average payment rates reported in Rule 606
reports for PFOF broker-dealers in listed options in Q1 2022. The
statistics are further broken down by trading venue and order type,
with rates given in cents per 100 shares.\461\ The average PFOF rates
are negative for the marketable limit orders and other orders routed to
exchanges, but the rate is positive for non-marketable limit orders
suggesting the brokers route most of the non-marketable limit orders to
the maker-taker exchanges to collect rebates. According to the table,
the average PFOF rates paid by clearing firms are smaller but not much
smaller than wholesalers across all order types suggesting that
clearing firms pass majority of the monetary compensation from
wholesalers to the retail brokers with which they have PFOF
arrangements.
---------------------------------------------------------------------------
\461\ The PFOF rate is missing for the market orders routed
directly to the options exchanges because, according to the rule 606
reports, these brokers neither paid fees nor received rebates from
exchanges for the market orders in Q1 2022.
[[Page 5509]]
Table 14--Average Rule 606 Payment Rates for Q1 2022 to PFOF Broker-Dealers by Venue Type for Listed Options
----------------------------------------------------------------------------------------------------------------
Marketable limit Non-marketable
Venue type Market orders orders limit orders Other orders
----------------------------------------------------------------------------------------------------------------
Exchange.................................. N/A -43.1 42.6 -59.6
Clearing firm............................. 38.4 33 35.2 39.8
Wholesaler................................ 39.9 52.5 51.8 40.4
----------------------------------------------------------------------------------------------------------------
This table shows the average payment rates (in cent per 100 shares) made from different types of venues in Q1
2022 to 23 broker-dealers that received PFOF from wholesalers based on their Rule 606 reports. The table
breaks out average rates from wholesalers and clearing firms for market orders, marketable limit orders, non-
marketable limit orders, and other orders in listed options. Twenty-three retail brokers are identified as
PFOF retail brokers that receive payments for routing orders to wholesalers or clearing firms. This analysis
uses the retail broker-dealer's Rule 606 report if it publishes one or the Rule 606 report of its clearing
broker if the retail broker did not produce a Rule 606 report itself. The reports are aggregated using a
weighting factor equal to the PFOF amount.
b. Empirical Relation Between PFOF and Price Improvement
Although wholesalers provide individual investor orders with price
improvement relative to exchanges, the magnitude of this price
improvement is not uniform across retail brokers.\462\ Analysis in this
section shows that two factors driving variation in the price
improvement wholesalers provide are the amount of PFOF the wholesaler
pays to the retail brokers and the average adverse selection risk posed
by the customers of the retail broker.
---------------------------------------------------------------------------
\462\ Several recent working papers found that price improvement
varies across retail brokers; see Schwarz, supra note 458, and
Bradford Lynch, Price Improvement and Payment for Order Flow:
Evidence from A Randomized Controlled Trial (Working paper, June 27,
2022), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4189658 (retrieved from Elsevier database)
(``Lynch''). These studies only included trades that were initiated
by the authors, and do not include other trades that were handled by
the brokers in their samples. In contrast, the Commission's analysis
is based on the data reflecting all orders routed by 58 broker-
dealer MPIDs.
---------------------------------------------------------------------------
Commission analysis presented in Table 15 compares average
execution quality for PFOF and non-PFOF brokers for executed marketable
orders of individual investors under $200,000 in NMS common stocks and
ETF orders that are routed to wholesalers.\463\ Results are divided
between orders that were executed by the wholesaler on a principal
basis (i.e., internalized) and those executed via other methods (the
majority of which are in a riskless principal capacity).
---------------------------------------------------------------------------
\463\ Some brokers that do not accept PFOF for orders in
equities accept PFOF for orders in options. Certain items in Table
15 may also be affected by MDI Rules once they are implemented. See
supra note 415.
Table 15--Comparison of PFOF and Non-PFOF Broker Execution Quality in NMS Common Stocks and ETFs
----------------------------------------------------------------------------------------------------------------
Principal transactions Other transactions
---------------------------------------------------------------
Non-PFOF PFOF Non-PFOF PFOF
----------------------------------------------------------------------------------------------------------------
Average Price................................... $41.79 $31.35 $23.90 $12.47
Wholesaler (WH) Share Volume (billion shares)... 14.32 55.96 3.40 13.43
WH Dollar Volume (billion $).................... $598.44 $1,754.36 $81.23 $167.41
Pct of Executed Dollar Volume................... 23.00% 67.44% 3.12% 6.44%
WH Effective Spread (bps)....................... 1.50 1.86 4.57 5.75
WH Realized Spread (bps)........................ 0.88 0.85 0.83 0.66
WH Realized Spread Adj PFOF (bps)............... 0.88 0.43 0.83 -0.55
WH Price Impact (bps)........................... 0.62 1.01 3.74 5.07
WH E/Q Ratio.................................... 0.30 0.37 0.78 0.67
WH Pct Executed with Price Improvement.......... 90.59% 94.32% 46.89% 62.87%
WH Conditional Amount Price Improvement (bps)... 2.75 2.34 2.31 4.30
----------------------------------------------------------------------------------------------------------------
The table summarizes execution quality statistics from the CAT retail analysis in Common Stocks and ETFs based
on whether the retail broker MPID receives PFOF from wholesalers (PFOF) or does not (Non-PFOF) and whether the
wholesaler executed the individual investor order in a principal capacity or in another capacity (i.e., in an
agency or riskless principal capacity). A broker-dealer MPID was determined to be a PFOF broker if the broker-
dealer reported receiving PFOF on its Q1 2022 606 report, or if the report of its clearing broker reported
receiving PFOF in the event that the broker did not publish a Rule 606 report. Broker-dealers or clearing
brokers that handled orders on a not held basis and did not disclose PFOF information in their Rule 606 report
were classified as PFOF brokers if disclosures on their websites indicated they received PFOF. Twenty-two
MPIDs belonging to 19 retail brokers were classified as receiving PFOF. The majority of the other transactions
are executed by the wholesaler in a riskless principal capacity. See supra Table 6 for additional details on
the sample and metrics used in the analysis. WH Realized Spread Adj PFOF is the estimated realized spread in
bps earned by the wholesaler after adjusting the realized spread for the estimated PFOF they pay to retail
brokers.\a\ Share-weighted percentage metrics are averaged together at the individual PFOF-execution capacity-
stock-week-order-size category level for the wholesaler sample using the methodology in Table 6. Weighted
averages for the metrics are then calculated for each PFOF-execution capacity category by averaging across
execution capacity-stock-week-order size category levels based on their total dollar transaction volume during
the sample period in the wholesaler CAT sample. This analysis uses data from prior to the implementation of
the MDI Rules and specific numbers may be different following the implementation of the MDI Rules. See supra
note 415
\a\ See infra note 467 for further details on estimated PFOF retail brokers receive. Realized spreads for
marketable orders routed to wholesalers are adjusted for PFOF by subtracting the estimated dollar per share
PFOF rate the retail broker receives from the average per share dollar realized spread in the execution
capacity-stock-week-order type-order size category and then dividing by the average transaction price to
calculate the percentage metric as discussed in further detail in supra Table 6.
The results in Table 15 show that wholesaler internalized orders
(Principal Transactions) originating from PFOF brokers are associated
with (1) higher effective spreads, (2) higher E/Q ratios, and (3)
slightly smaller price improvement on orders that achieved at least
some price improvement (WH Conditional Amount Price
[[Page 5510]]
Improvement), relative to wholesaler internalized orders originating
from non-PFOF brokers. However, the results also show that orders
internalized from non-PFOF brokers also have lower adverse selection
risk and similar realized spreads (before PFOF is paid), indicating the
lower adverse selection risk could explain differences in the observed
execution quality.
Because the results in Table 15 are averages across broker-dealers,
they cannot disentangle the effects of PFOF on execution quality from
differences in the adverse selection risk of different broker-
dealers.\464\ In order to control for these differences, the Commission
analyzed the effects of PFOF and differences broker-dealer adverse
selection risk on execution quality in a regression framework that
controls for other factors that could affect the price improvement
provided by wholesalers.
---------------------------------------------------------------------------
\464\ They also cannot disentangle the effects of differences in
the stocks traded by PFOF and non-PFOF brokers.
---------------------------------------------------------------------------
Table 16 displays regression results from Commission CAT retail
analysis of NMS Common stock and ETF orders,\465\ and shows that the
previous results indicating that brokers that receive PFOF receive
inferior execution quality are robust to the inclusion of controls for
differences in the type of order flow coming from different broker-
dealers.\466\ The regression tests whether there is a relationship
between execution quality and the amount of PFOF a broker-dealer
receives and includes several individual stock- and market-level
controls \467\ as well as the retail broker's average price impact and
size (as measured by percent of executed individual investor dollar
volume). Four different measures of execution quality are used for the
dependent variable, including E/Q ratio, effective spread, realized
spread, and price improvement.\468\
---------------------------------------------------------------------------
\465\ Certain items in this Table 16 may also be affected by the
amendments in the MDI Rules once they are implemented. See supra
note 415.
\466\ Schwarz et. al., supra note 458, did not find a
relationship between the amount of PFOF a retail broker receives and
the amount of price improvement its customers' orders receive.
However, they noted that the variation in the magnitude of price
improvement they saw across retail brokers was significantly greater
than the amount of PFOF the retail broker received, which could
indicate their sample was not large enough to observe a
statistically significant effect. Similarly, when we examine
variation in effective spreads across retail brokers based on their
average price impact (i.e., their average adverse selection risk),
we observe that the differences between the effective spreads of
PFOF and non-PFOF brokers as shown in Table 15, infra, are
significantly smaller than the differences observed across retail
brokers based on variation in their average price impacts. Lynch,
supra note 462, compares the execution quality of similar orders
routed to two different retail brokers that receive different
amounts of PFOF from wholesalers. The study finds that the retail
broker that received a greater amount of PFOF from wholesalers
(i.e., had a higher per share PFOF rate reported in their Rule 606
reports) provided less price improvement compared to a similar order
routed to a retail broker that received less PFOF. Importantly, both
studies only included trades that were initiated by the authors and
do not include other trades that were handled by the brokers in
their samples, preventing them from examining the attributes of a
typical retail order handled by each broker. As such, these studies
do not observe the variation in price improvements that reflect
differences in the adverse selection risk associated with the order
flow of different brokers, and hence, likely conflate the impacts of
PFOF with those of adverse selection risk. That is, these studies
cannot control for the possibility that a wholesaler would offer
smaller price improvement to order flows with higher adverse
selection risk. In contrast, the Commission relies on CAT data to
examine the adverse selection risk at the broker level, which is a
determinant of the amounts of price improvements that a given
wholesaler would offer to different brokers. The regression
framework in infra Table 16 controls for the adverse selection risk
of the retail broker and finds that is has a negative relationship
with the magnitude of price improvement their customers' orders
receive. We also find a negative relationship between the amount of
PFOF a broker-dealer receives and the magnitude of the price
improvement their customers' orders receive after controlling for
the retail broker adverse selection risk.
\467\ Broker-dealer cents per 100 shares PFOF rates (dollar PFOF
rates) are determined from their Q1 2022 Rule 606 reports (see supra
Table 2) or the Rule 606 reports of its clearing broker reported
receiving PFOF in the event that the broker did not publish a Rule
606 report. A PFOF rate of 20 cents per 100 shares was used for the
introducing broker-dealers and clearing broker that reported handled
orders on a not held basis and did not disclose PFOF information in
their Rule 606 report but disclosed on their website that they
received PFOF for their order flow. 20 cents per 100 shares was the
PFOF rate that the clearing broker that handles orders on a not held
basis disclosed on their website that they received. Twenty-two
MPIDs belonging to 19 retail brokers were classified as receiving
PFOF. Dollar PFOF rates for each retail broker were merged with the
corresponding stock (S&P 500 and non-S&P 500) and order type in the
CAT sample. For the regressions in Table 16, percentage PFOF rates
are estimated in basis points by dividing the PFOF cents per 100
share values from Rule 606 reports (after converting them to dollar
per share values) by the stock-week VWAP for the security in the CAT
sample. Stock-level controls include average share volume, VWAP,
return, average effective spread, average realized spread, and
average quote volatility during a week. Market-level controls
include market volatility, market return, and the market's average
daily trading volume during week.
\468\ The regression also includes variables to control for
differences in execution quality across different wholesalers and
across different order size categories. The analysis examines trades
in Q1 2022 that wholesalers execute in a principal capacity from
market and marketable limit orders from individual investors that
are under $200,000 in value and are in NMS Common Stocks and ETFs.
See supra Table 6 for further discussion on the sample. The unit of
observation for the regression is the average execution quality
provided to trades that are aggregated together based on having the
same stock, week, order type, order size category, wholesaler, and
retail broker MPID. The coefficients are estimated by weighting each
observation by the total dollar volume of trades executed in that
observation.
Table 16--Regression Analysis Showing Relationship Between Execution Quality and PFOF in NMS Common Stocks and ETFs
--------------------------------------------------------------------------------------------------------------------------------------------------------
(4) Amount price improvement
Variables (1) E/Q ratio (2) Effective spread (bps) (3) Realized spread (bps) (bps
--------------------------------------------------------------------------------------------------------------------------------------------------------
PFOF Rate.................... 0.0132 *** [2.82]............ 0.217 *** [6.31]............. 0.211 *** [7.13]............. -0.170 *** [-5.52].
Stock Share Volume........... 0.0379 [0.51]................ -0.0462 [-0.14].............. -0.886 * [-1.65]............. -0.533 ** [-2.53].
Stock VWAP................... -0.000028 [-1.06]............ 0.000233 [0.61].............. -0.000450 [-0.78]............ 0.000014 [0.04].
Stock Return................. -0.000273 [-0.21]............ -0.0200 * [-1.93]............ -0.0120 [-0.36].............. 0.00840 [0.84].
VIX.......................... 0.00968 *** [7.29]........... 0.0122 * [1.79].............. 0.0607 *** [2.85]............ -0.000256 [-0.05].
Market Return................ -0.00710 ** [-2.02].......... 0.00787 [0.36]............... 0.00686 [0.15]............... -0.0150 [-0.96].
Market Dollar Volume......... 0.0306 *** [9.70]............ 0.0641 *** [3.44]............ 0.164 *** [3.07]............. -0.0390 *** [-2.69].
Stock Avg Effective spread... 0.00700 *** [3.34]........... 0.122 *** [6.07]............. -0.0455 * [-1.94]............ 0.00746 [0.52].
Stock Avg Realized spread.... -0.00169 * [-1.87]........... -0.00902 [-1.45]............. 0.0730 *** [2.98]............ -0.00552 [-1.48].
Stock Quote Volatility....... 0.457 ** [2.09].............. 2.232 [1.05]................. -1.799 [-0.65]............... 4.458 ** [2.03].
Broker-Dealer Average Price 0.145 *** [14.74]............ 0.414 *** [9.83]............. 0.316 *** [8.50]............. -0.417 *** [-10.21].
Impact.
Broker-Dealer Pct Volume..... -2.45e-05 [-0.07]............ -0.00207 * [-1.76]........... -0.00546 *** [-3.77]......... 0.000124 [0.12].
Average Trade Qspread........ -0.00720 *** [-10.12]........ 0.517 *** [19.78]............ 0.378 *** [10.84]............ 0.392 *** [21.14].
Wholesaler Fixed Effects..... Yes.......................... Yes.......................... Yes.......................... Yes.
Order Size Category Fixed Yes.......................... Yes.......................... Yes.......................... Yes.
Effects.
Stock Fixed Effects.......... Yes.......................... Yes.......................... Yes.......................... Yes.
Observations................. 13,365,122................... 13,365,122................... 13,365,122................... 12,453,440.
[[Page 5511]]
Adjusted R-squared........... 0.279........................ 0.574........................ 0.060........................ 0.594.
--------------------------------------------------------------------------------------------------------------------------------------------------------
This table presents the results of a regression analysis examining the effect of retail brokers receiving PFOF from wholesalers on levels of price
improvement and the execution quality of their customers' orders when the wholesaler internalizes the order on a principal basis.
The analysis examines trades in Q1 2022 that wholesalers execute in a principal capacity from market and marketable limit orders from individual
investors that are under $200,000 in value and are in NMS Common stocks and ETFs. See supra Table 6 for further discussion on the CAT retail sample.
The unit of observation for the regression is the average execution quality provided to trades that are aggregated together based on having the same
stock, week, order type, order size category, wholesaler, and retail broker MPID. Weighted regression are performed based on the total dollar value
executed by the wholesaler in that observation (i.e., total shares executed for all orders that fit within that stock-week-retail broker-wholesaler-
order type-order size category). This means that the regression coefficients capture the effect on execution quality on a per-dollar basis.
Dependent variables include: the average E/Q ratio of the shares traded; the average percentage effective spread of the shares traded measured in basis
points; the average percentage realized spread of the shares traded measured in basis points; and the average percentage value of the amount of price
improvement measured in basis points, conditional on the order being price improved. These variables are from the CAT retail analysis and described in
supra Table 6.
Explanatory variables include: PFOF Rate is the retail brokers' PFOF rates in bps (the per share rates were determined from retail broker Rule 606
reports and divided by the VWAP of the executed shares in the sample to determine the PFOF rate on a percentage basis, see supra note 467); Broker-
Dealer Pct Volume is the retail broker size (in terms of percentage total executed dollar trading volume in the sample); Stock Share Volume is the
stock's total traded share volume during the week (from TAQ in billions of shares); Stock VWAP is the VWAP of stock trades during the week (from TAQ);
Stock Return is the stock's return during the week (from CRSP 1925 US Stock Database, Ctr. Rsch. Sec. Prices, U. Chi. Booth Sch. Bus. (2022)); VIX is
the average value of the VIX index during the week (from CBOE VIX data); Market Return is the average CRSP value weighted market return during the
week, Market Dollar Volume is the total market dollar trading volume during the week (from CRSP 1925 US Stock Database, Ctr. Rsch. Sec. Prices, U.
Chi. Booth Sch. Bus. (2022)); Stock Avg Effective spread is the stock's share weighted average percent effective half spread during the week measured
in basis points (from TAQ); Stock Avg Realized spread is the stock's share weighted average percent realized half spread during the week measured in
basis points (from TAQ); Stock Quote Volatility is the stock's average 1 second quote midpoint volatility measured in basis points (from TAQ); Broker-
Dealer Average Price Impact is calculated for each Retail Broker MPID's by share weighting their average percentage price impact half spread within an
individual NMS common stock or ETF and then averaging across stocks using the weighting of the dollar volume the retail broker MPID executed in each
security (see supra Table 6 for additional details on how the metric is constructed); Average Trade Qspread is the average percentage quoted half
spread at the time of order submission for orders in that stock-week-retail broker-wholesaler-order type-order size category measured in basis points;
wholesaler fixed effects (i.e., indicator variables for each wholesaler that control for time-invariant execution quality differences related to each
wholesaler); order-size category fixed effects (i.e., indicator variables for each order-size category that control for time-invariant execution
quality differences related to order-size category); and individual stock fixed effects (i.e., indicator variables for each stock that control for
time-invariant execution quality differences related to individual stocks). The order size categories include less than 100 shares, 100-499 shares,
500-1,999 shares, 2,000-4,999, 5,000-9,999 shares, and 10,000+ shares. Brackets include t-statistics for the coefficients based on robust standard
errors that are clustered at the stock level. ***, **, and * indicate the t-statistics for the coefficients are statistically significant at the 0.01,
0.05, and 0.1 levels, respectively.
This analysis uses data from prior to the implementation of the MDI Rules and specific numbers may be different following the implementation of the MDI
Rules. See supra note 415
Regression results in Table 16 support the conclusion that
wholesalers provide worse execution quality to brokers that receive
more PFOF. The coefficients on the PFOF Rate variable indicates that,
all else equal, for the orders wholesalers internalize, execution
quality declines as the amount of PFOF paid to the retail broker
increases. Orders from retail brokers that receive a greater amount of
PFOF have higher E/Q ratios and effective spreads and receive less
price improvement. The regression results (as measured by the
coefficient on the PFOF Rate variable) indicate that, all else equal,
wholesalers earn higher realized spreads on orders for which they pay
more PFOF. Note that PFOF is not taken out of the realized spread
measure, so the realized spread serves as a proxy for wholesaler's
economic profits before any fees are taken out.
The regression results in Table 16 also show that the retail
broker's adverse selection risk (as measured by the coefficient on the
Broker-Dealer Average Price Impact variable) has a statistically
significant effect on the execution quality wholesalers give on trades
they internalize. The positive coefficient indicates that wholesalers
provide worse execution quality to broker-dealers whose customers'
orders pose a greater adverse selection risk.
(b) Fixed Income Securities
i. Corporate Debt Securities
The market for corporate debt securities (``corporate bonds'')
represents a significant part of the fixed income market. In July 2022,
the average daily par value dollar volume of corporate bond trading was
$34.2 billion.\469\ Estimates put the annualized growth rate of the
corporate bond market at 5.2 percent between 2008 and 2019, a growth
rate second only to that of U.S. Treasury securities within the fixed
income space.\470\
---------------------------------------------------------------------------
\469\ Average daily par value dollar volume is reported by FINRA
each month. See FINRA Data, TRACE Monthly Volume Files, available at
https://www.finra.org/finra-data/browse-catalog/trace-volume-reports/trace-monthly-volume-files. The corporate bond market has
over 58,000 outstanding issues. Maureen O'Hara and Xing (Alex) Zhou,
Corporate Bond Trading: Finding the Customers' Yachts, 48 J.
Portfolio Mgt Mkt Microstructure 96, 98 (June 2022), available at
https://jpm.pm-research.com/content/early/2022/06/11/jpm.2022.1.373.
\470\ Vega Economics, Trends in the U.S. Corporate Bond Market
Since the Financial Crisis (Oct. 12, 2020), available at https://vegaeconomics.com/trends-in-the-us-corporate-bond-market-since-the-financial-crisis.
---------------------------------------------------------------------------
[[Page 5512]]
Fixed income securities trading venues (e.g., ATSs, non-ATS trading
venues (RFQ platforms), voice methods) compete on fees and trading
protocols that help expose retail customer orders to attract order
flows from retail broker-dealers. Corporate bond ATSs are primarily
used by broker-dealers to trade on behalf of retail customers or to
rebalance excess inventories.\471\ In September 2021, corporate bond
trading on ATSs accounted for 7.7 percent of total TRACE-reported
corporate bond trading dollar volume (calculated using bond par
value).\472\ Currently, the Commission understands that there are 12
ATSs with a Form ATS on file trading corporate bonds.\473\ Trading
protocols offered on corporate bond ATSs include, among other things,
limit order books (LOBs), displayed and non-displayed trading
interests, and auctions (e.g., RFQ, bids-wanted-in-competition (BWIC),
and offers-wanted-in-competition (OWIC)).
---------------------------------------------------------------------------
\471\ See, e.g., Matthew Kozora, Bruce Mizrach, Matthew Peppe,
Or Shachar & Jonathan Sokobin, Alternative Trading Systems in the
Corporate Bond Market, Fed. Res. B.N.Y. Staff Report No. 938 (Aug.
2020), available at https://www.newyorkfed.org/medialibrary/sr938.pdf. See, Louis Craig, Abby Kim & Seung Won Woo, Pre-trade
Information in the Corporate Bond Market, SEC Division of Economic
and Risk Analysis White Paper (Oct. 2020), available at https://www.sec.gov/files/corporate_bond_white_paper.pdf. White papers and
analyses are prepared by SEC staff in the course of rulemaking and
other Commission initiatives. The U.S. Securities and Exchange
Commission disclaims responsibility for any private publication or
statement of any employee or Commissioner. White papers express the
authors' views and do not necessarily reflect those of the
Commission, the Commissioners, or other members of the staff. This
staff white paper on corporate bond ATSs finds that large dealers
(i.e., those in the highest quartile of trading volume and number of
bonds traded) are more likely to provide corporate bond quotes on
ATSs than smaller dealers.
\472\ See FINRA, TRACE Monthly Volume Files, available at
https://www.finra.org/finra-data/browse-catalog/trace-volume-reports/trace-monthly-volume-files. One commenter referenced similar
numbers for 2020, stating that corporate bond trades (including both
investment-grade and high-yield bonds) on all ATSs represented 6.4
percent of the trade volume and 18.7 percent of the trade count
reported to TRACE. See MarketAxess Letter, at 1.
\473\ In addition, a small percentage of corporate bonds are
exchange-traded on trading systems such as NYSE Bonds and the Nasdaq
Bond Exchange. See generally, https://www.nyse.com/markets/bonds.
Trading volume in exchange-traded bonds was reported to be around
$19 billion as of January 2020. See Eric Uhlfelder, A Forgotten
Investment Worth Considering: Exchange-Traded Bonds, Wall St. J.
(Jan. 6, 2020) available at https://www.wsj.com/articles/a-forgotten-investment-worth-considering-exchange-traded-bonds-11578279781. (Retrieved from Factiva database).
---------------------------------------------------------------------------
BILLING CODE 8011-01-P
Table 17--Estimated Transaction Costs and Trade Price Dispersion Across
Fixed Income Categories
[[Page 5513]]
[GRAPHIC] [TIFF OMITTED] TP27JA23.000
BILLING CODE 8011-01-C
The aforementioned changes in bond market structure have
fundamentally lowered the cost of trading. Though the corporate bond
market remains subject to periodic and security-specific illiquidity
constraints, one recent academic study finds that corporate bond
transactions costs have decreased by 70% over the past decade.\474\
According to Commission analyses, par volume-weighted average effective
[[Page 5514]]
spreads \475\ calculated in the year ending July 2022 in corporate bond
markets were approximately 27 basis points. Liquidity often
concentrated in the largest and most recently issued bonds.\476\
Additional Commission analyses indicate that the top and bottom
quartile of corporate bond effective spreads differ by more than 30
bps.
---------------------------------------------------------------------------
\474\ See O'Hara and Zhou, supra note 469.
\475\ Effective spread calculation is defined in Table 17.
\476\ See A Financial System That Creates Economic
Opportunities, Capital Markets, U.S. Department of the Treasury,
October 2017, available at https://www.treasury.gov/press-center/press-releases/documents/a-financial-system-capital-markets-final-final.pdf (``Treasury Report'') at 85.
---------------------------------------------------------------------------
Effective spreads for retail-sized trades are nearly twice as wide
as larger size trades (see Panel A of Table 17).\477\ The Commission
estimates that effective spreads on riskless principal transactions are
approximately 12 bps lower for retail-sized corporate bond trades, but
the difference between large size trade effective spreads remains wide
at 26 bps.
---------------------------------------------------------------------------
\477\ Neither FINRA TRACE nor MSRB RTRS data provide explicit
identification of trades as ``retail'' in fixed income markets. We
use the widely held convention of retail ``size'' trades of being
under $100,000 consistent with studies including Lawrence Harris &
Anindya Mehta, Riskless Principal Trades in Corporate Bond Markets
(Aug. 26, 2020), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3681652 (retrieved from Elsevier database)
and Griffin, supra note 66, in the corporate and municipal bond
markets, respectively.
---------------------------------------------------------------------------
The standard deviation ratio statistics of Panel B in Table 17 show
dispersion in the execution quality for corporate bond trades. The
standard deviation ratio statistics compare interdealer trade execution
prices to those of customers within a given bond-trading day. Even for
large trades, a standard deviation ratio of 1.92 suggests that for
every dollar of price dispersion in the interdealer market customers
see almost twice the dispersion in prices. For retail trades, this
difference increases to 2.87 suggesting an even wider range of price
execution quality outcomes.\478\
---------------------------------------------------------------------------
\478\ Commission analyses for corporate debt securities trades
with no remuneration/markups show the dispersion of customer
execution prices was 65% greater than that of interdealer trades,
suggesting that price dispersion in customer trades may not solely
be driven by disparate markups.
---------------------------------------------------------------------------
ii. Municipal Securities
The market for municipal securities (``municipal bonds'')
represents another important part of the fixed income market. Unlike in
the markets for other fixed income securities, which are mostly owned
by institutional investors, retail investors play a prominent role in
the ownership of municipal bonds, with 40 percent of municipal bonds
held by households and nonprofits as of Q1 2022.\479\ This is largely
due to the tax-exempt status of most municipal bonds, which makes them
attractive to households but less attractive to institutional investors
such as pension funds, whose holdings are already tax-deferred or tax
exempt. Municipal bond markets also tend to be highly localized, as
investors that are located in geographic proximity to an issuer are
more likely to be informed about that issuer, and tax benefits are
often conferred on investors that are located in the same state as the
issuer.\480\ Daily trading volumes in the municipal bond market
averaged around $9 billion during the 2021 calendar year.\481\ Average
trade sizes in this market tend to be smaller than in other fixed
income markets: in July 2022, 81 percent of trades were for $100,000 or
less, reflecting the higher presence of retail investors in this
market.\482\
---------------------------------------------------------------------------
\479\ See, John Bagley, Marcelo Vieira & Ted Hamlin, Trends in
Municipal Securities Ownership, at 6, Munic. Sec. Rulemaking Bd
(June 2022), available at https://www.msrb.org/sites/default/files/Trends-in-Municipal-Securities-Ownership.pdf. Data used by this
paper is largely from the Federal Reserve's Financial Accounts of
the United States. Id., at 2. See also infra note 495 and
accompanying text.
\480\ See, Paul Schultz, The market for new issues of municipal
bonds: The roles of transparency and limited access to retail
investors, 106 J. Fin. Econ. 492, 492 (2012).
\481\ See Municipal Securities Rulemaking Board, Muni Facts,
available at https://www.msrb.org/News-and-Events/Muni-Facts.
\482\ See Municipal Securities Rulemaking Board, Municipal Trade
Statistics, available at https://emma.msrb.org/MunicipalTradeStatistics/ByTradeCharacteristic.aspx.
---------------------------------------------------------------------------
Municipal securities trading venues (e.g., ATSs, non-ATS trading
venues (RFQ platforms), voice methods) compete on fees and trading
protocols that help expose retail customer orders in order to attract
order flows from retail broker-dealers. ATSs play an increasingly
important role in the municipal bond market. Between August 2016 and
April 2021, an estimated 56.4 percent of municipal bond interdealer
trades (26 percent in terms of par volume) were executed on ATSs.\483\
Municipal bond ATSs are primarily used by broker-dealers to execute
trades on behalf of retail customers or to rebalance excess
inventories. ATSs may help to reduce search costs. Indeed, one study
finds that dealers are more likely to access ATS systems for trades
that are more difficult to price and that face substantial search
costs, such as smaller size trades and trades involving municipal bonds
with complex features.\484\ Accordingly, 90 percent of quotes on
municipal bond ATSs are offer quotes.\485\ On the other hand, the vast
majority of RFQs on municipal bond ATSs are requests for bids,
reflecting that RFQ protocols are more likely to be used when customers
want to sell. Similar to the case of corporate bond markets, RFQs may
instead be preferred by traders that want to limit information leakage,
such as in case of large size trades. At least 43.6 percent of
interdealer trades (74.1 percent in terms of par volume) in the
municipal bond market take place via trading methods that are not ATSs,
with 38.3 percent taking place on interdealer platforms and 5.3 percent
on broker's broker platforms.\486\
---------------------------------------------------------------------------
\483\ See Simon Z. Wu, Characteristics of Municipal Securities
Trading on Alternative Trading Systems and Broker's Broker
Platforms, Municipal Securities Rulemaking Board (Aug. 2021), (``Wu
(2021)''), available at https://msrb.org/sites/default/files/MSRB-Trading-on-Alternative-Trading-Systems.pdf. See also Letter from
Edward J. Sisk, Chair, Municipal Securities Rulemaking Board, dated
March 1, 2021 (``MSRB Letter''), stating that MSRB trade data shows
that ATSs were involved in 21 percent of all trades and 55 percent
of all inter-dealer trades in the municipal bond market.
\484\ See Wu (2021), supra note 483.
\485\ See Simon Z. Wu, John Bagley, & Marcelo Vieira, Municipal
Securities Pre-Trade Market Activity: What Has Changed Since 2015?,
Municipal Securities Rulemaking Board (2020), available at https://www.sec.gov/spotlight/fixed-income-advisory-committee/msrb-staff-analysis-of-municipal-securities-pre-trade-data.pdf.
\486\ See Wu (2021), supra note 483.
---------------------------------------------------------------------------
Transaction costs in the municipal bond market have typically been
large compared to other markets, and academic studies have attributed
these large transaction costs to a lack of price transparency and
subsequent information asymmetry between dealers and customers.\487\
One MSRB staff report suggests that a movement away from voice trading
and towards electronic trading may have helped reduce transaction costs
for customer trades by 51 percent between 2005 and 2018.\488\ The
Commission estimates that effective spreads for retail-sized trades
remain approximately 23 basis points higher than that of larger
municipal bond trades.
---------------------------------------------------------------------------
\487\ See, e.g., Lawrence E. Harris, & Michael S. Piwowar,
Secondary Trading Costs in the Municipal Bond Market, 61 J. Fin.
1361 (2006).
\488\ See Simon Z. Wu, Transaction Costs for Customer Trades in
the Municipal Bond Market: What is Driving the Decline?, Municipal
Securities Rulemaking Board (July 2018), at 15, available at https://www.msrb.org/sites/default/files/Transaction-Costs-for-Customer-Trades-in-the-Municipal-Bond-Market.pdf.
---------------------------------------------------------------------------
Commission estimates in Panel B of Table 17 show average execution
price standard deviation ratios, however, which suggest much higher
price dispersion for customers in the municipal bond market relative to
other fixed income market segments. For retail-sized trades in
municipal
[[Page 5515]]
securities, the Commission estimates retail-size trades have more than
four times the amount of price dispersion as dealers experience. One
recent academic specifically examines execution quality in the market
for municipal bonds.\489\ Consistent with the Commission analysis in
Table 17, the study examines bond prices for the same bond on the same
trading day and finds significant dispersion in execution quality.
Furthermore, the study finds differences in execution quality
discrepancies within each broker-dealer in the same bond trading
day.\490\
---------------------------------------------------------------------------
\489\ See, e.g., Griffin, supra note 66.
\490\ The study finds that the range of differences in dealer
fixed effects from the worst to best dealer markup is consistently
2% and retail-sized trades have, controlling for bond
characteristics, 75 bps higher markups relative to larger trades.
Furthermore, the study summarizes by stating that municipal bond
``markup differences represent different prices for the same
security from the same dealer at essentially the same time, which
would seem to be a clear failure of pricing fairness according to
MSRB regulations and guidance.''
---------------------------------------------------------------------------
iii. Government Securities
The market for U.S. government securities is large both in terms of
the outstanding debt amount and trading volume. According to the
Treasury Department, the total amount outstanding for marketable
Treasury securities was approximately $23.4 trillion.\491\ The
Financial Accounts of the United States Z.1 released by the Federal
Reserve Board shows that the amount outstanding for Agency- and GSE-
Backed Securities is about $10.9 trillion, as of the end of Q1
2022.\492\ According to data published by SIFMA, in September 2021, the
average daily trading volume in government securities was about $850.1
billion, which is roughly 95 percent of all fixed income securities
trading volume in the U.S.\493\ This includes $582.1 billion average
daily trading volume in U.S. Treasury securities, $265.7 billion in
Agency MBSs, and $2.4 billion in other Agency securities.
---------------------------------------------------------------------------
\491\ See Monthly Statement of the Public Debt of the United
States, dated July 31, 2020, available at https://fiscaldata.treasury.gov/datasets/monthly-statement-public-debt/summary-of-treasury-securities-outstanding.
\492\ See Financial Accounts of the United States Z.1, First
Quarter 2022, at 177, available at https://www.federalreserve.gov/releases/z1/20220609/z1.pdf.
\493\ See SIFMA Fixed Income Trading Volume, available at
https://www.sifma.org/resources/research/us-fixed-income-securities-statistics/. The stated figures include Treasury Securities, Agency
MBS, and Federal Agency Securities.
---------------------------------------------------------------------------
Government securities are traded through a diverse set of venues,
including ATSs, RFQs, and bilateral protocols, such as voice methods.
Government securities trading venues (e.g., ATSs, non-ATS trading
venues (RFQ platforms), voice methods) compete on fees and trading
protocols that help expose retail customer orders in order to attract
order flows from retail broker-dealers. Currently, government
securities ATSs account for a significant percentage of all U.S.
Treasury securities trading activity reported to TRACE.\494\ The
Commission estimates that ATSs account for approximately 37.8% percent
of U.S. Treasury securities trading volume from April 2021 through
March 2022. Broker-dealers utilize ATSs to source liquidity in
government securities, including the liquidity needed to efficiently
fill customer orders outside ATSs. The Commission understands that this
means some portion of broker-dealer transactions on government
securities ATSs are associated with the dealers' activity in filling
customer orders.
---------------------------------------------------------------------------
\494\ TRACE aggregation and analysis methods follow those used
by Treasury market regulators and FINRA, including adjustments for
multiple trade reports for a single transaction and counting only
one trade report for an ATS or IDB. The regulatory version of TRACE
was used in the analysis. A ``Give-Up'' ID is reported when a
principal to a transaction delegates another participant to report a
trade on its behalf. When a ``Give-Up'' ID is reported, the
corresponding reporting or contra- party is replaced with the
``Give-Up'' ID. This ensures that trades are attributed to the
principals to each transaction. System control numbers are used to
link corrected, canceled, and reversed trade messages with original
new trade messages. In these cases, only corrected trades are kept
and all cancellation and reversal messages and their corresponding
new trade messages are removed. Special care must be taken when
counting market volume. When a FINRA registered broker directly
purchases from another FINRA member, two trade messages are created.
If those FINRA registered brokers transact through an inter-dealer
broker (IDB), four trade messages are created, two for the IDB and
one for each member. In both cases, the volume from only one report
is needed. To ensure that double counting of transactions does not
occur, only the following trade messages are summed to calculate
market volume: sales to non-IDB members, sales to identified
customers, such as banks, hedge funds, asset managers, and PTFs, and
purchases from and sales to customers and affiliates. Any trade in
which the contra-party is an IDB is excluded. Thus, in the case of
trades involving IDBs, only the IDBs' sale message is added to
overall volume.
---------------------------------------------------------------------------
Effective spreads for Treasuries in Table 17 are the lowest among
all of the presented fixed income securities categories. Effective
spreads for retail-sized trades are only 3 bps higher relative to
larger trades. Agency securities exhibit relatively higher effective
spreads in comparison to U.S. Treasury securities but remain the second
least costly fixed income securities category in terms of transaction
costs. There is less dispersion in execution quality for U.S. Treasury
securities trades. Price dispersion in large size customer trades is
small relative to that of interdealer trades (1.11) but is somewhat
larger, albeit at an overall level less than other fixed income
securities categories, for retail-sized trades (1.38).
iv. Market Access
With respect to fixed income securities trading, executing brokers
provide market access to other broker-dealers including retail broker-
dealers that qualify as introducing brokers under the FINRA/MSRB rules.
The Commission understands executing broker-dealers that provide market
access to retail introducing brokers under the FINRA and MSRB rules do
not engage in conflicted transactions as defined under the proposal.
Furthermore, the Commission understands that these executing brokers
would consider factors, such as contemporaneous trade prices (e.g.,
interdealer prices), quotes, trade prices and quotes of similar fixed
income securities, yield curve, matrix prices, and different types of
trading protocols (e.g., RFQs and BWICs) in handling orders from other
retail broker-dealers and also supply execution quality statistics to
their customers. These executing brokers compete on the basis of fees,
efficiency in order handling procedures, and efficiency in the
selection of trading venues or counterparties, which determine overall
execution quality.
v. Retail Order Handling and Execution
Retail investors transacting in fixed income securities most often
trade municipal securities, and to a smaller extent, corporate debt
securities and U.S. Treasury securities. As of 2021, household holdings
of municipal securities hovered above 40 percent \495\ of outstanding
municipal securities,\496\ but this share has been declining.\497\
Households owned only roughly one percent of outstanding corporate debt
securities in 2021.\498\ U.S. Treasury securities have slightly higher
household participation, at approximately three percent.
[[Page 5516]]
Households own a similar amount of U.S. agency securities, also at
approximately two percent.\499\ In general, retail investors do not
trade in the market for other fixed income securities, such as asset-
backed securities, although broker-dealers offer trading services for
these fixed income securities to their retail customers.
---------------------------------------------------------------------------
\495\ See Financial Accounts of the United States Z.1, Fourth
Quarter 2021, available at https://www.federalreserve.gov/releases/z1/20220310/z1.pdf.
\496\ In the Z.1 Financial Accounts of the United States,
estimates for the `household' sector include non-profits and
domestic hedge funds. See Financial Accounts of the United States
Z.1, Technical Q&As (September 23, 2022), available at https://www.federalreserve.gov/releases/z1/z1_technical_qa.htm.
\497\ See Heather Gillers, Municipal Bonds Increasingly Held by
Funds, Not Individuals, Wall St. J. (Jun. 29, 2022). Available at
https://www.wsj.com/articles/municipal-bonds-increasingly-held-by-funds-instead-of-individuals-11656408601.
\498\ See id.
\499\ See id.
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The Commission understands that retail investors generally use one
broker-dealer for fixed income securities trading services. Broker-
dealers execute retail customer orders mostly on a principal basis
(e.g., riskless principal trades, internalized trades). Broker-dealers
may execute against resting orders (e.g., limit orders displayed on
ATSs), conduct RFQs/BWICs/OWICs,\500\ and utilize voice methods (e.g.,
telephone) in handling retail customer orders. For executing small or
medium size retail customer orders, a broker-dealer may utilize limit
orders or RFQs, while it might utilize voice methods for executing
large retail customer orders or orders on illiquid fixed income
securities. Only a few broker-dealers offer a trading service to
represent a retail customer order in a limit order book. The Commission
does not know the number of trading venues (e.g., ATSs, RFQ platforms,
broker's broker platforms, single dealer platforms) to which broker-
dealers maintain access/connection for executing retail customer
orders. The Commission also does not know the number of broker-dealers
that access or connect to these venues through each type of interface
(e.g., via application programming interface (API), graphical user
interface (GUI)). Furthermore, the Commission does not know how broadly
broker-dealers expose retail customer orders, for example, via RFQs or
limit order books for the purpose of riskless principal transactions
and internalization.
---------------------------------------------------------------------------
\500\ Bid wanted in competition (BWIC) is a request for bids on
a single security or a list of securities, submitted by a market
participant (a broker-dealer or an institutional investor) to a
number of broker-dealers. Offer wanted in competition (OWIC) is a
request for offers on a single security or a list of securities,
submitted by a market participant (a broker-dealer or an
institutional investor) to a number of broker-dealers.
---------------------------------------------------------------------------
The Commission understands that retail customer order handling
practices for fixed income securities vary across retail broker-dealers
offering different types of trading services and between the sides of
the market (customer buy order vs. customer sell order). Some broker-
dealers offer self-directed trading to their retail customers, whereas
for some broker-dealers, the firm's brokers handle retail customer
orders, and some offer both self-directed and broker-assisted trading
services. Furthermore, some broker-dealers make only internal
inventory, only external inventory (for brokers that do not carry
inventory), or both internal and external inventory of fixed income
securities available for retail customer trading. The Commission
understands that some broker-dealers whose primary service is not
focused on fixed income securities trading outsource fixed income
securities execution services to another broker (i.e., executing
broker). The Commission does not know how many executing brokers
perform fixed income securities trading services on behalf of these
brokers. The Commission understands that executing brokers maintain
access to multiple trading venues (e.g., ATSs, RFQ platforms, broker's
broker platforms, single dealer platforms) and generally handle orders
from other broker-dealers, for which they provide execution services,
on agency or riskless principal basis.
Some broker-dealers ingest offer quotes from internal inventory
and/or trading venues (e.g., ATSs, electronic venues) and then display
them to their self-directed retail customers or the firm's brokers who
handle retail customer orders. These offer quotes displayed to self-
directed retail customers typically embed markup. Self-directed retail
customers are able to submit buy orders to execute against offer quotes
displayed on their systems. The Commission understands that some
broker-dealers do not assess the competitiveness of ingested quotes or
filter out quotes that may not be reflective of the prevailing market
before displaying them to self-directed retail customers. Furthermore,
the Commission does not have information about how orders submitted by
self-directed retail customers are handled: the Commission does not
know how a broker-dealer ensures the displayed quote, against which a
self-directed retail customer submitted an order to execute, is
reflective of the current market. For a broker-assisted customer buy
trade, a broker handling a retail customer order would follow order
handling procedures based on the FINRA/MSRB best execution rules. The
broker may consider, among other things, prices, such as trade prices,
trade prices of similar fixed income securities, internal and/or
external offer quotes, offer quotes of similar fixed income securities,
matrix prices, and prices derived from yield curve, as well as trading
protocols, such as limit order, RFQ, and OWIC, in handling the retail
customer buy order. The Commission understands that broker-dealers that
carry inventory of fixed income securities may internalize retail
customer buy orders by executing them against internal inventory after
charging a markup. Broker-dealers may use offer quotes resting on
trading venues and/or offer responses to RFQ/OWIC as reference prices
to match or improve (via last-look practice) for the purpose of
internalization.
Only a few retail broker-dealers display external and/or internal
bid quotes of fixed income securities to their self-directed retail
customers or the firm's brokers who handle retail customer orders. To
the extent that these retail broker-dealers display external and/or
internal bid quotes of fixed income securities to their self-directed
retail customers, self-directed retail customers are able to submit
sell orders to execute against bid quotes displayed on their systems.
For a broker-assisted customer sell trade, a broker handling a retail
customer order would typically conduct RFQ or BWIC to collect multiple
bids. A broker would also consider other pricing sources, such as trade
prices, trade prices of similar fixed income securities, bid quotes of
similar fixed income securities, matrix prices, and prices derived from
yield curve in handling the retail customer sell order. For broker-
dealers that carry inventory of fixed income securities, these broker-
dealers may internalize customer sell orders by buying the bond from
their customer into inventory after charging a markdown to have an
opportunity to resell the bond to another customer (earning the bid-ask
spread and markup when the broker-dealer resells the bond to another
customer). In conducting RFQs or BWICs for the purpose of
internalization, the Commission understands that some broker-dealers
may use last-look to apply trade desk spreads (in the form of markdown)
to external bids but not to internal bids, which results in more
favorable comparisons for the internal bids, to win RFQs/BWICs.\501\
---------------------------------------------------------------------------
\501\ See infra Section V.C.1.b for the discussion of last look
practices and application of trade desk spreads.
---------------------------------------------------------------------------
vi. Principal Trading
With respect to fixed income securities trading, principal
transactions \502\ with retail customers, in which broker-dealers
engage, include riskless principal \503\ and internalized
[[Page 5517]]
trades. With limited transparency in the fixed income securities
markets, an internalized trade may represent conflicts of interest
between a broker-dealer and its retail customer because the retail
customer may not be able to assess broker-dealer compensation (e.g.,
markup/markdown). Provided that transaction costs of riskless principal
transactions are disclosed on a post-trade basis in customer
confirmations, these riskless principal transactions represent
potentially fewer conflicts of interest compared to internalization.
When the transaction costs of riskless principal transactions are
disclosed on a pre-trade basis via a markup/markdown schedule, there
would be even fewer conflicts of interest between retail customers and
broker-dealers handling their orders.\504\ A significant portion of
customer trades are executed on a principal basis. Table 18 shows that
87% and 80% of the corporate debt securities and municipal securities
customer par volume trades, respectively, are executed on a principal
basis. Furthermore, Table 18 shows that riskless principal transactions
represent 31% and 48% of principal trades in the corporate debt
securities and municipal securities markets, respectively.\505\ An
academic study has found a persistent increase in the frequency of
riskless principal trades in the corporate debt securities market since
2014.\506\
---------------------------------------------------------------------------
\502\ Principal transactions with retail customers would be
subject to the requirements of the proposed rule 1101(b). See also
supra section IV.E.
\503\ These riskless principal trades would include retail
customer self-directed trades. Some broker-dealers execute self-
directed trades of retail customers on a riskless principal basis
and charge markups/markdowns for their trading services. Retail
customer self-directed trades would not be considered unsolicited
instructions from customers under FINRA Rule 5310.08.
\504\ Some broker-dealers disclose a markup/markdown schedule
broken out by trade size on a pre-trade basis for retail customer
self-directed trading on customer facing websites.
\505\ Principal trading represents a relatively smaller
proportion of retail-sized customer trades in the U.S. Treasury
securities market. Commission analyses show trades executed in an
agency capacity represent approximately 36.7% of all retail-sized
U.S. Treasury securities trades. The commission estimates that
riskless principal trades represent 7.9% of principal trades in the
U.S. Treasury securities market, whereas the share of riskless
principal trades for retail-sized trades is 10.2%.
\506\ See O'Hara and Zhou, supra note 469. The study suggests
that implementation of the Volcker Rule in 2014 led to a large
increase in riskless principal capacity trading, particularly among
bank broker-dealers who are subject to proprietary trading
restrictions under the rule.
Table 18--Fixed Income Dealer Trading Capacity and Trade Size
--------------------------------------------------------------------------------------------------------------------------------------------------------
Panel A: Corporate Debt Securities
---------------------------------------------------------------------------------------------------------------------------------------------------------
Total distinct Trade Par volume (in Par volume
Corporate bond Trade size Type MPIDs Trades percent billions) percent
--------------------------------------------------------------------------------------------------------------------------------------------------------
Dealer Buy................... Retail Trades (<=$100k). Agency................. 446 782,685 7.9 11.82 0.2
Principal.............. 465 1,466,145 14.8 42.63 0.6
Riskless Principal..... 474 553,908 5.6 12.39 0.2
Large Trades (>$100k)... Agency................. 241 163,505 1.6 201.03 2.7
Principal.............. 413 1,596,162 16.1 3,164.41 43.3
Riskless Principal..... 392 183,391 1.8 235.28 3.2
Dealer Sell.................. Retail Trades (<=$100k). Agency................. 338 1,052,845 10.6 18.40 0.3
Principal.............. 460 1,341,692 13.5 47.88 0.7
Riskless Principal..... 475 704,699 7.1 19.71 0.3
Large Trades (>$100k)... Agency................. 475 172,630 1.7 213.28 2.9
Principal.............. 458 1,698,176 17.1 3,140.93 43.0
Riskless Principal..... 474 209,196 2.1 203.39 2.8
-----------------------------------------------------------------------
Total.................... ........................ ....................... ................ 9,925,034 100 7,311 100
--------------------------------------------------------------------------------------------------------------------------------------------------------
Panel B: Municipal Securities
--------------------------------------------------------------------------------------------------------------------------------------------------------
Municipal Trade size.............. Type................... Total distinct Trades Trade Par volume Par volume
bond MPIDs percent (in billions) percent
--------------------------------------------------------------------------------------------------------------------------------------------------------
Dealer Buy................... Retail Trades (<=$100k). Agency................. 331 263,505 5.1 6.49 0.3
Principal.............. 325 737,050 14.4 24.56 1.2
Riskless Principal..... 458 847,353 16.5 24.80 1.2
Large Trades (>$100k)... Agency................. 188 19,119 0.4 7.16 0.4
Principal.............. 284 244,097 4.8 458.28 22.5
Riskless Principal..... 354 138,851 2.7 194.91 9.6
Dealer Sell.................. Retail Trades (<=$100k). Agency................. 237 319,597 6.2 9.28 0.5
Principal.............. 339 1,037,384 20.2 35.86 1.8
Riskless Principal..... 365 817,050 15.9 24.16 1.2
Large Trades (>$100k)... Agency................. 365 34,090 0.7 16.04 0.8
Principal.............. 384 558,594 10.9 1,115.44 54.7
Riskless Principal..... 440 119,447 2.3 123.77 6.1
-----------------------------------------------------------------------
Total.................... ........................ ....................... ................ 5,136,137 100 2,041 100
--------------------------------------------------------------------------------------------------------------------------------------------------------
This table presents summary statistics for dealer trading capacity across corporate (using FINRA TRACE data) and municipal (MSRB RTRS) fixed income
categories from April 1, 2021 through March 31, 2022. We drop all interdealer trades keeping only customer trades from TRACE and RTRS main data files.
We then collapse this file by Buy/Sell indicator, Agency/Principal/Riskless Principal indicator and Trade size bucket. The table reports the total
distinct MPIDs in each group the total trade count (with percentage), total Par volume (with percentage), the weighted markup of riskless principal
trades, and unweighted markup of riskless principal trades. Riskless principal trade indicators are not provided in the main data but are inferred
using trade pairs matched by MPID and trade size over a 15-minute window.
The Commission understands that there may be conflicts of interest
in handling retail customer orders in fixed income securities markets,
which could result in retail customers not receiving the most favorable
prices under
[[Page 5518]]
prevailing market conditions. A broker-dealer that submits an RFQ \507\
on behalf of a retail customer typically has the option of selecting
potential counterparties, from which it is requesting prices, on behalf
of its customer. Applying counterparty filtering or limiting the number
of counterparties in RFQs could result in less competitive prices for
retail customer orders.\508\ An academic study links competitiveness
(i.e., the number of bids and difference between winning and second
best bid) directly to price improvement.\509\ Another market practice
is price matching using the best response to RFQ via ``last look'' or
``pennying'' for the purpose of internalization rather than customer
benefit.\510\ Such practice would discourage market participants from
submitting competitive prices because responders to RFQs are not
compensated for submitting competitive quotes (i.e., selected to
trade).
---------------------------------------------------------------------------
\507\ The Commission understands that, in general, responding to
RFQs is a manual process. Recently, some market participants (e.g.,
large broker-dealers) automated responses to RFQs for small order
sizes.
\508\ While filtering practices might be conducted by broker-
dealer for order execution efficiency purposes (i.e., evaluating
only counterparties who provide firm indications), a broker-dealer
must evaluate any efficiency gains directly against filtering quotes
that may be more favorable to the end customer. Filtering
counterparties to reduce information leakages is likely to produce
little benefit for retail trades.
\509\ See Terrence J. Hendershott, Dmitry Livdan & Norman
Schuerhoff, All-to-All Liquidity in Corporate Bonds, Swiss Finance
Institute Research Paper No. 21-43 (October 27, 2021), available at
https://ssrn.com/abstract=3895270 or https://dx.doi.org/10.2139/ssrn.3895270.
\510\ The Commission understands that such practice is more
common in RFQs on the bid side of the market.
---------------------------------------------------------------------------
(c) Crypto Asset Securities
As discussed Section III.A.3, crypto asset securities, also called
digital asset securities, refer to a range of assets that are issued
and/or transferred using distributed ledger technology and that meet
the definition of a security.\511\ The Commission has provided a
statement regarding broker-dealers engaging in custody and transactions
of crypto asset securities.\512\ Broker-dealers transacting in crypto
asset securities would be subject to the requirements of this
proposal.\513\
---------------------------------------------------------------------------
\511\ See, e.g., Report of Investigation Pursuant to Section
21(a) of the Securities Exchange Act of 1934: The DAO, Exchange Act
Release No. 81207 (July 25, 2017). See SEC v. W. J. Howey Co., 328
U.S. 293 (1946). See Framework for ``Investment Contract'' Analysis
of Digital Assets, available at https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets.
\512\ See supra III.A.3. Since 2013, the Commission has brought
a significant number of enforcement actions against issuers of
crypto asset securities and crypto asset security market
participants. Such enforcement investigations and actions have been
brought for, among other things, violations of the registration
requirements of the Securities Act of 1933 for offers and sales of
crypto assets to the public as securities, violations of the
exchange registration requirements of the Securities Exchange Act of
1934 for operating trading platforms for digital assets that are
securities, and violations of the anti-fraud and other provisions of
Federal securities laws. See, e.g., Crypto Assets and Cyber
Enforcement Actions, available at https://www.sec.gov/spotlight/cybersecurity-enforcement-actions for more information about these
enforcement actions.
\513\ See supra section III.A.3 for criteria of applicability to
crypto asset securities.
---------------------------------------------------------------------------
Because transaction data and other information on the crypto asset
securities market is limited,\514\ the Commission does not have a
complete understanding of market participants' current practices with
respect to order handling and best execution for crypto asset
securities, including the extent to which current practices in the
market for crypto asset securities are consistent with FINRA Rule
5310.\515\
---------------------------------------------------------------------------
\514\ See, e.g., FSOC Report, supra note 95, at 119, which notes
that the digital asset ``ecosystem is characterized by opacity that
creates challenges for the assessment of financial stability risks.
Collection and sharing of data, as appropriate, could help reduce
this opacity.'' See also Raphael Auer et al., supra at note 95
(discussing data gaps in the crypto market).
\515\ As noted in supra Section III.A.3, circumstances have made
it difficult for the Commission to have a full picture of the
current market for crypto assets.
---------------------------------------------------------------------------
Most known, off-chain trading activity for crypto asset securities
occurs on online, openly accessible centralized platforms. These
platforms are typically vertically integrated, combining account
holding and trading services. The prevalence of vertically integrated
trading platforms distinguishes the crypto asset securities market from
other asset markets. These platforms often operate using a centralized
limit order book, similar to exchanges for stocks and futures, but the
volume is not audited or verified in any known manner.\516\ Some
platforms that trade crypto asset securities are domiciled and operated
outside the U.S.\517\ To trade on a centralized crypto asset securities
platform, the only prerequisites for a retail investor are to sign up
for an account with a location-accessible platform and link his or her
bank account or digital asset wallet.\518\
---------------------------------------------------------------------------
\516\ See, for example, Le Pennec, G., Fiedler, I., and Ante,
L., Wash trading at cryptocurrency exchanges, 43 Finance Research
Letters 101982 (2021).
\517\ Some platforms that purport to be located outside of US
nevertheless seek to cater to US customers, among other ways, by
complying with certain requirements set by the CFTC and FinCEN. As
of August 30, 2022, only three of the top 25 trading platforms
(according to CoinMarketCap) have registered FINRA entities. See
CoinMarketCap's Top Cryptocurrency Spot Exchanges, available at
https://coinmarketcap.com/rankings/exchanges/ for further exchange
level information.
\518\ A digital asset wallet is a software, algorithm, or
storage medium to store the public and private keys of the digital
asset transactions. See, for example the definition of wallet in
Cryptocurrencies glossary, Fidelity Investments, available at
https://www.fidelity.ca/en/investor/cryptocurrencies-glossary/.
---------------------------------------------------------------------------
The Commission understands that retail customers represent
approximately 30% of trading in crypto asset securities at the largest
centralized trading platforms.\519\ Instead of trading directly on
centralized platforms, some retail customers may choose to place crypto
asset securities orders with retail businesses, which could be
affiliates of SEC registrants, fintech firms, or even payment
applications.\520\ Those businesses typically route the order flow to
unregistered third-party wholesalers, proprietary traders, or market
makers for execution. Some of them provide zero or low commissions for
trading crypto assets, and obtain all or a significant portion of their
compensation through payments from the wholesalers for directed order
flow. The Commission is not certain how these orders are handled (i.e.,
internalized, routed to centralized platforms, etc.), given the lack of
reporting in the crypto asset securities market. It is possible that
crypto asset wholesalers internalize most of the order flow they
purchased within their own proprietary trading desks and they may route
any remaining order flow perceived to be from informed traders to a lit
(i.e., transparent order book driven) venue.
---------------------------------------------------------------------------
\519\ This estimate comes from two different sources: (1)
disclosures from Coinbase's 2021 10-K filings; and (2) a direct
statement made by Binance US's CEO at the 2022 Georgetown Financial
Market Quality Conference.
\520\ Payment apps allow individuals and businesses to transfer
funds outside of the traditional banking and payment processing
systems. Many of these fintech or payment app entities are not
registered with the Commission in any capacity. Thus, this activity
is not visible to the Commission.
---------------------------------------------------------------------------
The Commission lacks knowledge on the prevalence of broker-dealer
activity in this market and the routing behavior of broker-dealers in
this market. The Commission likewise has limited information about the
pervasiveness of payment for order flow in the crypto asset securities
market.\521\
---------------------------------------------------------------------------
\521\ The Commission understands PFOF rates from wholesalers for
crypto assets are significantly higher than the PFOF rates from
wholesalers for NMS securities.
---------------------------------------------------------------------------
(d) Non-NMS Stock Equity Securities
Non-NMS stock equity securities trade in a market that appears to
be a hybrid of the NMS securities market and the fixed income market.
The non-NMS stock equities market is informally
[[Page 5519]]
referred to as the ``OTC market.'' The securities traded in the non-NMS
stock equities market are typically unregistered equities; however,
many non-NMS equities traded were formerly registered and formerly
exchange listed. Analogous to the fixed income market, there are some
securities which are very liquid, and also many securities that are
difficult to trade. For FINRA members, non-NMS stock equities trading
is subject to FINRA Rule 5310 for execution standards; however, there
are other standards that also affect this market (i.e., state law and/
or platform/venue requirements). Academic studies have found that
differences in regulation can impact market quality.\522\ Trading in
non-NMS stock equities primarily takes place via dealer-to-dealer
trades or on one of several ATSs that specialize in non-NMS stock
equities. In the interdealer market, broker-dealers interact directly
with one another to fill customer orders or manage inventory. ATSs in
the non-NMS stock equities market offer opportunities for broker-
dealers to interact in either a traditional limit order book or in a
negotiation feature somewhat similar to RFQs in fixed income markets.
Some ATSs in this market allow direct participation by any client,
including retail clients; however, as the Commission understands, most
ATSs are accessible only by dealers.
---------------------------------------------------------------------------
\522\ See, e.g., Ulf Br[uuml]ggemann, Aditya Kaul, Christian
Leuz & Ingrid M. Werner, The Twilight Zone: OTC Regulatory Regimes
and Market Quality, 31 Rev. Fin. Stud. 898 (March 2018), available
at https://doi.org/10.1093/rfs/hhx102. The authors find that
increased regulation of OTC trading improves market quality in US
OTC stocks.
---------------------------------------------------------------------------
From the perspective of order handling, retail orders are processed
in a manner very similar to NMS stocks. Retail broker-dealers that
offer the ability \523\ to trade in the non-NMS stock equities market
typically route an order to a wholesaler, who may internalize the
order, or if the broker-dealer is directly connected to a non-NMS stock
equities liquidity source, such as an ATS, may trade in a principal
capacity with the customer. Orders that are not routed to wholesalers
or internalized directly by the retail broker-dealer may be routed to
an ATS to expose the order. From the Commission's analysis of non-NMS
stock equities trades in March 2022, 63.2% of non-institutional trades
were traded in a principal capacity. As noted in this section, some
ATSs allow direct participation of any trader who registers and
connects to their platform. Thus, some retail investors may be able to
access liquidity without the aid of a broker-dealer in this market. In
terms of pricing orders, non-NMS stock equities are not protected by a
trade-through rule. Thus, pricing could be highly variable from one
trade to the next in a given security. The non-NMS stock equities
market is not required by regulation to report individual trades for
public dissemination. This market frequently lacks quotes entirely, or
lacks displayed quotes that are frequently updated. Despite this lack
of mandated transparency, the largest \524\ ATS serving this market
offers pre-trade and post-trade information (e.g., quotes, transaction
prices).\525\
---------------------------------------------------------------------------
\523\ This ability often costs a premium compared to trading in
NMS stocks. Many brokers will still charge commissions for trades in
this market.
\524\ See ATS Transparency Data Quarterly Statistics, FINRA.org,
available at https://www.finra.org/filing-reporting/otc-transparency/ats-quarterly-statistics. This ATS is largest by number
of OTC Stocks traded in Q2 2022. FINRA posts records on a quarterly
basis listing ATSs trading OTC Stocks and the share volume traded on
the ATS.
\525\ See Anna-Louise Jackson, What is the OTC Market?, Forbes
Advisor (Jun. 9, 2022), available at https://www.forbes.com/advisor/investing/otc-market/. See generally, OTC Markets Group, Inc. and
OTC Link ATS, available at https://www.otcmarkets.com/.
---------------------------------------------------------------------------
(e) Institutional Customer Order Handling
The Commission understands that institutional investors generally
use multiple broker-dealers for NMS stock and options trading services.
Institutional broker-dealers typically engage in order splitting when
handling large institutional customer orders, often utilizing SORs to
break up large, institutional ``parent'' orders into multiple smaller
``child'' orders.\526\ It is the Commission's understanding that when
an institutional customer gives a large order to be executed on behalf
of one account (e.g., a single mutual fund or pension fund), it expects
the broker-dealer that handles and executes such large order to do so
in a manner that ensures best execution is provided to the ``parent''
order. In other words, to the extent that a parent order is split into
smaller ``child'' orders, the institutional customer expects the best
execution analysis to evaluate whether the parent order was executed at
the most favorable price possible under prevailing market conditions
according to customer instructions.\527\ A significant portion of
institutional customer orders in NMS stocks and options is not
held.\528\ The Commission understands that institutional customer
orders handled on a not held basis may sometimes be executed based on
customer-specified standards that may prioritize outcomes other than
execution prices, such as reducing the price impact of an order or
matching volume weighted average price (VWAP) over a certain time
horizon. An academic study looked at order routing by institutional
brokers in the equity markets and found that institutional brokers who
route more orders to affiliated ATSs are associated with lower
execution quality in the form of lower fill rates and higher
implementation shortfall costs than institution brokers that route more
orders to non-affiliated ATSs.\529\
---------------------------------------------------------------------------
\526\ The small-sized and mid-sized institutional customer
orders for options are typically routed to electronic order routing
platforms. These platforms allow order entry and provide smart
routers and order and position management. Furthermore, these
platforms offer customized execution algorithms on an order-by-order
basis. See also Tyler Beason & Sunil Wahal, The Anatomy of Trading
Algorithms, (working paper Jan. 21, 2021), available at https://ssrn.com/abstract=3497001 (retrieved from SSRN Elsevier database)
for a discussion of institutional investor parent and child order
handling in NMS stocks.
\527\ See supra note 169.
\528\ An analysis in the Rule 606 Adopting Release 83 FR 58338
(Jan 2019), studied orders submitted from customer accounts of 120
randomly selected NMS stocks listed on NYSE during the sample period
between December 5, 2016 and December 9, 2016, consisting of 40
large-cap stocks, 40 mid-cap stocks, and 40 small-cap stocks. The
analysis found that among the orders received from the institutional
accounts, about 69% of total shares and close to 39% of total number
of orders in the sample are not held orders, whereas among the
orders received from the individual accounts, about 19% of total
shares and about 12% of total number of orders in the sample are not
held orders. See Rule 606 Adopting Release, 83 FR 58393.
\529\ See Anand, supra note 91.
---------------------------------------------------------------------------
With respect to fixed income securities trading, the Commission
understands that institutional investors, such as mutual funds, pension
funds, insurance companies, and banks, in general directly trade with
market participants (e.g., broker-dealers) by accessing RFQs, platform-
wide RFQs, firm quotes, and indicative quotes on trading venues.
Institutional investors generally trade large blocks of fixed income
securities via voice with broker-dealers. Furthermore, the Commission
understands that institutional investors generally use multiple broker-
dealers for trading services. Based on customers' instructions, broker-
dealers may represent institutional customer orders by posting firm
quotes on many-to-many and one-to-many platforms, or conduct RFQs on
behalf of institutional customers.
Institutional investors may utilize third-party vendors to conduct
transaction cost analysis and evaluate the performance of their broker-
dealers based on those reports. If an institutional investor uses
multiple brokers-dealers, it may direct more orders to broker-dealers
that have better performance. This may reduce the
[[Page 5520]]
switching costs for institutional investors related to changing broker-
dealers and increase competition among broker-dealers to attract
institutional orders.
4. Broker-Dealer Services and Revenue
A small subset of broker-dealers hold most customer accounts and
control a significant portion of broker-dealer assets. Table 19 shows
statistics on broker-dealer customers and total assets. Based on FOCUS
data as of Q2 2022, there were approximately 3,498 broker-dealers, 162
of which carry their own customer accounts. These broker-dealers
reported carrying over 240 million public customer accounts. Of the
total population of these broker-dealers, approximately 2,440 reported
retail customer activity.\530\ Of the broker-dealers that reported
retail customer activity, 144 reported carrying their own customer
accounts.\531\ A small set of 23 broker-dealers report more than 50
billion dollars in total assets and 119 report between 1 billion and 50
billion in assets. The majority of broker-dealers have less than 10
million dollars in assets, with 1,613 having less than 1 million
dollars in assets. However, most customer accounts are concentrated in
the 142 large broker-dealers with 1 billion dollars or more in assets:
119 of them are from the category of broker-dealers with assets greater
than 1 billion dollars and less than 50 billion dollars and 23 of them
are from the category of broker-dealers with assets greater than 50
billion dollars. Ninety eight broker-dealers carry non-customer
accounts for other broker-dealers. The majority of these, 66, are large
broker-dealers with 1 billion dollars or more in assets. On average,
they carry accounts for over 50 other broker-dealers.
---------------------------------------------------------------------------
\530\ See item 8080 on FOCUS Report Form X-17A-5 Schedule I for
additional information on the number of reported public customer
accounts.
\531\ Retail sales activity is identified from Form BR, which
categorizes retail activity broadly (by marking the ``sales'' box)
or narrowly (by marking the ``retail'' or ``institutional'' boxes as
types of sales activity). We use the broad definition of sales as we
believe that many firms will just mark ``sales'' if they have both
retail and institutional activity. However, we note that this may
capture some broker-dealers that do not have retail activity,
although we are unable to estimate that frequency.
Table 19--Number of Broker-Dealers and Customer Accounts by Asset Size
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Size of broker-dealer (total assets)
Variable -------------------------------------------------------------------------------------------------------------------------------
>50bn 1bn-50bn 500mn-1bn 100mn-500mn 10mn-100mn 1mn-10mn <1mn Total
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Panel A: All Broker-Dealers
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Number of Broker-Dealers........................................ 23 119 30 136 523 1,054 1,613 3,498
Number of Broker-Dealers Registered as Investment Advisers...... 11 22 4 35 95 179 134 480
Number of Broker-Dealers with Investment Adviser Affiliate...... 19 74 17 87 274 401 445 1,317
Number of Broker-Dealers Carrying Own Customer Accounts......... 19 59 8 22 26 21 7 162
Total Number of Public Customer Accounts........................ 75,834,917 153,216,558 6,045,929 3,555,383 606,606 887,833 6,668 240,153,894
Total Number of Omnibus Accounts................................ 421,583 525 12 4 33 19 0 422,176
Number of Broker-Dealers Carrying Non-Customer Accounts......... 18 48 7 9 11 5 0 98
Avg Number Other Broker-Dealers Carrying Customer Accounts For 57.5 50.7 30.5 9.0 2.5 1.0 .............. ..............
Fully Disclosed Basis..........................................
Avg Number Other Broker-Dealers Carrying Accounts for Omnibus 19.2 26.3 15.3 3.5 2.5 .............. 1.0 ..............
Basis..........................................................
-------------------------------------------------------------------------------------------------------------------------------
Panel B: Retail Broker-Dealers
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Number of Retail Broker-Dealers................................. 19 76 21 109 393 750 1,072 2,440
Number of Broker-Dealers Registered as Investment Advisers...... 11 21 4 34 92 171 128 461
Number of Broker-Dealers with Investment Adviser Affiliate...... 17 56 12 76 228 331 350 1,070
Number of Broker-Dealers Carrying Own Customer Accounts......... 18 51 7 20 22 19 7 144
Total Number of Public Customer Accounts........................ 75,829,888 142,899,902 6,012,125 2,641,879 606,447 880,021 6,668 228,876,930
Total Number of Omnibus Accounts................................ 421,583 524 12 1 33 15 0 422,168
Number of Broker-Dealers Carrying Non-Customer Accounts......... 17 44 7 8 8 5 0 89
Avg Number Other Broker-Dealers Carrying Customer Accounts For 60.9 55.4 30.5 8.0 2.0 1.0 .............. ..............
Fully Disclosed Basis..........................................
[[Page 5521]]
Avg Number Other Broker-Dealers Carrying Accounts for Omnibus 19.2 28.5 15.3 2.0 2.5 .............. 1.0 ..............
Basis..........................................................
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
This table summarizes the number broker-dealers (Panel A) and retail broker-dealers (Panel B), their investment adviser status, their customer account carrying status, and the number of
customer and omnibus accounts they carry broken out into groups based on their total assets. The number of Broker-dealers comprises the broker-dealers that had a valid FOCUS Report for Q2
2022 and a valid Form Custody and Form BD for Q2 2022. Total Assets are estimated by Total Assets (allowable and non-allowable) from Part II/IIA of the FOCUS filings (Form X-17A-5 Part II/
IIA) from Q4 2021 and correspond to balance sheet total assets for the broker-dealer. The numbers of public and omnibus accounts are from FOCUS Schedule I from Q4 2021. Broker-dealer
registration as an investment adviser is from Form Custody from Q2 2022 and includes broker-dealers that are registered as an investment adviser with the Commission or with a state. Broker-
dealers carrying customer accounts and non-customer accounts is identified from Form Custody from Q2 2022. Average number of other broker-dealer carrying accounts on a fully disclosed or
omnibus basis is the average number of other broker-dealers for which a broker-dealer carrying non-customer accounts holds accounts for and it is determined from Form Custody from Q2 2022.
Retail brokers are identified based on retail sales activity from Form BR in Q2 2022, which categorizes retail activity broadly (by marking the ``sales'' box) or narrowly (by marking the
``retail'' or ``institutional'' boxes as types of sales activity). We use the broad definition of sales as we believe that many firms will just mark ``sales'' if they have both retail and
institutional activity. However, we note that this may capture some broker-dealers that do not have retail activity, although we are unable to estimate how often it does so.
A small number of broker-dealers with more than 1 billion dollars
in revenue account for the majority of broker-dealer assets, revenue,
and expenses. Table 20 shows statistics on total assets, total
revenues, total expenses, and net income based on broker-dealer asset
size. The top 23 brokers, each with assets over $50 billion, have more
than 3.8 trillion dollars in assets out of a total of 5.4 trillion
dollars across all broker-dealers. The top 142 brokers account for the
majority of revenue, earning over 71 billion dollars in Q2 2022 out of
total of 97 billion dollars for all broker-dealers. Similarly, the top
142 broker-dealers accounted for the majority of expenses and net
income.
Table 20--Assets, Revenue and Expenses of Broker-Dealers by Asset Size
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Size of broker-dealer (total assets)
Variable Statistic ---------------------------------------------------------------------------------------------------------------------
>50bn 1bn-50bn 500mn-1bn 100mn-500mn 10mn-100mn 1mn-10mn <1mn
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Total Number of Broker-Dealers 23 119 30 136 523 1,054 1,613
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Total Assets ($1,000s)................... Mean........................... $168,631,851 $12,226,934 $737,161 $207,753 $34,340 $3,580 $299
Median......................... $85,750,282 $6,628,584 $737,598 $181,812 $25,645 $2,757 $207
Total.......................... $3,878,532,570 $1,455,005,108 $22,114,818 $28,254,392 $17,959,877 $3,773,694 $481,530
---------------------------------------------------------------------------------------------------------------------
Total Revenue ($1,000s).................. Mean........................... $1,495,923 $315,344 $84,500 $76,247 $17,310 $2,622 $378
Median......................... $841,321 $81,517 $25,232 $30,703 $7,638 $1,396 $99
Total.......................... $34,406,232 $37,525,938 $2,535,011 $10,369,565 $9,036,076 $2,695,264 $508,546
---------------------------------------------------------------------------------------------------------------------
Total Expenses ($1,000s)................. Mean........................... $1,263,904 $283,825 $75,088 $66,749 $15,760 $2,349 $293
Median......................... $973,919 $67,638 $22,577 $25,153 $6,213 $1,064 $78
Total.......................... $29,069,788 $33,775,125 $2,252,648 $9,077,875 $8,242,340 $2,473,435 $470,898
---------------------------------------------------------------------------------------------------------------------
Net Income ($1,000s)..................... Mean........................... $219,406 $30,564 $12,941 $9,243 $1,470 $206 $24
Median......................... $33,372 $5,377 $4,553 $3,032 $417 $29 -$6
Total.......................... $5,046,337 $3,637,137 $388,236 $1,257,046 $769,031 $217,453 $37,856
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
This table estimates average, median and total values for broker-dealer assets, total revenue, total expenses, and net income broken out into groups based on their total assets. Number of
Broker-dealers is based on the broker-dealers that had a valid FOCUS Report for Q2 2022. Statistics for Total Assets (allowable and non-allowable), Total Revenue, Total Expenses, and Net
Income (after Federal income taxes) are computed from the corresponding items in Part II and Part IIA of the FOCUS filings (Form X-17A-5 Part II/IIA) from Q2 2022.
From the perspective of the number of individual customer accounts,
the broker-dealer market appears to be somewhat concentrated, with the
top four brokers handling about 106 million accounts, equal to 44% of
the industry, while the top eight firms have about 159 million
accounts, or 66% of the industry. From the perspective of total assets,
the level of concentration is slighter lower, with the top four
brokerages having a total of around $2.1 trillion, equal to 39% of all
assets held by broker-dealers, and the top eight firms about $2.8
trillion, or 52% of total industry assets. The broker-dealer industry
looks less concentrated from the perspective of revenue, with the top
four firms earning more than $18 billion, or 19% of the market, and the
top eight firms earning $28 billion, or 29% of total industry revenues.
Table 21--Broker Dealer Market Concentration--Assets, Revenues, and Customer Accounts
----------------------------------------------------------------------------------------------------------------
Total assets Total revenue
(1,000s) (1,000s) Customer accounts
----------------------------------------------------------------------------------------------------------------
4-firm total........................................ $2,112,685,000 $18,039,203 106,463,445
8-firm total........................................ $2,834,007,000 $28,402,354 158,609,487
All broker dealers.................................. $5,406,121,988 $97,076,632 240,153,894
4-firm concentration................................ 39.08% 18.58% 44.33%
[[Page 5522]]
8-firm concentration................................ 52.42% 29.26% 66.04%
----------------------------------------------------------------------------------------------------------------
This table uses FOCUS data analyzed in the previous table to calculate the market share of broker dealers based
on firm total assets, total revenue, and customer accounts. The sum of the top four and eight firms for each
of these variables is compared to the sum of all broker dealers for each of these three variables (assets,
revenue, total accounts) that submitted a Form FOCUS PART II for Q2 2022. Total accounts are from FOCUS Report
Schedule I for Q4-2021.
There is significant variation in the sources of broker-dealer
revenue. Table 22 reports sources of broker-dealer revenue along with
the revenue as a percentage of the broker-dealer's total revenue in Q1
2022. A broker-dealer reports a source of revenue on its supplemental
statement of income (SSOI) if it is more than 5% of its total revenue.
Larger broker-dealers tend to have more diversified sources of revenue
than smaller broker-dealers, with the majority of broker-dealers with 1
billion or more in assets reporting earning revenue in a number of
categories. Smaller broker-dealers appear to earn more of their revenue
from a limited number of sources, with some broker-dealers with under
10 million dollars in assets on average earning more than 50% of their
revenue from one source. Larger broker-dealers appear to earn more
money from fees and interest, rebate, and dividend income. Smaller
broker-dealers appear to earn more money from fees and commissions and
other revenue sources.
Table 22--Sources of Broker-Dealer Revenue as a Percentage of Broker-Dealer Total Revenue by Asset Size
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Size of Broker-Dealer (Total Assets)
Revenue source Statistic ---------------------------------------------------------------------------------------------------------------
>50bn 1bn-50bn 500mn-1bn 100mn-500mn 10mn-100mn 1mn-10mn <1mn
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Total Broker-Dealers Reporting Revenue 21 100 27 127 511 1,042 1,588
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Total Commissions............................ Count............................ 18 69 21 86 299 518 428
Mean............................. 10.75% 4.28% 26.47% 27.05% 30.03% 29.40% 26.48%
Revenue from Sale of Investment Company Count............................ 11 33 6 54 166 305 375
Shares. Mean............................. 0.79% 3.53% 0.40% 6.97% 6.41% 6.39% 13.80%
Total Revenue From Sale of Insurance Based Count............................ 9 34 5 44 145 278 320
Products. Mean............................. 0.22% 3.08% 7.65% 17.10% 24.81% 22.93% 30.67%
Total Net Gains or Losses on Principal Count............................ 18 80 19 66 201 224 86
Trading. Mean............................. 4.40% 7.81% 16.42% 3.76% 20.16% 29.47% 50.26%
Capital Gains (Losses on Firm Investments)... Count............................ 8 42 11 43 123 189 141
Mean............................. -3.10% -3.41% 14.38% -7.26% -4.97% 19.70% 5.34%
Total Interest/Rebate/Dividend Income........ Count............................ 21 90 22 109 370 604 520
Mean............................. 43.20% 31.27% 14.99% 5.42% 4.54% 2.68% 14.05%
Total Revenue From Underwritings and Selling Count............................ 17 65 12 62 187 272 231
Group Participation. Mean............................. 9.49% 10.67% 14.94% 18.03% 37.33% 39.07% 46.40%
Total Fees Earned............................ Count............................ 19 82 24 114 434 812 897
Mean............................. 32.01% 37.00% 42.37% 58.92% 52.46% 56.79% 69.35%
Other Revenue................................ Count............................ 17 75 18 85 307 513 469
Mean............................. 3.37% 1.20% 2.88% 8.96% 7.47% 16.93% 30.82%
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
This table estimates the number of broker-dealers reporting different sources of revenue and the average percentage of the reported revenue source as a percentage of broker-dealer total
revenue for Q2 2022 broken out into groups based on the broker-dealer's total assets. The different sources of revenue and total revenue are reported by each broker-dealer during Q2 2022 in
their FINRA Supplemental Statement of Income Form (Form SSOI). Form SSOI does not require a broker-dealer to report a revenue or expense section source if the revenue or expenses for that
section is less than the greater of $5,000 or 5% of the broker-dealer's total revenue or total expenses, as applicable. Total Assets are estimated by Total Assets (allowable and non-
allowable) from Part II of the FOCUS filings (Form X-17A-5 Part II) from Q2 2022 and correspond to balance sheet total assets for the broker-dealer.
Retail brokers compete for customers by providing a range of
services that assist their clients in transacting in securities
including stocks, bonds, mutual funds, ETFs, options, futures, and
crypto asset securities. Retail broker services can broadly be divided
into ``discount brokers'' and ``full-service'' brokers. Discount
brokers typically provide commission-free trading for online purchases
of stocks and ETFs, but often charge fees for purchases of other
securities, such as mutual funds, options, and futures. Some discount
brokers' affiliates manage proprietary mutual funds and ETFs, which
earn them management fees paid by the investors that purchase these
funds. Compared to discount brokers, ``full-service'' brokers charge
higher commissions that may include compensations for other services,
such as investment research and personalized financial guidance.
Some brokers seek to differentiate themselves from other broker-
dealers by providing increased access to crypto asset securities
futures, forex, or fractional share trading. Brokers also distinguish
themselves by the accessibility and functionality of their trading
platform, which can be geared towards less experienced or more
sophisticated investors. Discount retail brokers can also differentiate
themselves by providing more extensive customer service as well as
tools for research and education on financial markets. Full-service
brokers compete by developing a personalized broker-customer
relationship and providing guidance based on the detailed knowledge of
the customer's financial goals.
Broker-dealers may incur costs \532\ or earn rebates in seeking to
fill their
[[Page 5523]]
customers' orders. These costs and rebates may be passed on to
customers in whole or in part. Some of these costs are indirect: an
illiquid or unlisted security may require the broker to search for
liquidity either by attempting multiple routings to find a
counterparty, or by contacting broker-dealers that may formally (in
association with an ATS that specializes in unlisted securities) or
informally make markets in unlisted or hard to trade securities. For
some unlisted securities, there may be no market maker expected to
continually provide two-sided quotes.
---------------------------------------------------------------------------
\532\ Some exchanges pay rebates to orders that either provide
or remove liquidity from their limit order books. Some trading
venues charge fees to one or both counterparties to the trade.
---------------------------------------------------------------------------
C. Economic Effects and Effects on Efficiency, Competition, and Capital
Formation
The Commission preliminarily believes that the proposed
requirements with respect to introducing brokers could result in better
execution quality for retail customer orders to the extent that the
proposal leads to changes in broker-dealers' order handling practices.
Furthermore, the proposal would enable the Commission to exercise
additional enforcement capabilities \533\ that the Commission believes
would enhance investor protection and improve specific deterrence.\534\
The Commission also believes that the documentation requirement with
respect to conflicted transactions could help enhance regulatory
oversight, as well as promote broker-dealer compliance, and thus,
improve investor protection to the extent that the documented
information includes information or data that is not currently
documented nor available through public or regulatory data sources.
However, the Commission lacks detailed data on broker-dealers' current
order handling practices and documentation practices that would allow
it to predict the extent of changes as a result of this proposal.\535\
The Commission therefore cannot ascertain the extent to which these
benefits would be realized, as discussed below.
---------------------------------------------------------------------------
\533\ This full complement of enforcement capabilities is not
available to the Commission to enforce FINRA rules.
\534\ See also infra section V.C.1.
\535\ Considering broker-dealers are diverse in business models
and practices, the Commission lacks quantifiable data that
summarizes how order handling data are currently documented, which
might serve as a baseline in assessing the effects of the proposed
rule. While CAT includes routing data for NMS securities, no similar
database exists for fixed income or other assets covered by the
proposed rules. Although the Commission could discuss current
routing practices through an analysis of CAT data, it would not
capture the information set that a broker-dealer evaluated in making
its routing decisions, such as what pricing information it had when
it made the routing choice, what venues were considered for the
order, or why those venues were considered for the order. The
Commission also has no information regarding the broker-dealer's
assessment as to how the specific customer and order characteristics
affected its decision to handle a customer order in a certain way.
Based on its experience, the Commission believes that some larger
broker-dealers already maintain documentation on their transactions
that exceeds what would be required under the proposed rules, but
the Commission does not know the extent to which other broker-
dealers also maintain such documentation. Consequently, some broker-
dealers would incur fewer costs (and their compliance would result
in fewer benefits) than others.
---------------------------------------------------------------------------
The Commission preliminarily believes that the proposal would
result in costs associated with reviewing, updating, and establishing
policies and procedures, and to the extent that the proposal leads to
changes in broker-dealers' order handling practices, could result in
costs associated with implementing changes to order handling practices
according to the updated policies and procedures. The proposed
requirements for broker-dealers that engage in conflicted transactions
could result in further changes to order handling practices, but the
extent of those changes is unknown. Due to the diversity of broker-
dealer business models and operations and the lack of quantifiable data
on how practices vary across broker-dealers, the Commission cannot
reasonably estimate how many of these broker-dealers would choose to
de-conflict \536\ to avoid the costs associated with the proposed
requirements that apply solely to conflicted transactions.
---------------------------------------------------------------------------
\536\ To de-conflict, a broker-dealer might need to deal with
the treatment of exchange rebates, payment for order flow, or the
nature of its executing brokers' business (i.e., principal versus
agency capacity), among other factors.
---------------------------------------------------------------------------
The Commission preliminarily believes that the proposal could
promote competition in the market for trading services (e.g.,
exchanges, ATSs, non-ATS trading venues) and also in the market for
market access. However, the Commission believes that the proposal could
have mixed effects on competition in the market for broker-dealer
services. While it could promote competition among broker-dealers,
especially on the basis of execution quality, it could also result in
higher barriers to entry and potential exit of small broker-dealers.
The Commission assesses the economic effects of the proposed
amendments in NMS stocks relative to a regulatory baseline in NMS
stocks that includes the implementation of the MDI Rules.\537\
Furthermore, the Commission's analysis reflects the Commission's
assessment of the anticipated economic effects, including potentially
countervailing or confounding economic effects from the MDI Rules in
NMS stocks.\538\ However, given that the MDI Rules have not yet been
implemented, they have not affected market practice and therefore data
that would be required for a comprehensive quantitative analysis of the
economic effects in NMS stocks that includes the effects of the MDI
Rules is not available. It is possible that the economic effects in NMS
stocks relative to the baseline could be different once the MDI Rules
are implemented.
---------------------------------------------------------------------------
\537\ See supra section V.B.3.(a).d.
\538\ See id. for a discussion of the Commission's anticipated
economic effects of the MDI Rules as stated in the MDI Adopting
Release.
---------------------------------------------------------------------------
1. Benefits
The Commission preliminarily believes the proposal, which
incorporates and goes beyond the existing best execution regulatory
regime set forth by FINRA and MSRB, could promote investor protection
(e.g., better execution quality for retail customer orders) by
facilitating regulatory oversight and enforcement.\539\ The Commission
believes that benefits could result from, among other things, the
requirements with respect to introducing brokers, the documentation
requirements for conflicted transactions, and additional enforcement
capabilities of the Commission.
---------------------------------------------------------------------------
\539\ See the discussion of enforcement mechanisms in supra
section V.B.1.(a). In enforcement situations limited to violations
of proposed Regulation Best Execution, the Commission would gain the
ability to (i) obtain civil money penalties against defendants in
injunctive actions; (ii) order respondents to cease-and-desist and
obtain related relief and sanctions; and (iii) in situations limited
to violations of proposed Regulation Best Execution involving
broker-dealers and associated persons that would not potentially be
subject to MSRB best execution rules, obtain relief available under
Sections 15(b)(4) and (6).
---------------------------------------------------------------------------
The Commission preliminarily believes that the proposal would
enhance investor protection and improve retail customer order execution
quality to the extent that the proposal improves broker-dealers' order
handling practices. Specifically, broker-dealers could improve their
customer order handling practices, resulting from documentation,
updates and reviews of both existing and the best execution policies
and procedures that would be required under the proposal including the
reductions in conflicts of interest when handling retail customer
orders. The Commission also believes the proposal would enhance
investor protection by enabling the Commission to exercise additional
enforcement capabilities and improving specific deterrence through the
ability to bring
[[Page 5524]]
injunctive actions for violations of this rule, issue cease-and-desist
proceedings for allegations of violations of this rule, and, among
other things, order remedial actions and sanctions against a broader
group of registered persons pursuant to Exchange Act Section 15(b)(4)
for willful violations of this rule. Furthermore, improvements in
investor protection could result from increased documentation
requirements for conflicted transactions, particularly in fixed income
and thinly traded non-NMS stock equity securities. The extent of this
improvement depends on whether the documented information include
information or data that is neither currently documented nor available
through public or regulatory data sources. The proposed documentation
requirement would help facilitate the Commission's and SRO's
enforcement and examinations, as well as promote broker-dealer
compliance, and thus, result in better investor protection.
The Commission preliminarily believes the proposal could lead to
changes in order handling practices, and in turn, improve the execution
quality of retail customer orders, through four mechanisms. First, the
proposal would require that introducing brokers that route their orders
to executing brokers compare that broker's execution quality to what
might have been received from competing executing brokers.\540\ The
Commission believes that some broker-dealers that currently rely on
executing brokers already compare their executing broker's execution
quality to the execution quality of competing executing brokers, so
these broker-dealers are unlikely to be affected by this element of the
proposal. Introducing brokers that do not currently implement rigorous
comparison of executing brokers are expected to adjust their routing
practices in response to this newly required analysis, or justify in
their policies and procedures how they fulfill their best execution
duties in light of these analyses. Because FINRA's and MSRB's current
policies and procedures requirements do not require this level of
detail, the Commission cannot ascertain how many brokers already
conduct such a comparison with alternative executing brokers and how
many would need to make adjustments. However, any such adjustments
could improve the execution quality that retail customers receive for
their orders.
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\540\ While FINRA Rule 5310.09(c) allows an introducing broker,
instead of conducting its own regular and rigorous review, to review
the methodology and results of its executing broker's regular and
rigorous review of its execution quality on a quarterly basis, it
does not specifically require the introducing broker to compare the
execution quality of its executing broker to what it would have
received from other executing brokers. See supra section V.B.2.(a)
for a discussion on introducing broker best execution review
requirements. See also FINRA Rule 5310.09(c), Regular and Rigorous
Review of Execution Quality.
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Second, the Commission preliminarily believes that the proposal's
heightened standards for conflicted transactions could lead to improved
prices for retail customers.\541\ Under the proposal, broker-dealers
that handle retail customer orders and that choose to accept PFOF, to
participate in transactions on a principal basis, or to route to
affiliated broker-dealers that execute orders would be subject to
heightened standards. In response to this proposed requirement, the
Commission believes that some broker-dealers that route to executing
broker dealers that engage in conflicted transactions could seek to
remove such conflicts, for example by no longer accepting payment for
order flow or selecting executing brokers that do not execute on a
principal basis.\542\ The Commission also believes that executing
brokers (e.g., wholesalers) in NMS stocks and options could adjust
their order handling practices under the proposal in anticipation of
increased execution quality analysis by retail broker-dealers, from
whom they receive order flow. These executing brokers in NMS stocks and
options that routinely pay for retail order flow and/or engage with it
on a principal basis could adjust their order handling practices to
access additional venues to seek midpoint liquidity, additional price
improvement, or offer more price improvement to the orders routed by
those retail broker-dealers.\543\ Although the Commission cannot
quantify the degree of reduction in conflicted transactions that would
occur under the proposal because it cannot predict how individual
broker-dealers would adjust their business models to comply with the
proposal, the Commission preliminarily believes that any resulting
reduction in conflicted transactions could improve the prices retail
customers realize for their transactions. That said, the Commission
acknowledges that some retail customers could pay more for their
transactions when in reducing its conflicted transactions, a broker-
dealer changes order handling practices to route to destinations, which
may not always provide the same price improvement that was previously
realized for conflicted transactions.
---------------------------------------------------------------------------
\541\ See supra section IV.C about the discussion for the
requirements involving conflicted transactions for retail orders and
supra sections V.C.2.a and V.C.2.b.i describing the conflicts of
interest in retail order handling.
\542\ See infra section V.C.2 for the discussion about costs of
broker-dealer efforts to de-conflict versus comply with requirements
of conflicted transactions.
\543\ See infra section V.C.2.b for the discussion of wholesaler
costs with respect to conflicted transactions.
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Third, the Commission preliminarily believes the proposal could
result in better execution quality for retail customer orders to the
extent that the proposal leads to changes in broker-dealers' order
handling practices. Compared to the FINRA and MSRB rules, the
Commission believes that the proposal would require greater specificity
in the policies and procedures with respect to best execution. Upon
reviewing its existing policies and procedures, a broker-dealer could
be required to update its policies and procedures to comply with the
proposed requirements. To the extent that updated policies and
procedures would require corresponding changes in order handling
practices, the broker-dealer would adjust its order handling practices
for retail customer orders. The Commission acknowledges that many
broker-dealers currently may have order handling practices that are
consistent with the requirements under the proposed Rule 1101(a).\544\
In this case, the Commission does not expect the order handling
practices of these broker-dealers to change.\545\ On the other hand,
many broker-dealers could be required to adjust order handling
practices, including conducting more detailed reviews of their
practices, under the proposal. However, the Commission lacks detailed
information on broker-dealers' current policies and procedures with
respect to best execution standards and order handling practices to
determine how many broker-dealers would be required to change their
order handling practices under the proposal.\546\
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\544\ See infra section IX for proposed Rule 1101(a).
\545\ As previously discussed in supra section IV.B, the factors
that must be included in a broker-dealer's policies and procedures
under proposed Rule 1101(a) are generally consistent with the
factors that FINRA and the MSRB have identified as relevant to a
broker-dealer's best execution determinations.
\546\ See supra note 535 for the discussion about data
availability on broker-dealers' current order handling practices.
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Fourth, the Commission preliminarily believes that the proposal
could help ensure the effectiveness of broker-dealers' best execution
policies and procedures, and thus, result in better execution quality
for retail customer orders to the extent that the requirements under
the proposed Rule 1102 enhances broker-dealers' current review process
with respect to order
[[Page 5525]]
handling practices. The Commission acknowledges that many broker-
dealers currently may conduct reviews that are consistent with the
requirements under the proposed Rule 1102, which includes a specific
requirement to review order handling practices. In this case, the
Commission does not expect the order handling practices of these
broker-dealers to change, and there would thus be no change in
execution quality for their retail customer orders.
The Commission does not believe that the order handling practices
or execution quality of institutional customer orders would be
significantly impacted by the proposal. The Commission understands that
institutional customers often utilize multiple broker-dealers in the
handling of their orders, which lowers the costs of switching brokers
if they exhibit poor execution quality. Furthermore, in general, the
Commission believes that there is less conflict in institutional
customer order handling because institutional customers have better
access (compared to retail customers) to data, which they utilize to
monitor and analyze the execution quality that various broker-dealers
offer.\547\ The Commission believes that (compared to retail brokers)
institutional monitoring and lower switching costs encourage broker-
dealers to provide increased execution quality in order to compete to
attract institutional orders. Thus, the Commission does not expect that
broker-dealers would make significant adjustments to their order
handling practices for institutional customer orders under the
proposal.
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\547\ The Commission understands that institutional customers
also utilize third-party vendors to conduct transaction cost
analysis and evaluate the performance of their broker-dealers based
on those reports. See also supra section V.B.3.e) for a discussion
about institutional customer order handling practices.
---------------------------------------------------------------------------
(a) NMS Stocks and Options
The Commission preliminarily believes the proposed documentation
requirement with respect to conflicted transactions could result in
benefits in the NMS stock and options markets. However, a significant
amount of information that would help reconstruct market conditions
(e.g., NBBO, size at NBBO, trade prices, volume, order level
information in CAT) around the time of conflicted transactions is
currently available through public and regulatory data sources (e.g.,
SIP, CAT, OPRA), so those benefits may be small. To the extent that the
documented information includes information that is not currently
documented nor available through public or regulatory data sources ,
the proposed documentation requirement would help promote broker-dealer
compliance and facilitate enforcement and examination, and thus, result
in better investor protection. Furthermore, the Commission believes
that any additional documentation could enhance internal review process
(e.g., a review by the best execution committee). Documented
information could inform broker-dealers in adjusting order handling
procedures with respect to conflicted transactions, which would result
in better execution quality.
The Commission preliminarily believes that retail customer
execution prices in NMS stocks and options could improve to the extent
that there is a trade-off between the amount of PFOF a retail broker
receives and the price improvement, which wholesalers provide to its
customers' orders.\548\ Under the proposal, retail broker-dealers
accepting PFOF would be subject to the proposed Rule 1101(b), which
would require a broker-dealer to establish additional policies and
procedures and retain certain documentation with respect to conflicted
transactions.\549\ The proposed Rule 1101(b) would also require them to
document any arrangement, whether written or oral, concerning PFOF,
including the parties to the arrangement, all qualitative and
quantitative terms concerning the arrangement, and the date and terms
of any changes to the arrangement. Additionally, broker-dealers that
accept PFOF would not qualify as introducing brokers under the proposed
Rule 1101(d), which otherwise would permit these broker-dealers to rely
on their executing broker's compliance with the proposed Rules 1101(a),
(b), and (c).\550\ Some broker-dealers, particularly those with
business models that do not rely extensively on payment for retail
order flow, could elect to pass any PFOF on to customers rather than
complying with provisions of the proposal that apply only to broker-
dealers that do not qualify for the relief provided to introducing
brokers.\551\
---------------------------------------------------------------------------
\548\ See supra section V.B.3.(a).b.
\549\ See supra section IV.C.
\550\ Under proposed Rule 1101(d), principal trades by an
executing broker with the introducing broker's customer to fill
fractional share orders in NMS stocks would be considered to be
handled on an agency basis, and thus, allow it to rely on its
executing broker's compliance with the proposed Rules 1101(a), (b),
and (c). See supra section IV.E. for a discussion on proposed Rule
1101(d) and supra section V.B.3.(a).i.d for additional discussion on
fractional share orders in NMS stocks.
\551\ As explained in supra note 183, when all payment for order
flow for a customer order from a particular market is passed through
to the customer and the broker-dealer retains no part of the payment
for order flow associated with that customer order, the broker-
dealer would not be engaging in a conflicted transaction under
proposed Rule 1101(b) with respect to that customer order. See also
infra section V.C.2.a for the discussion about the costs of broker-
dealer efforts to de-conflict versus comply with requirements of
conflicted transactions.
---------------------------------------------------------------------------
The requirement for a broker-dealer to engage in additional due
diligence if it engages in a conflicted transaction for or with a
retail customer order could improve execution quality to the extent the
requirement promotes competition between broker-dealers to provide best
execution to retail broker-dealers that continue to accept PFOF.
Because the proposal would require these retail broker-dealers to
document their compliance with the best execution standard for
conflicted transactions, including all efforts to enforce their best
execution policies and procedures for conflicted transactions and the
basis and information relied on for their determinations that such
conflicted transactions would comply with the best execution standard,
broker-dealers that pay for order flow could be incentivized to both
improve the execution prices of orders routed to them for execution and
to provide more information to broker-dealers routing to them, allowing
those broker-dealers to improve their customers' execution prices and
more easily comply with the provisions of the proposal that require
more extensive documentation of their best execution standards.
To the extent broker-dealers that receive PFOF change their order
handling practices to comply with the heightened standards in the
proposal, these changes are likely to reduce the profitability of their
business model because the orders they are routing may be more likely
to be executed on venues that charge for providing liquidity, or do not
provide compensation for order flow, or that provide compensation that
is less than what these broker-dealers could realize by internalizing
order flow, or routing elsewhere under existing procedures. Faced with
potentially lower revenues from changing order handling procedures,
broker-dealers that pay to receive order flow could choose to make few
or no changes to their routing practices and could instead focus on
maintaining arrangements with specific broker-dealers \552\ (from whom
they are already
[[Page 5526]]
receiving orders or could determine that their current PFOF arrangement
meets the requirements under the proposal) to meet their obligations
under the proposal without significant changes. Some broker-dealers
that make payments for order flow could compete on the basis of
providing service and information to their broker-dealer customers that
help those broker-dealers satisfy their own requirements under the
proposal, such as providing additional information on routing practices
and data on how they provide the best execution possible. Competition
between these broker-dealers could foster innovation that improves
prices received by retail customer orders executed under PFOF
agreements.
---------------------------------------------------------------------------
\552\ See infra section V.C.2.a for the discussion of how
broker-dealers who route to other broker-dealers for execution may
choose to comply with the proposal. The Commission recognizes that
it is possible under the proposal that these broker dealers would
reduce their payments for order flow because broker-dealers who
route orders to them may choose to stop accepting PFOF in order to
meet the definition of ``introducing broker'' in proposed Rule
1101(d). However, the Commission preliminarily believes this would
not increase the profitability of broker-dealers that currently pay
to receive order flow because presumably their payments to secure
order flow are less than the profits they earn to execute that order
flow often in a principal capacity.
---------------------------------------------------------------------------
With respect to listed options, the Commission preliminarily
believes that retail order execution quality could improve to the
extent that the proposal results in broker-dealers adjusting their
customer order handling practices consistent with the heightened
standards required of conflicted transactions.\553\ Some broker-dealers
that handle retail options orders and engage in conflicted
transactions, such as executing orders on a principal basis or routing
to affiliates, may adjust their routing practices to access additional
venues or consider additional opportunities for price improvement. This
could be driven both by the requirements of proposed Rule 1101(b) to
consider additional opportunities for price improvement and in
anticipation of increased execution quality analysis by other broker-
dealers, for whom they route orders. For example, these broker-dealers
may adjust their routing practices to further consider the
possibilities of exposing a smaller customer order of 5 contracts or
less for price improvement opportunities in auctions or look for
liquidity within the NBBO spread instead of routing the customer order
to a venue that would allow a market maker to internalize 100% of a
given customer order with 5 contracts or less on the limit order book
at the best displayed prices without competition from other liquidity
providers.\554\ Additionally, broker-dealers may route more customer
orders to price improvement auctions that are more competitive rather
than ones that provide the broker-dealer a better chance at
internalizing a larger share of the customers' orders. Furthermore,
with regards to non-marketable limit orders, broker-dealers may
consider routing more orders to exchanges that have higher likelihood
of executions in the form of fill rates and average shorter time to
execution rather than to the exchanges that pay the highest liquidity
rebates.
---------------------------------------------------------------------------
\553\ See supra section IV.C about the discussion for the
requirements involving conflicted transactions for retail orders and
supra Sections V.C.2.a and V.C.2.b.i describing the conflicts of
interest in retail order handling.
\554\ See supra section V.B.3.(a).ii for discussion of the
handling of retail orders in the options markets.
---------------------------------------------------------------------------
(b) Fixed Income Securities
The Commission preliminarily believes that the proposed
documentation requirement with respect to conflicted transactions could
facilitate regulatory oversight and enforcement and promote broker-
dealer compliance with best execution standards, promoting investor
protection in the fixed income securities markets. For introducing
brokers that utilize trading services of executing brokers, the
requirement to review and compare execution quality of various
executing brokers could result in better execution quality for retail
customer trades to the extent that brokers choose to change their
executing brokers to those that offer better execution quality. In
general, the proposal would improve execution quality to the extent
that the proposal results in enhancements to broker-dealers' order
handling procedures. The extent to which customer order execution
quality would improve depends on how many and to what extent broker-
dealers would adjust their order handling procedures as a result of
this proposal. However, the Commission cannot ascertain the extent to
which this benefit would be realized because the Commission lacks data
on how many broker-dealers would change order handling procedures in
response to the proposal.
For very illiquid fixed income securities, execution quality
improvement resulting from changes in order handling procedures with
respect to conflicted transactions could be limited. Because a broker-
dealer transacting in illiquid fixed income securities will only have a
few potential counterparties, exposing retail orders to a greater
number of trading venues (e.g., through RFQs) may not result in more
responses nor more competitive responses. On the other end of the
spectrum, the Commission expects little impact on the execution quality
of on-the-run U.S. Treasury securities because transaction costs for
such securities are already low. The impact is most likely to
materialize in fixed income securities that have moderate liquidity, as
discussed further below.
The Commission preliminarily believes that the documentation
requirement for conflicted transactions under the proposal could
facilitate regulatory oversight and promote broker-dealer compliance
with best execution standards, promoting investor protection in the
fixed income securities markets.\555\ To the extent that broker-dealers
do not currently document efforts to obtain the most favorable price in
conflicted transactions, these broker-dealers would be required to
document such information. Compared to the markets for equities and
listed options where quotes and trades are widely disseminated, in most
fixed income markets only transactions are reported and disseminated
publicly. The extent to which the proposed documentation requirement
would help facilitate regulatory oversight depends on the types of
documented information. To the extent that the documented information
includes information or data that is not currently documented nor
available through public or regulatory data sources, such as the
markets checked, internal and external quotes, and other factors (e.g.,
trading protocols, prices, immediacy, trade size) considered for the
basis of best execution, the proposed documentation requirement would
help facilitate regulators' enforcement and examination of a broker-
dealer for compliance, and thus, result in better investor protection.
Furthermore, the Commission believes that documentation could enhance
internal review process (e.g., a review by best the execution
committee). Documented information could inform the broker-dealer in
adjusting order handling procedures with respect to conflicted
transactions, which would result in better execution quality.
---------------------------------------------------------------------------
\555\ FINRA members are currently required to conduct regular
and rigorous review of execution quality under FINRA Rule 5310.09.
However, the Commission does not know the types of information that
broker-dealers document for the purpose of regular and rigorous
review of execution quality under FINRA Rule 5310 and MSRB Rule G-
18.
---------------------------------------------------------------------------
The Commission preliminarily believes that the execution quality of
retail customer trades in fixed income securities effected by brokers
that qualified for relief under the FINRA/MSRB rules by relying on
their executing brokers for trading services could improve. Under the
proposal, introducing brokers,\556\ as defined in proposed Rule
1101(d), and carrying
[[Page 5527]]
brokers that currently avail themselves of the relief under the FINRA/
MSRB rules and hence rely on their executing brokers for retail
customer trading services, would be required to review and compare the
execution quality of their executing brokers with the execution quality
they might have obtained from other executing brokers and adjust their
routing practices accordingly.\557\ To the extent that some of these
brokers change their executing brokers for trading services to those
that offer better execution quality, retail customer trades of the
brokers would receive better execution quality.\558\ Furthermore, the
requirement to review and compare execution quality of executing
brokers could promote competition among executing brokers, which could
result in better execution quality for retail customer trades.\559\
---------------------------------------------------------------------------
\556\ These brokers are non-carrying brokers that qualified for
relief under the FINRA/MSRB rules.
\557\ Carrying brokers that qualified for relief under the
FINRA/MSRB rules would not have relief from the requirements of the
proposal unless these brokers restructure their business to become
non-carrying brokers. Under the proposed rule 1101(c) with respect
to regular review of execution quality, these carrying brokers would
be required to review and compare the execution quality of their
executing brokers with the execution quality they might have
obtained from other executing brokers, and adjust their order
handling and routing practices accordingly.
\558\ The Commission acknowledges that some brokers could
already be reviewing and comparing the execution quality, of which
various executing brokers offer, in the selection of their executing
brokers.
\559\ Executing brokers would compete on, among other things,
fees, markups/markdowns, and the quality of trading services.
---------------------------------------------------------------------------
The Commission preliminarily believes that the proposed
requirements with respect to conflicted transactions could result in
better execution quality for internalized trades in fixed income
securities. To the extent that broker-dealers make changes to order
handling procedures (upon reviewing and comparing execution quality
across competing markets) and connect to additional trading venues to
expose retail customer orders (e.g., via RFQs and BWICs) more broadly
across multiple trading venues for the purpose of internalization, the
execution quality of internalized trades could improve. Sending RFQ
messages more broadly across multiple trading venues may result in
better execution quality for internalized trades if a broader exposure
of customer order results in more competitive prices for the purpose of
internalization (i.e., price-matching using more competitive price).
For example, exposing a customer order via RFQs on multiple trading
venues could result in more competitive responses to be used as the
reference price to match or improve for the purpose of internalization.
However, to the extent that broker-dealers continue to engage in last-
look practices in RFQs for the purpose of internalization, conducting
RFQs on more trading venues may not necessarily result in more
responses nor more competitive responses as discussed below.
To the extent that a broker-dealer determines, upon reviewing data,
that the use of last-look in RFQs impedes attracting competitive
responses, the broker-dealer could discontinue last-look practices or
limit the use of last-look to meaningfully improve price in an occasion
when RFQ responses are not reflective of the market. For example, a
broker-dealer handling a retail customer order may participate in an
RFQ by blind bidding/offering and internalize the order only if the
broker-dealer is the best bid/offer in the RFQ, or otherwise give up
the order to another responder with the best bid/offer. Such RFQ
practice could attract more competitive responses thereby improving the
execution quality of internalized trades via RFQs.\560\ However, the
Commission believes that this benefit is not likely to be realized.
Broker-dealers would continue to use last-look in conducting RFQs for
the purpose of internalization so long as such internalization practice
continues to provide profit incentive for those broker-dealers.
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\560\ See infra section V.C.2.b for the discussion about how the
proposal might adversely impact market liquidity. The Commission
preliminarily believes that this benefit in the execution quality
improvement for retail customer trades may be reduced to the extent
that eliminating last-look practices in RFQ for the purpose of
internalization adversely affects the principal trading activities
of inventory carrying broker-dealers.
---------------------------------------------------------------------------
In order to justify the continued use of last-look in fixed income
securities trading, broker-dealers could provide meaningful price
improvement by exercising last-look in RFQs for the purpose of
internalization, which would result in better execution quality. To the
extent that a broker-dealer's review or assessment reveals that the use
of last-look in RFQs impedes attracting competitive responses, the
broker-dealer could respond by providing price improvements to the best
response bids/offers to compensate for receiving less competitive bids/
offers in RFQs as compared to, for instance, in a blind auction as
described above.
Broker-dealers' assessment of last-look practices in fixed income
securities trading may not affect execution quality for internalized
trades via RFQs. Unless a broker-dealer's review or assessment shows a
negative impact of last-look practices on the execution quality of
internalized trades, the Commission does not expect the broker-dealer
to alter nor discontinue last-look practices in RFQs for the purpose of
internalization. If the broker-dealer makes no changes, the rule would
produce no improvement in the execution quality for internalized trades
via RFQs. Specifically, in exercising last-look, a broker-dealer that
currently applies trade desk spreads (in the form of markdown/markup)
to external bids/offers but not to internal bids/offers, which results
in more favorable comparisons for the internal bids/offers, to win
RFQs, may continue to apply such practice so long as the execution
quality of external trades would be worse than that of internalized
trades.
The Commission preliminarily believes that the proposed
requirements with respect to conflicted transactions could result in
better execution quality for riskless principal trades in fixed income
securities. To the extent that broker-dealers make changes to order
handling procedures (upon reviewing and comparing execution quality
across competing markets) and connect to additional trading venues in
order to search or expose retail customer orders more broadly across
multiple trading venues, the execution quality of riskless principal
trades for retail customers could improve. Broker-dealers could
increase the use of RFQs across multiple trading venues to expose
retail customer orders in order to obtain competitive prices.
Furthermore, as another way to expose retail customer orders more
broadly, broker-dealers could represent retail customer orders on limit
order systems across multiple trading venues. For example, in case of a
retail customer sell order, instead of conducting an RFQ on the bid
side of the market, a broker-dealer could represent the customer order
by placing a limit order on the offer side of the market for certain
fixed income securities (e.g., liquid on-the-run Treasury securities,
liquid corporate debt securities) should the broker-dealer determine
that the characteristics of the customer order are consistent with this
type of order handling (e.g., the customer is not demanding immediacy
of execution). This would lower transaction costs of the retail
customer because this customer would not pay the bid ask spread if the
order is executed at the offer price (compared to executing at the bid
price obtained via an RFQ).
In response to the proposed requirements with respect to conflicted
transactions, retail broker-dealers could stop executing retail
customer fixed income securities orders on a riskless principal basis.
To the extent that it is
[[Page 5528]]
more cost effective for broker-dealers to handle retail customer orders
on an agency basis rather than a riskless principal basis under the
proposal, broker-dealers could change business practices to handle
retail customer orders on agency basis and not incur the costs
associated with the requirements under conflicted transactions (e.g.,
trading venue subscription fees and implementation costs associated
with changing order handling procedures).\561\ In such case, execution
quality may not change. In particular, a broker-dealer, whose primary
business is retail self-directed trading conducted on riskless
principal basis, could change its business practices to handle retail
self-directed trading on agency basis to the extent that conducting its
self-directed trading business on an agency basis would be less costly
compared to doing so on a riskless principal basis.
---------------------------------------------------------------------------
\561\ See infra section V.C.2.(a) for discussions about trading
venue subscription fees and costs associated with making changes to
order handling procedures.
---------------------------------------------------------------------------
(c) Non-NMS Stock Equity Securities
There are three possible channels through which benefits of the
proposal to the non-NMS stock equities market may derive: (1)
requirements with respect to conflicted transactions; (2) the regular
review of execution quality of executing brokers used by introducing
brokers; and (3) some broker-dealers implementing policies and
procedures to comply with this proposal, which may offer improved
execution quality to transactions effected by these broker-
dealers.\562\
---------------------------------------------------------------------------
\562\ See section V.C.1 introduction for more explanation of the
general benefit to execution quality that retail customers could
experience. In the non-NMS stock equity securities market, the
Commission believes a majority of transactions would be subject to
the Conflicts of Interest provisions in proposed Rule 1101(b);
however, there may be some broker-dealers who could improve
execution quality while implementing policies and procedures as
explained in section V.C.1.
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The Commission preliminarily believes that the documentation
requirement with respect to conflicted transactions could help
facilitate regulatory oversight and enforcement, as well as promote
broker-dealer compliance, and thus, enhance investor protection in the
non-NMS stock equity securities market. To the extent that the
documented information includes additional information beyond what
broker-dealers currently record, and which may not be currently
available through public or regulatory data sources (e.g., CAT), such
as non-firm quotes on trading venues and factors (e.g., immediacy,
trade size) considered for the basis of best execution, the proposed
documentation requirement would help facilitate Commission and SRO
enforcement and examinations, and thus, result in better investor
protection. Similarly, the Commission believes that documentation could
enhance the internal review process (e.g., a review by best execution
committee). Documented information could inform broker-dealers in
adjusting order handling procedures with respect to conflicted
transactions, which could result in better execution quality.
The proposal would require additional policies and procedures,
beyond FINRA Rule 5310 and related FINRA notices \563\ that currently
address non-NMS stock equities transactions, when engaging in
transactions that are executed in a principal capacity, routed to an
affiliate for execution, or involve PFOF. Conflicted transactions are
ubiquitous in the non-NMS stock equities market. These enhanced
policies and procedures may induce broker-dealers to more carefully
consider and change routing behavior in handling customer orders. While
this proposal does not mandate changes, the changes could arise as
broker-dealers are required to maintain policies and procedures that
dictate the handling of conflicted transactions. In some cases, this
could induce broker-dealers to reduce or eliminate conflicted
transactions they participate in due to heightened costs of procedures,
such as the documentation requirement. While in other cases, there
could be no such inducement of broker-dealers to change order routing
behavior. Trading in non-NMS stock equity securities is heavily
concentrated in two platforms; however, there are other sources of
liquidity beyond those two. This proposal could induce broker-dealers
to connect to additional liquidity sources due to the requirements of
conflicted transactions of this proposal. To the extent that broker-
dealers' enhanced policies and procedures determine that they should
connect to additional liquidity sources for conflicted transactions,
customers' transaction costs could be lowered through better prices
found on the additional sources. Additionally, to the extent that
broker-dealers are either no longer routing to wholesalers or
internalizing orders based on policies and procedures that resulted in
different routing decisions, customer orders could experience price
improvement opportunities, as their orders would be exposed to external
competition.
---------------------------------------------------------------------------
\563\ See supra section II.C for details on FINRA rules and
notices with respect to the concept of ``best execution.''
---------------------------------------------------------------------------
Introducing brokers, as defined in proposed Rule 1101(d), would be
required to conduct regular reviews of executing brokers they use for
their retail customer transactions. This review, which differs from the
quarterly review \564\ required by FINRA Rule 5310 for all brokers,
could cause introducing brokers to seek out additional executing
brokers to develop business relationships with. These additional
options, from which introducing brokers could choose to route their
customer orders, could promote competition among executing brokers in
the non-NMS stock equities market. This increased competition could
result in better execution quality to the introducing brokers' retail
customers in the form of lower transaction costs and increased fill
rates for illiquid securities.
---------------------------------------------------------------------------
\564\ When transacting in municipal securities, broker-dealers
are subject to MSRB Rule G-18. The rule requires an annual review of
policies and procedures, which could take into account execution
quality review. The rule in this proposal is substantively different
from FINRA Rule 5310 or MSRB Rule G-18.
---------------------------------------------------------------------------
(d) Crypto Asset Securities \565\
---------------------------------------------------------------------------
\565\ For purposes of measuring the benefits and costs of the
proposed rule on a broker-dealer's duty of best execution in the
crypto market, this analysis assumes that market participants are
compliant with existing applicable Commission, FINRA, and MSRB
rules, including those directly addressing the duty of best
execution for the handling and execution of customer orders in
securities and government securities. See supra section III.A.3. To
the extent that some entities engaged in broker-dealer activities
with regard to crypto asset securities are not FINRA or Commission
registered entities, they may incur additional costs to comply with
existing registration obligations that are distinct from the costs
associated with the proposed rule and are not discussed in this
analysis. Similarly, any benefits from coming into compliance with
existing registration obligations are also not discussed in this
analysis. See id.
---------------------------------------------------------------------------
As mentioned above in Section V.B.3.c, the Commission lacks data on
broker-dealer routing behavior, the frequency of crypto asset
securities trading in both non-conflicted and conflicted transactions,
and many details of trading protocols and crypto asset securities
trading platforms. Also, as noted in Section V.B.3.c, this market
features many vertically integrated trading platforms, which makes
analogous comparison to other asset markets less exact. To the extent
that broker-dealers operate in a fashion similar to other asset
markets,\566\ the Commission preliminarily believes the proposal could
drive benefits in the crypto asset securities market through three
possible channels: (1) the requirements with respect to conflicted
[[Page 5529]]
transactions; (2) the regular review of execution quality of executing
brokers used by introducing brokers \567\; and (3) some broker-dealers
implementing policies and procedures to comply with this proposal,
which could offer improved execution quality to all transactions
conducted by these broker-dealers.
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\566\ The Commission preliminarily believes the closest market
comparison may be the non-NMS stock equity securities market;
though, no exact comparison to any other asset market is likely with
crypto asset securities.
\567\ The Commission understands the crypto asset securities
market has several large, vertically integrated platforms. The
Commission lacks the data to determine whether entities analogous to
introducing brokers are prevalent in this market. However, the
discussed benefits are those which the Commission believes could
accrue in cases where such market structure exists.
---------------------------------------------------------------------------
The Commission preliminarily believes that the documentation
requirement with respect to conflicted transactions could help
facilitate regulatory oversight and enforcement, as well as promote
broker-dealer compliance, and thus, enhance investor protection in the
crypto asset securities market. To the extent that documented
information includes information or data that is not currently
documented nor available through public or regulatory data sources, the
proposed documentation requirement would help facilitate enforcement
and examination, and thus, result in better investor protection.
Furthermore, the Commission believes that documentation could enhance
internal review process (e.g., a review by the best execution
committee). Documented information could inform broker-dealers in
adjusting order handling procedures with respect to conflicted
transactions, which would result in better execution quality.
The proposal would also require written policies and procedures
beyond those required under FINRA Rule 5310,\568\ when engaging in
transactions that are executed in a principal capacity, routed to an
affiliate for execution, or involve PFOF. While this proposal does not
mandate changes, the enhanced policies and procedures required by this
proposal may induce brokers to more carefully consider and change
routing behavior in handling customer orders. Specifically, as broker-
dealers are directed to write and maintain policies and procedures that
dictate the handling of currently conflicted transactions, they may
review their existing routing behavior. In some cases, this could
induce broker-dealers to reduce or eliminate conflicted transactions,
in which they participate due to heightened costs of procedures, such
as the documentation requirement. To the extent that broker-dealers
with enhanced policies and procedures determine that they should
connect to additional liquidity sources for conflicted transactions,
investors' transaction costs could be lowered through better prices
being found on the additional sources. Additionally, to the extent that
broker-dealers are either no longer routing to wholesalers or
internalizing based on policies and procedures that resulted in
different routing decisions, customer orders could experience price
improvement opportunities, as their orders would be exposed to external
competition.
---------------------------------------------------------------------------
\568\ See supra section II.C for details on FINRA rules and
notices surrounding the concept of ``best execution.''
---------------------------------------------------------------------------
Introducing brokers,\569\ as defined in the proposed Rule 1101(d),
would be required to conduct regular review of executing brokers they
use to for their customer transactions. This review, which differs from
the quarterly review \570\ required by FINRA Rule 5310 for all brokers,
could cause introducing brokers to seek out additional executing
brokers with whom to develop business relationships. These additional
options, from which introducing brokers could choose to route their
customer orders, could promote competition among executing brokers in
the crypto asset securities market. This increased competition could
result in better execution quality to the introducing brokers' retail
customers in the form of lower transaction costs and increased fill
rates for illiquid securities.
---------------------------------------------------------------------------
\569\ As noted in the introduction of this section, the
Commission lacks data on broker-dealer activities in this market. In
this instance, the Commission does not have data on the prevalence
of introducing brokers in the crypto asset securities market. This
discussion applies to the extent these entities operate in this
market.
\570\ When transacting in municipal securities, broker-dealers
are compelled by MSRB Rule G-18. The rule requires an annual review
of policies and procedures, which could take into account execution
quality review. The rule in this proposal is substantively different
from FINRA Rule 5310 or MSRB Rule G-18.
---------------------------------------------------------------------------
2. Costs
In order to comply with the proposal, broker-dealers would
collectively incur costs to: update their policies and procedures;
review and update those policies and procedures annually; conduct and
document regular reviews of best execution compliance; and possibly
make operational changes in response to those regular reviews. Assuming
all broker-dealers will need to perform each of these activities and do
not do so already, and do not have policies and procedures in place
that would be consistent with the proposed rules, the Commission
estimates one-time compliance costs of up to $165.4 million and annual
costs of $128.9 million. To the extent that broker-dealers already have
policies and procedures and practices that are consistent with the
proposed rules, aggregate implementation costs would be less than these
estimates, and based on the Commission's experience, the Commission
preliminarily believes these estimates overstate costs broker-dealers
would bear in implementing the proposed rules.\571\
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\571\ The one-time costs average $47,298 per broker-dealer;
ongoing costs average $36,843 per broker-dealer annually. Again,
these estimates assume that all broker-dealers will need to
implement new or updated policies and procedures or practices to be
consistent with the proposed rules. Based on its experience, the
Commission preliminarily believes that some broker-dealers may
already have policies and procedures and other practices that are
consistent with proposed Rule 1101. If, for example, all 3,273 of
the broker-dealers that the Commission estimates would choose to not
engage in conflicted transactions have policies and procedures and
other practices consistent with proposed Rule 1101, the aggregate
total cost of the proposal to all broker-dealers would be $38.8
million in one-time costs and $48.1 million in annual costs. Because
not all broker-dealers are likely to already have policies and
procedures and other practices that are consistent with proposed
Rule 1101, aggregate implementation costs would be higher than these
estimates. Accordingly, it is likely that actual costs would fall
between these estimates and those cited above.
---------------------------------------------------------------------------
The proposal would entail other costs as well, as discussed below.
Where possible, the Commission has attempted to estimate these costs.
Other costs are discussed qualitatively. The Commission believes it is
likely these costs would be passed to broker-dealer customers, and
would ultimately be borne by customers.
(a) Compliance Costs for Broker-Dealers
i. Carrying Broker-Dealers
Under the proposal, broker-dealers would fall into three groups:
(1) those that qualified for relief from the FINRA Regular and Rigorous
Review of Execution Quality under FINRA Rule 5310.09(c) from primary
analysis requirements under FINRA/MSRB rules previously and would meet
the introducing broker requirements to qualify for the proposed relief
under proposed Rule 1101(d); \572\ (2) those that did not qualify for
relief under FINRA Rule 5310.09(c) and would not qualify for the
proposed relief under proposed Rule 1101(d); and (3) those that
qualified for relief under FINRA Rule 5310.09(c) previously but would
not qualify for the proposed relief under proposed Rule 1101(d). The
third group, which may include as many as 144 \573\ broker-dealers that
carry customer accounts, would be required under the
[[Page 5530]]
proposed rule to comply with the policies and procedures and regular
review provisions of proposed Rules 1101(a), (b), and (c) because these
broker-dealers would not qualify for the introducing broker exemption
(because they carry customer accounts). Under the proposal, a broker-
dealer that qualified for relief under FINRA Rule 5310.09(c) that does
not meet the definition of introducing broker under proposed Rule
1101(d) would be required to incur costs to set up their own best
execution policies and procedures, and it would likely no longer be
able to rely on an executing broker for its analysis of execution
quality, unless the broker-dealer were to revise their business model
to no longer carry customer accounts. The Commission's cost estimates
below assume that all broker-dealers will implement this review under
the proposal. Based on the Commission's experience, the Commission
preliminarily believes that many broker-dealers in the first two groups
already conduct reviews of execution quality consistent with the
requirements of the proposal. Consequently, the Commission believes its
cost estimates for compliance overestimate costs broker-dealers will
collectively bear to implement the proposal.
---------------------------------------------------------------------------
\572\ See supra section II.C for the discussion about FINRA Rule
5310.09(c) and supra Section IV.E for the discussion about
introducing broker requirements under proposed Rule 1101(d).
\573\ Based on April-June 2022 FOCUS data.
---------------------------------------------------------------------------
ii. Conflicted Broker-Dealers
Conflicted broker-dealers may comply with the proposed requirements
in a number of ways. First, they may choose to engage in more rigorous
analysis of the execution quality their orders receive than is required
of unconflicted broker-dealers, comparing the execution quality of
multiple possible broker-dealers that they could route order flow to
for execution, as well as execution quality available on other venues
where liquidity is reasonably available, and regularly update routing
practices based on these analyses. Based on the Commission's
experience, the Commission preliminarily believes that some broker-
dealers already engage in these practices. However, particularly
smaller broker-dealers who continue \574\ to accept PFOF from an
executing broker-dealer may have previously relied on the best
execution obligations of broker-dealers they route to, and under the
proposal, would no longer qualify for the relief from such analyses
previously provided under FINRA/MSRB rules. For these broker-dealers,
performing such analyses might require engaging external consultants to
provide such analyses if the broker-dealer's staff does not possess the
necessary expertise or if the broker-dealer's staffing is not adequate
to support the additional duties required, and might also require
engaging external consultants to obtain analyses incorporating the
necessary data (such as information on alternative trading system
liquidity) to which they may not currently have access. The
Commission's cost estimates below assumes that smaller broker-dealers
(those carrying less than $100MM in total assets) will incur costs to
engage external parties for this review.
---------------------------------------------------------------------------
\574\ Resolving conflicts is discussed below.
---------------------------------------------------------------------------
The Commission preliminarily believes that due to the prevalence of
exchange rebates, many of the 2,440 retail broker-dealers \575\ are
likely to qualify as conflicted under the proposal. The Commission is
able to preliminarily estimate an upper bound on potential
implementation costs from these broker-dealers by assuming that all
2,440 retail broker-dealers would remain conflicted after
implementation of the proposal,\576\ but the Commission preliminarily
believes the implementation costs for many broker-dealers are likely to
be lower than this estimate because some conflicted broker-dealers
receive payments from their conflicted order flow that are less than
the implementation costs they would incur under the proposed rule;
consequently, the Commission preliminarily believes that some broker-
dealers will choose to de-conflict to avoid incurring these costs. For
purposes of its analysis, the Commission assumes that broker-dealers
with less than $100MM in total assets will comply with the proposal by
removing their conflicts.\577\ The Commission preliminarily believes
that some broker-dealers may continue to use one or more clearing
broker-dealers that have previously paid to receive their order flow,
and in such cases the primary cost to the broker-dealer would be the
lost PFOF revenue. However, if a broker-dealer needed to change the
broker-dealer it routed to, or engage the services of another
intermediary to handle its order flow in order to remove conflicts, the
broker-dealer would likely incur switching costs such as staff time
allocated to researching and negotiating with alternative providers of
services.\578\
---------------------------------------------------------------------------
\575\ Based on Q2 2022 FOCUS data.
\576\ If all 2,440 broker-dealers were to implement the more
rigorous requirements required for broker-dealers engaging in
conflicted transactions, these broker-dealers would collectively
incur $155.3MM in implementation costs averaging $63,637 per broker-
dealer. The Commission also assumes each would incur $9,000 per year
in costs to update order-handling procedures in response to its
annual review of execution quality, for ongoing annual costs of
$22.0 MM.
\577\ If a broker-dealer has revenue from conflicted
transactions that over time sufficiently exceeds the $24,935 in
additional implementation costs the Commission estimates conflicted
broker-dealers will incur and the $9,000 annual cost to update
order-handling procedures, the broker-dealer is likely to choose to
continue to engage in conflicted transactions since its revenue from
such activities exceeds the additional implementation and ongoing
costs necessary to comply while engaging in conflicted transactions.
Because the majority of PFOF revenues accrue to a small number of
broker-dealers, the Commission preliminarily believes that smaller
broker-dealers are unlikely to receive significant PFOF revenue that
would justify the additional implementation costs. For some of these
broker-dealers, passing the PFOF they receive on to their customers
may suffice to de-conflict. See note 183, supra.
\578\ See infra note 581 and text for discussion of related
costs the broker-dealer would likely incur to operationalize
changing a routing destination.
---------------------------------------------------------------------------
The Commission preliminarily believes that each broker-dealer that
would be required under the proposed rules to comply with provisions of
the proposal applicable to conflicted broker-dealers would consider its
options under the proposed rules strategically. For some firms, the
costs of staffing the activities required for compliance would exceed
their expected profits from conflicted transactions. The Commission
expects these firms would choose to alter their business models to
reduce conflicts so compliance changes necessary for conflicted
transactions are not required under the proposed rules. It is possible
that a consolidation of business would result: some broker-dealers may
exit the market, while others would invest further and compete to serve
the customers of exiting broker-dealers. Some broker-dealers may reduce
conflicts identified under the proposed rules and compete for customer
order flow on the basis of their less-conflicted status. To the extent
that exiting broker-dealers were able to offer lower-costs than broker-
dealers that either reduce conflicts or comply with provisions of the
proposal required of conflicted broker-dealers, direct costs such as
commissions and fees for these firms' investor customers may increase.
[[Page 5531]]
iii. All Broker-Dealers
Broker-dealers would incur costs to update policies and procedures
to reflect the proposal. They would incur other costs to regularly
review the execution quality of venues or other broker-dealers to which
they route customer orders. To the extent that broker-dealers already
have policies and procedures that comply with the proposal, aggregate
implementation costs would be less than this estimate, and based on the
Commission's experience, the Commission preliminarily believes these
estimates overstate costs broker-dealers would bear in implementing the
proposal. Implementation costs are summarized in Table 23 below.\579\
---------------------------------------------------------------------------
\579\ See infra Section VI.7 for detailed discussion of these
estimates.
Table 23--Total Implementation Costs
--------------------------------------------------------------------------------------------------------------------------------------------------------
Per registrant ($) Industry-wide ($)
Required Policies and Procedures -------------------------------------------------------------------------------------------------------------
Internal labor External Internal labor External Total
--------------------------------------------------------------------------------------------------------------------------------------------------------
BDs excluding conflicted retail (3273):
Update policies and procedures........ One time.................... 6,462 32,240 21,150,126 105,521,520 126,671,646
Annual review and update of P&P....... Annual...................... 2,154 8,800 7,050,042 28,802,400 35,852,442
Conduct and document review of Annual...................... 7,642 6,080 25,012,266 19,899,840 44,912,106
execution quality.
Conflicted BDs (225):
Update policies and procedures........ One time.................... 55,701 7,936 12,532,725 1,785,600 14,318,325
Annual review and update of P&P....... Annual...................... 6,421 .............. 1,444,725 .............. 1,444,725
Conduct and document review of Annual...................... 20,840 .............. 4,689,000 .............. 4,689,000
execution quality.
Annual Report
Unconflicted BDs (3273):
Update procedures for reviewing best One time.................... 1,795 4,960 5,875,035 16,234,080 22,109,115
ex policies and procedures.
Conduct and document regular reviews.. Annual...................... 4,062 7,920 13,294,926 25,922,160 39,217,086
Conflicted BDs (225):
Update procedures for reviewing best One time.................... 8,952 1,488 2,014,200 334,800 2,349,000
ex policies and procedures.
Conduct and document regular reviews.. Annual...................... 12,278 .............. 2,762,550 .............. 2,762,550
-----------------------------------------------
Total Implementation Costs........ ............................ .............. .............. 41,572,086 123,876,000 165,448,086
-----------------------------------------------
Total Annual Costs................ ............................ .............. .............. 54,253,509 74,624,400 128,877,909
--------------------------------------------------------------------------------------------------------------------------------------------------------
Costs in this table are constructed from estimates in Section VI.D. In its economic analysis, the Commission assumes that the 225 retail broker-dealers
with over $100MM in total assets are large and will continue to engage in conflicted transactions if the proposed rules are adopted, and follows the
Section VI.D estimates for large broker-dealers. The remaining 3,273 broker-dealers are assumed to be unconflicted for purposes of the proposed rules,
and this analysis follows the Section VI.D estimates for small broker-dealers. Section VI.D assumes that smaller broker-dealers are less likely to
engage in conflicted transactions, but acknowledges some costs associated with conflicted transactions. Furthermore, Section VI.D cost estimates
assume broker-dealers will outsource many compliance tasks and thus relies more upon external costs. To the extent that these broker-dealers elect to
perform these tasks with internal personnel, their implementation costs are likely to be over-stated in this analysis. Consequently, this analysis is
likely to over-estimate compliance costs for unconflicted broker-dealers.
Where internal burden hours appear in Section VI.D, the Commission employed hourly rates to monetize these costs. These hourly rates are based on
SIFMA's Management & Professional Earnings in the Securities Industry 2013, modified by Commission staff to account for an 1,800-hour work-year and
multiplied by 5.35 to account for bonuses, firm size, employee benefits and overhead, and adjusted with a factor of 1.27 for inflation based on the
27% change in the Consumer Price Index from December 2013 to September 2022. The Commission employed the following hourly rates, with the description
employed in Section VI.D in parenthesis: Attorney (legal counsel) $483 per hour; Compliance Attorney (compliance counsel) $424 per hour; General
Counsel (general counsel) $693 per hour; CCO (CCO) $616 per hour; Compliance Manager (compliance manager) $359 per hour; Paralegal (legal personnel)
$253 per hour; Compliance Manager (compliance personnel) $359 per hour; Operational Specialist (business-line personnel) $159 per hour.
The previous table discusses the costs broker-dealers would incur
to comply with the proposal.\580\ In the case of conflicted broker-
dealers that would be newly required to evaluate execution quality from
multiple sources in evaluating execution quality, it is possible they
would periodically need to change their routing practices to reflect
changes they observe in their data analysis. The Commission
preliminarily estimates that each conflicted broker-dealer that changes
its routing practices will incur costs of approximately $9,000.\581\
The Commission cannot estimate the number of broker-dealers that would
need to make this change periodically,
[[Page 5532]]
but the Commission preliminarily estimates that the changes will be no
more than $2 million \582\ annually in aggregate.
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\580\ See infra section VI.D.
\581\ The Transaction Fee Pilot required re-programming of SORs
as well. For that pilot, the Commission estimated that the costs of
a one-time adjustment to the order routing systems of a broker-
dealer would $9,000 per broker-dealer. The Commission preliminarily
believes that this estimate remains a reasonable estimate of costs
associated with changes that broker-dealers would incur from having
to update their routing systems. See Securities Exchange Act Release
No. 84875 (Dec. 19, 2018), 84 FR 5202 (Feb. 20, 2019) (Transaction
Fee Pilot for NMS Stocks).
\582\ 225 conflicted broker-dealers x $9,000 per order-handling
change = $2.025MM annually. The Commission assumes that order-
handling changes would be annual because the proposal requires the
annual review of the best execution policies and procedures,
including order handling practices. Based on the Commission's
experience, the Commission preliminarily believes that many broker-
dealers, including many that the Commission believes will be
unconflicted if the proposal is adopted and implemented, already
change order-handling practices regularly for both best-execution
and other operational reasons, such as reducing costs. Consequently,
the Commission preliminarily believes that this estimate exceeds the
annual costs that broker-dealers would bear under the proposal.
---------------------------------------------------------------------------
iv. Additional Compliance Costs for NMS Stocks and Options
For NMS stocks, a broker-dealer engaging in conflicted transactions
would currently be required to subscribe to SIP data under current SRO
best execution rules. To consider a broader range of markets, such
broker-dealers might add connections to one or more ATSs, subscribe to
more detailed data or consider connecting to ``ping'' destinations
(automated systems run by OTC liquidity providers that may elect to
internalize any order routed to their system).\583\ In making this
choice, some broker-dealers may compare their current routing practices
to a hypothetical competitor that does the bare minimum and consider
their practices compliant with the proposal even if all competitors
currently do more than this hypothetical minimum.\584\ To the extent
broker-dealers believe that their current routing practices are in
compliance and do not make changes to routing practices, both the
benefits and the costs of the proposed rules would be less than they
would be otherwise.
---------------------------------------------------------------------------
\583\ The Commission preliminarily believes that larger broker-
dealers that are likely to continue engaging in conflicted
transaction if the proposed rules are adopted are likely to already
connect to a broader range of venues than would be represented by
SIP data. The Commission cannot predict how many broker-dealers that
elect to engage in conflicted transactions would increase the range
of venues to which they connect and what costs they would incur to
do so because broker-dealers are diverse in business models and
practices and each broker-dealer would need to evaluate its own
operational procedures to make such a determination.
\584\ Based on staff discussion with market participants, the
Commission preliminarily believes that broker-dealers are often not
certain what their competitors' routing practices are. Such
information is proprietary and generally not publicly available.
---------------------------------------------------------------------------
v. Additional Compliance Costs Associated With Fixed Income Securities
With respect to fixed income securities trading, broker-dealers
that engage in conflicted transactions could add subscription to one or
more trading venues (e.g., ATSs, RFQ platforms, single dealer
platforms) to the extent that the benefit (i.e., improvement in
execution quality) from adding subscription to trading venue outweighs
the costs (e.g., venue subscription fees).\585\ The Commission expects
that a broker-dealer would subscribe to additional trading venues to
take liquidity (as opposed to provide liquidity by posting quotes or
responding to RFQs) in executing retail customer orders on riskless
principal basis or to discover prices for the purpose of
internalization. The Commission understands that subscription fees for
liquidity takers are not significant. Furthermore, the broker-dealer
would choose to connect to a trading venue via low cost means, for
example, web-based graphical user interface (GUI) rather than via more
costly application programming interface (API), which may include the
costs associated with connectivity and systems reconfiguration (e.g.,
reconfiguring to adjust API), to the extent that the broker-dealer does
not expect to maintain constant connection to execute a large number of
customer orders on the venue. To the extent that making changes to
business practices to handle customer orders on an agency basis in
fixed income securities trading is less costly than incurring costs to
comply with the requirements with respect to conflicted transactions,
broker-dealers may choose to handle retail customer orders on an agency
basis rather than a riskless principal basis. In particular, a broker-
dealer whose primary business is retail self-directed trading conducted
on a riskless principal basis could change its business practices to
convert its self-directed trading business to handling orders on an
agency basis. The Commission preliminarily believes that the costs
associated with such a conversion could include the costs related to
changing risk management practices for intraday capital commitment,
compliance systems, recordkeeping practices for orders and
transactions, and accounting practices. However, the Commission is
uncertain about these costs associated with the business practice
changes needed to convert a self-directed trading business from a
riskless principal to agency based model and requests comments on the
costs.
---------------------------------------------------------------------------
\585\ In their Form ATS submissions, 15 of 33 ATSs state they
have no access, connectivity and/or subscription fees. The
Commission preliminarily believes that most ATSs charge fees
primarily based on transactions, and subscribers are responsible for
any costs related to providing their connectivity. To the extent an
ATS does charge subscription fees, broker-dealers are likely to
consider those fees in making a determination of whether the
liquidity on such an ATS is reasonably available.
---------------------------------------------------------------------------
vi. Additional Compliance Costs for Non-NMS Stock Equity Securities
In the case of non-NMS stock equities, liquidity on ATSs beyond
those that specialize in non-NMS stock equities may be rare. For a
broker-dealer that currently participates in the non-NMS stock market,
adding additional markets may mean subscribing to additional ATSs, or
possibly, contacting other broker-dealers that act as liquidity
providers of last resort through direct messages thus seeking
additional sources of liquidity manually. To the extent that broker-
dealers are able to bear the costs of seeking this additional liquidity
(through ATS subscriptions or manual negotiation) while maintaining a
profitable trading service, broker-dealers in the non-NMS stock
equities market could pursue these actions and pass on the costs to
customers. In the case of very illiquid non-NMS stock equities, broker-
dealers may be left with either no apparent options to add additional
markets, or with markets which are prohibitively expensive to consider
as additional liquidity sources (such as contacting other broker-
dealers or block holders of the security to inquire about their
interest in being a counterparty). In such cases, there may not be
additional implementation costs for conflicted transactions because
alternative markets may not be available.
vii. Additional Compliance Costs Associated With Crypto Asset
Securities
Broker-dealers trading crypto assets that are securities may incur
costs to comply with the proposed rule.\586\ Because the Commission
lacks data and other information on existing broker-dealers and their
practices in the crypto asset securities market, it is difficult to
precisely determine the costs of compliance for such broker-dealers.
Generally, the Commission expects the costs of compliance to be most
similar
[[Page 5533]]
to costs associated with trading non-NMS stocks. To the extent that the
current market practices of market participants that would need to
comply with the proposed rule differ significantly from the practices
required under the proposed rule, the costs for compliance with the
proposal may be large; this may be the case, for example, for market
participants whose practices are not currently consistent with FINRA
Rule 5310. On the other hand, market participants with existing best
execution policies and procedures, such as those that operate across
other asset classes (e.g., NMS securities), may bear incremental lower
costs of compliance.
---------------------------------------------------------------------------
\586\ Affected parties that effect transactions in the crypto
market may include some market participants that may not be
currently registered as a broker-dealer but should be under existing
regulations. As noted above, this analysis does not account for
costs of such market participants to register as broker-dealers or
otherwise come into compliance with existing applicable regulation.
---------------------------------------------------------------------------
For crypto asset securities that are traded on multiple platforms,
conflicted broker-dealers may need to connect to additional platforms
to comply with the proposal. In the case of crypto asset securities
that are not traded on multiple platforms, broker-dealers would incur
costs to directly contact liquidity providers of last resort, such as
broker-dealers that might agree to trade the asset if contacted
directly. Because transacting manually in this manner involves the time
of a professional trader, the cost to make these additional inquiries
required by the proposal might be uneconomical, particularly in the
case of small trades.
(b) Other Costs
As discussed previously, currently many retail orders in NMS
securities are executed without paying commissions.\587\ The Commission
preliminarily believes that the proportion of retail order flow being
executed under PFOF agreements may decrease, although the Commission is
uncertain of the magnitude of this reduction.\588\ It is possible that
reductions in the proportion of retail order flow being executed under
such agreements could cause the prevalence of retail commissions to
increase because revenues from these agreements may have previously
offset retail broker dealer costs that would otherwise be covered by
commissions collected from retail investors. This effect may be
mitigated if broker-dealers elect to pass exchange rebates to their
customers. The Commission preliminarily believes that it is unlikely
that the proposal would significantly increase the prevalence of retail
commissions because the market to provide retail broker-dealer services
is competitive and many of the broker-dealers that the Commission
believes will remove their conflicts receive relatively small payments
for their order flow.\589\
---------------------------------------------------------------------------
\587\ See supra Section V.B.3.a
\588\ See supra Section V.C.1.
\589\ In the case of larger broker-dealers that derive
significant revenue from PFOF, the Commission preliminarily believes
that they will continue to do so and incur the additional compliance
costs discussed previously in Table 23.
---------------------------------------------------------------------------
The Commission further believes that the costs of the rule could
advantage larger broker-dealers and may increase barriers to entry and
disadvantage smaller broker-dealers, potentially resulting in some of
them exiting the market. To the extent that smaller broker-dealers are
more likely to provide specialized services and provide innovation,
there may be less competition to provide specialized services and less
innovation if the proposal is adopted. Investors whose broker-dealers
exit the market would face search costs to find alternative broker-
dealers that offer the same services; those services may be offered at
inferior prices by remaining competitors. Some services may no longer
be offered by any competitors if a specialized broker-dealer exits the
market, although the Commission preliminarily believes that if there is
sufficient demand for such a service, a broker-dealer may make it
available to customers when demand is sufficient, as may be the case
after one or more broker-dealers exit the market.
While the Commission cannot predict how many retail broker dealers
will terminate PFOF arrangements, the Commission preliminarily believes
that under the proposal, retail broker-dealers are likely to reduce
their use of PFOF agreements for both NMS stocks and listed options
because engaging in such agreements would cause the broker dealer to
incur heightened best execution obligations under the proposal and
satisfying those obligations may cause broker-dealers to incur costs in
excess of their PFOF revenue.\590\ Since most broker dealers that
receive PFOF receive relatively small payments for routing their order
flow,\591\ smaller broker-dealers in particular may consider curtailing
this practice to avoid incurring the additional compliance costs.
Furthermore, broker-dealers that currently pay to receive order flow
may adjust their business models \592\ to rely less on these
arrangements. The Commission preliminarily believes this is likely to
reduce the share of retail customer order flow that is internalized
because some broker-dealers that currently receive PFOF are likely to
stop receiving it to become de-conflicted, and some broker-dealers that
pay PFOF will internalize fewer of the orders they receive to comply
with the proposal. If this occurs, broker-dealers that reduce their
reliance on PFOF arrangements would also be likely to see commensurate
decreases in their revenue. This increase in costs to execute customer
orders may be passed on to retail investors as additional fees to
trade, or in the form of commissions.
---------------------------------------------------------------------------
\590\ The Commission lacks data on many broker-dealers' PFOF
revenue, but acknowledges that some broker-dealers will realize an
indirect cost from forgone PFOF revenue. In the case where a broker-
dealer receives PFOF from another broker-dealer or trading venue,
this will constitute a transfer from one registrant to another, and
will not increase industry costs in aggregate. In cases where a
broker-dealer passes PFOF on to its customers to avoid conflicts,
this payment may reduce investor trading costs and increase industry
costs in aggregate.
\591\ Many broker-dealers receive PFOF, but the majority of PFOF
is received by a small group of broker-dealers. Consequently, many
broker-dealers receive relatively small PFOF payments, although for
some broker-dealers these small payments may contribute
significantly to profits, depending on other revenue sources.
Regardless of this relative magnitude, the costs to comply with the
proposal's heightened standards may be prohibitive for broker-
dealers that receive relatively modest PFOF revenue, and their
compliance costs may exceed the revenue the broker-dealer receives
for engaging in conflicted transactions. See supra Section V.B.3 and
Section V.C.2.(a)i.
\592\ If broker-dealers choose to pass exchange rebates on to
their customers, they may incur additional costs associated with
updating systems to account for these payments.
---------------------------------------------------------------------------
Similarly, the Commission preliminarily believes that firms that
currently pay to receive retail order flow would likely receive less of
such directed order flow. While this may be a cost savings to those
firms, it is likely to represent a reduction in what was previously a
profitable business operation, and the lost profit opportunities are
not likely to offset any cost savings. It is possible such firms may
choose to compete on other venues (ATSs and exchanges) to participate
in this order flow, but the Commission preliminarily believes that
profits from such a venture are unlikely to be comparable to the
profits of internalization because, on other venues, other broker-
dealers would be able to compete with these broker-dealers to provide
liquidity to these orders which should reduce the cost of that
liquidity to investors.\593\ If these firms reduce the capital they
currently allocate to providing liquidity, spreads could increase
particularly in the short-term because fewer market participants would
be competing to provide liquidity. However, the Commission
preliminarily believes that the market to provide liquidity to retail
orders is competitive and other competitors are
[[Page 5534]]
likely to increase their capital provision over time to satisfy
demand.\594\
---------------------------------------------------------------------------
\593\ See supra Section V.C.1.
\594\ See infra Section V.D.3.
---------------------------------------------------------------------------
In addition to costs discussed previously, broker-dealers that
engage in conflicted transactions would face heightened standards under
the proposal. These standards would require them to obtain and assess
information beyond what would be required of a broker-dealer that is
not conflicted, including price, volume, and execution quality, in
identifying a broader range of markets beyond those identified as
material potential liquidity sources. The Commission preliminarily
believes that this requirement may be interpreted very differently by
different broker-dealers, and may prove challenging in markets for some
asset classes where the number of potential markets is limited and
broker-dealers may effectively be checking all reasonably available
prices in current practice.
i. Additional Other Costs in NMS Stocks and Options
In equities, the Commission preliminarily believes that firms that
internalize retail order flow provide liquidity to a wide range of
securities, including those that are very thinly traded. In fact,
fulfillment of these more difficult to fill orders may be part of a
service bundle that internalizers provide to broker-dealers that route
them their order flow. Generally, thinly traded securities are more
risky for liquidity providers because quotation data are relatively
sparse compared to more heavily traded securities, such quotations are
more likely to be stale, and there may be no market makers that have a
duty to maintain two-sided quotes in these securities.\595\ It is
possible that execution prices may be less favorable for retail
investors under the proposal if liquidity providers that previously
paid for order flow and fulfilled these difficult to execute orders
under such arrangements dedicate less capital to making markets in
these securities. It is possible that execution times for these
securities may be significantly delayed as broker-dealers would need to
search for liquidity to fill these orders, and this delay is an
additional factor that a broker-dealer would need to consider in the
order's execution quality. It is also possible that execution prices
for these transactions may be less favorable than they might be under a
PFOF arrangement because the price improvement statistics on these
orders are currently included in the criteria retail broker dealers
evaluate in choosing executing broker dealers.\596\ However, the
Commission preliminarily believes that the market to provide liquidity
to retail orders, including orders in less liquid securities is
competitive. If the proportion of such orders entering the market
beyond internalizers increases, it is likely other broker-dealers that
provide liquidity to asset markets would increase liquidity provision
to this segment of the equities market. The costs realized by investors
transacting in these securities may increase, however, because broker-
dealers are unlikely to provide additional liquidity unless they can
cover their costs and earn appropriate risk-adjusted returns.\597\
---------------------------------------------------------------------------
\595\ See, for example, Menkveld, Albert J. and Wang, Ting, How
do designated market makers create value for small-caps?, 16 Journal
of Financial Markets 571 (2013), available at https://www.sciencedirect.com/science/article/pii/S1386418112000535#aep-abstract-id6; Craig, Louis, Kim, Abby, and Won Woo, Seung, Pre-trade
Information in the Municipal Bond Market, (SEC Working Paper, July
2018), available at dera_wp_pre-
trade_information_in_the_municipal_bond_market.pdf (sec.gov)https://www.sec.gov/files/dera_wp_pre-trade_information_in_the_municipal_bond_market.pdf and Craig et al,
supra note 471.
\596\ Broker-dealers that pay to receive order flow may be
providing better execution to difficult to fill orders because the
execution in such orders is an element upon which their clients
evaluate them. Consequently, outside of PFOF arrangements, such
orders might receive inferior execution quality to what they would
receive under such an arrangement.
\597\ Securities for which it is more difficult to find trading
counterparties often are characterized by infrequent trades, less
frequent quotations and lower market capitalization. These factors
are likely to increase the adverse selection risk liquidity
providers face when providing liquidity to the market for these
securities.
---------------------------------------------------------------------------
In addition to the costs discussed above, the Commission
preliminarily believes that in the market for listed options, the NBBO
spreads set by resting best displayed liquidity could be wider and the
depths at the best market prices could be thinner because of the
increasing order flow segmentation under the proposal. Specifically,
liquidity providers could deploy less capital to provide the resting
displayed liquidity in the limit order books in favor of price
improvement auctions or price improving inside the NBBO. Because the
proposed rules could result in potentially more efficient price
improvement auctions and/or potentially more retail orders being routed
to the auctions for price improvement opportunities, order flow routed
there could become less impactful and more profitable. At the same
time, the orders filled by the lit quotes would become more impactful
and impose relatively more adverse selection risk on the liquidity
providers who provide resting displayed liquidity, in part due to the
increased level of order segmentation. Less capital from liquidity
suppliers would make the liquidity in order books thinner and
potentially widen the NBBO. Wider NBBO spread and thinner depth would
inevitably lead to worse execution quality to the orders that are not
exposed to price improvement opportunities. To the extent that the
proposal would make a subset of retail customers better off by
improving the prices those customers receive, it would correspondingly
adversely affect other customers by harming prices and liquidity in
displayed quotes.
ii. Additional Other Costs in Fixed Income Securities
With respect to fixed income securities trading, the Commission
preliminarily believes that the proposal could adversely affect
liquidity. To the extent that broker-dealers no longer practice last-
look in conducting RFQs for the purpose of internalization, these
broker-dealers could earn less profits from principal trading that
relies on broker-dealers' capacity to commit capital for carrying
inventory. A reduction in capital commitment for fixed income
securities intermediation could result in lower liquidity, particularly
for those trades that rely on broker-dealers' capacity to provide
immediacy by trading on a principal basis (by taking fixed income
securities into inventory). This would result in an increase in pre-
arranged trades between a buyer and a seller (so that the broker-dealer
can quickly offset its position in the opposite direction), which take
a longer time to execute, increasing transaction costs of market
participants.
To the extent that broker-dealers handling retail customer orders
choose to conduct RFQs to fulfill the proposed requirements with
respect to conflicted transactions, this could result in an increase of
RFQs to a degree that RFQ messages would overwhelm market participants
(e.g., broker-dealers responding to RFQs). This could increase the
number of RFQs with no or few responses resulting in less competitive
prices and worse execution quality for retail customer trades. However,
the Commission preliminarily believes that this effect would be
mitigated as more market participants adopt automation in the process
for responding to RFQ messages to be responsive to RFQs, and thus,
attract more order flow.
3. Efficiency, Competition, and Capital Formation
The Commission has considered the effects of the proposed
amendments on
[[Page 5535]]
efficiency, competition, and capital formation, and discussed these
effects below.
(a) Competition
i. Market for Trading Services
The Commission preliminarily believes that the proposal would
improve competition among trading venues. The proposal requires that
broker-dealers consider a wider range of trading venues. In the equity
and option markets, the Commission also preliminarily believes that the
proposal would reduce the proportion of retail order flow that is
internalized. The Commission preliminarily believes that this would
increase competitive opportunities for exchanges and other trading
venues because more broker-dealers will consider exchanges and ATSs as
potential execution venues. In the fixed income securities markets, the
proposal could promote competition among trading venues to the extent
that broker-dealers expose retail customer orders broadly across
multiple trading venues for the purpose of executing riskless principal
trades and for the purpose of internalization.
In the market for NMS stock and options trading services, the
Commission preliminarily believes that competition would increase. To
the extent that the proposal's requirement that broker-dealers
incorporate material sources of liquidity into their order handling
practices causes broker-dealers to consider additional execution venues
such as additional exchanges or ATSs for their orders, competition
between trading venues may increase. Other factors that may encourage
broker-dealers to more frequently use exchanges and ATSs for trading
include the heightened standards for conflicted transactions and the
heightened standards for transactions where a PFOF arrangement is in
place.
By considering more sources of liquidity and the heightened
standards for broker-dealers in conflicted transactions, it allows for
venues such as exchanges and ATSs to compete for order flow that may
have been internalized by wholesalers before the effects of this rule.
The requirement to consider price improvement from midpoint liquidity
before internalizing a retail trade could increase competition by
resulting in more trading venues competing to offer programs that offer
midpoint liquidity to retail orders. There will be increased demand for
the services of trading service venues. Given this increased demand,
the venues will compete to acquire as much of it as possible. Given
this increased demand, it is possible that the fees venues charge may
rise, particularly if large venues capture most of the increased order
flow.
The Commission preliminarily believes that the proposal would
increase competition between broker-dealers to provide liquidity to
retail orders by requiring broker-dealers that route to executing
brokers to consider a wider range of executing venues. Currently, most
retail order flow for which the customer has not specified an execution
venue is routed first to an internalizer. Under the proposal, broker-
dealers would need to consider a wider range of trading venues and
programs (such as retail liquidity programs \598\) before routing
customer orders.
---------------------------------------------------------------------------
\598\ See supra Section V.B.3(a).i.
---------------------------------------------------------------------------
The Commission preliminarily believes that the proposal would have
limited impact on the market to provide liquidity to unlisted stocks
and thinly traded NMS stocks. As the proposal requires brokers to check
material sources of liquidity, there will be little change if these
sources of liquidity are few to begin with.
The Commission preliminarily believes that the proposal would
promote price competition and competition in price improvement
mechanisms for listed options. Under current practice, in order to
attract order flow from wholesalers, the exchanges that provide the
price improvement auction mechanisms often establish asymmetric fee
schedules charging the competing liquidity providers higher fees than
the wholesaler for participating in the auction. This limits the
ability of competing liquidity providers to provide more favorable
pricing to compete with the wholesaler in those auctions, resulting in
less than fully efficient price improvement offered to the customer.
Under the proposal, when considering a price improvement auction, the
wholesaler would be required to consider a broad range of price
improvement auctions across the exchanges and evaluate the execution
quality that may be received from these auctions and how that might be
impacted by auction features such as asymmetric fee schedules after
controlling for all the other factors such as the allocation model.
Therefore, the option exchanges would have incentives to level the
playing field by reducing the existing auction transaction fee gap to
enhance competition in those auctions to attract the retail order flow.
Currently, there is no mid-point liquidity protocol available
across the limit order books operated by the exchanges for listed
options, but the Commission is aware that there is at least one option
exchange which provides a protocol allowing market participants to
provide liquidity on the limit order book within the NBBO prices to
interact with incoming marketable orders and provide price improvement
against NBBO at the same time. The Commission preliminarily believes
that, under this proposal, more exchanges would have incentives to
develop protocols which would facilitate liquidity provision within the
prevailing NBBO spread because broker-dealers would be required to have
policies and procedures that specifically address opportunities for
price improvement and other order exposure opportunities. Thus, the
wholesaler would need to check or reasonably estimate whether there
could be substantial midpoint or within-NBBO liquidity available on the
limit order books operated by other exchanges. Some exchanges may even
consider establishing protocols to allow customer order flow executed
at the midpoint of NBBO prices, which would further increase
opportunities for retail orders to receive price improvements.
ii. Market for Broker-Dealer Services
The Commission preliminarily believes that the proposal could have
mixed effects on competition in the market for broker-dealer services.
Changes in order handling practices that could occur as part of the
rule could promote competition between broker-dealers to attract
customers. However, the costs of the rule could advantage larger
broker-dealers and may increase barriers to entry and disadvantage
smaller broker-dealers, potentially resulting in some of them exiting
the market.
While modifying their policies and procedures, broker-dealers could
change their order handling practices and also the services they
utilize from other broker-dealers while handling customer orders. These
changes in order handling practices could promote competition among
broker-dealers, especially on the basis of execution quality, to
attract customers. It could also promote competition among broker-
dealers offering services to other broker-dealers to attract new
clients.\599\
---------------------------------------------------------------------------
\599\ See infra Section V.B.3.a.i for discussion about
competition about market for market access.
---------------------------------------------------------------------------
The Commission preliminarily believes that the proposal may
increase barriers to entry and disadvantage smaller broker-dealers
because of the increased compliance costs and resulting economies of
scale that would result under the proposal. Furthermore,
[[Page 5536]]
the proposal could result in consolidation among smaller broker-dealers
or these broker-dealers being absorbed (via merger) by larger broker-
dealers to take advantage of the economies of scale. Such a change to
the competitive landscape could also reduce competition in the market
for trading services. In the case of broker-dealers that meet the
definition of introducing broker under FINRA rules but do not do so
under the proposal, compliance costs may be high.\600\ Some of these
broker-dealers may adjust their business models to no longer compete as
introducing brokers, and new entrants may be discouraged due to
elevated costs of complying with the proposal.
---------------------------------------------------------------------------
\600\ See supra Section V.C.2.
---------------------------------------------------------------------------
Additionally, the proposed rules for conflicted transactions for
retail orders and on introducing brokers accepting PFOF may reduce the
PFOF retail brokers receive in the equity and options markets. To the
extent that these firms do experience a major reduction in their PFOF
revenue, they may face pressure to develop other lines of revenue,
including the addition of commissions and/or fees for trading and
advisory services, although broker dealers that have heavily promoted
their commission-free business model would be more reticent to add
commissions and/or fees, despite the loss of PFOF.
To the extent that some retail brokers do resume charging
commissions, they may be constrained by competitive pressures in the
commission rates they can charge. Larger retail brokers that do not
accept equity PFOF could continue to provide commission-free trading.
This, in turn, would put competitive pressure on the extent to which
retail broker-dealers could charge commissions and still retain
customers. If the ability of smaller retail brokers to charge
commissions is constrained by competition, it could increase the
competitive advantage of larger retail brokers, which could raise the
barriers to entry for new brokers and cause some smaller retail brokers
to exit the market.
The Commission is unable to quantify the likelihood that one or
more smaller brokers would cease operating. Even if one or more small
brokers were to exit, while the Commission acknowledges that services
to niche markets more likely served by smaller broker-dealers might
decline, the Commission does not believe this would significantly
impact competition in the larger market for generalized broker services
because the market is served by multiple large competitors.
Additionally, the market would likely still be served by many small
competitors. Consequently, if a smaller retail broker were to exit the
market, demand is likely to be swiftly met by existing competitors. The
Commission recognizes that small brokers may have unique business
models that are not currently offered by competitors, but the
Commission believes a competitor could create similar business models
previously offered by exiting firms if demand were adequate. Moreover,
if the services generated by these business models are not provided by
existing competitors, it seems likely new entrants would provide them
if demand were sufficient.
iii. Market for Market Access
The Commission preliminarily believes that the proposal would
increase competition in the market for market access. A number of
aspects of the proposal could result in more broker-dealers utilizing
the services of a routing or executing broker or engaging in more
extensive comparisons of the services and execution quality of
different routing or executing brokers. This would increase competition
among broker-dealers offering order routing and execution services to
other broker-dealers in order to attract new customers.
The introducing broker requirements under Rule 1101(d) would
enhance competition the market for market access in two ways. The
requirement for introducing brokers to regularly compare the execution
quality of their executing broker to that of other executing brokers
would promote competition between executing brokers. Broker-dealers
that carry customer accounts that currently route their order flow to
an executing broker to handle in an principal capacity would not be
eligible for the introducing broker relief under Rule 1101(d) and would
have to develop policies and procedures for handling customer orders.
If they utilized a routing broker as part of developing these policies
they would need to compare different routing brokers and develop the
criteria for selecting a routing broker as part of their policies and
procedures. They would have to also compare their routing broker to the
other routing brokers as part of their regular review of their policies
and procedures. This could enhance competition among routing brokers in
order to attract these broker-dealers as clients.
The heightened standards for broker-dealers handling retail orders
engaging in conflicted transactions may also promote competition in the
market for market access. The additional requirements for broker-
dealers handling retail orders engaging in conflicted transactions may
lead to some retail brokers that currently route orders to wholesalers
to instead utilize the services of a routing broker to handle their
orders.\601\ There could be increased competition among routing brokers
to provide these conflict-free routing services to retail brokers.
Additionally, the heightened standards for broker-dealers that accept
PFOF may foster competition between broker-dealers to provide best-
execution services to retail broker-dealers that continue to accept
PFOF. Because the proposal would require these retail broker-dealers to
document their compliance with the best execution standard for
conflicted transactions, including all efforts to enforce their best
execution policies and procedures for conflicted transactions and the
basis and information relied on for their determinations that such
conflicted transactions would comply with the best execution standard,
this could increase competition among broker-dealers that pay for order
flow to provide adequate information to broker-dealers routing to them,
allowing those broker-dealers to improve their customers' execution
quality. Without such assistance from broker-dealers that pay for order
flow, the broker-dealers that provide order flow may be faced with the
need to perform significant data analysis on multiple executing broker-
dealers if they intend to continue receiving PFOF. For some broker-
dealers, the expense of conducting such analysis is likely to exceed
the revenue they receive for directing their order flow to executing
broker-dealers that pay to receive their order flow. These broker-
dealers may choose to stop receiving PFOF or pass all PFOF they receive
through to their customers in order to avoid these expenses.
Consequently, broker-dealers that pay for order flow are likely to be
incentivized to assist their customer broker-dealers in complying with
the rule to avoid losing their order flow. It is also possible that
broker-dealers that currently receive PFOF may simply maintain their
routing practices and stop accepting PFOF to reduce their compliance
burden under the proposal.
---------------------------------------------------------------------------
\601\ See supra Section V.C.1.a.
---------------------------------------------------------------------------
With respect to fixed income securities trading, the proposed
requirements with respect to introducing brokers and regular review of
execution quality could promote competition in the market for market
access (i.e., amongst executing brokers). Brokers that outsource
execution services for fixed income securities
[[Page 5537]]
would conduct regular reviews and compare execution quality in the
selection of their executing brokers, which would promote competition
and innovation in the fixed income market for market access. Executing
brokers would compete on fees, efficiency in order handling procedures,
and efficiency in the selection of trading venues or counterparties,
which in turn, would result in better execution quality for retail
customer trades.
(b) Efficiency
The Commission preliminarily believes the proposal would improve
price efficiency in asset markets because broker-dealers will need to
consider a wider range of markets and execution methodologies when
routing customer orders. By facilitating competition between a larger
pool of liquidity providers, more liquidity providers may be
incentivized to compete to provide liquidity. This would provide a
wider range of quotes and facilitate price efficiency to the extent
that the expanded liquidity pool provides more informative quotes.
While the Commission preliminarily believes the proposal could
improve retail order execution prices,\602\ the Commission recognizes
that it could take longer for conflicted orders to be executed because
broker-dealers might need to consider additional venues before routing
an order, and they may need to perform more routings before the order
is fulfilled. It is possible that market prices could move unfavorably
during this time.
---------------------------------------------------------------------------
\602\ See supra Section V.C.1.
---------------------------------------------------------------------------
(c) Capital Formation
The Commission preliminarily believes that the proposal may improve
capital formation by incentivizing broker-dealers to allocate
additional capital to the provision of liquidity. The proposal's
requirement that broker-dealers consider additional pricing information
and execution venues before routing customer orders and heightened
standards for best execution for conflicted transactions may result in
more order flow being routed to venues with competitive quotations. If
such quotations are more likely to result in executions, particularly
with retail order flow that usually carries lower adverse selection
costs to broker-dealers,\603\ broker-dealers would have greater
incentives to provide such quotations.
---------------------------------------------------------------------------
\603\ See, e.g., Barber, Brad M., and Terrance Odean, Trading is
hazardous to your wealth: The common stock investment performance of
individual investors?, 55 J. Fin. 773 (2000).
---------------------------------------------------------------------------
The Commission also recognizes that liquidity provision in thinly
traded and unlisted securities may decrease. Currently, broker-dealers
with business models that specialize in internalizing retail order flow
may be providing liquidity in very thinly traded securities as part of
a bundle of services that they provide to their customers. If the
internalization of retail orders decreases as the Commission
preliminarily believes it might, broker-dealers may be faced with
difficult liquidity searches when their customers wish to trade thinly
traded or unlisted securities. It is possible that an increase in
retail demand for liquidity in these securities may be met with an
increase in liquidity supply from firms that are more willing under the
proposal to make markets in these securities than they were when a
greater proportion of retail flow was internalized. To the extent that
broker-dealers' willingness to make markets in these securities
decreases overall, this may increase trading costs for these securities
and make it more difficult for companies to go public before they are
eligible to be listed on registered exchanges.
D. Reasonable Alternatives
1. SEC Adopts FINRA Rule 5310 and MSRB Rule G-18 Best Execution Rules
As an alternative, the Commission could adopt existing FINRA Rule
5310 and MSRB Rule G-18 rules and associated guidance. This alternative
would have lower costs and benefits compared to the proposal, because
changes \604\ in order handling practices would be unlikely to occur
under this alternative compared to the proposal. Under this
alternative, improvements to investor protection might be less than
those from the proposed rules.
---------------------------------------------------------------------------
\604\ See supra Sections V.C.1, V.C.2, and V.C.3 for the
Commission's projections on the effect of broker-dealers' order
handling practices.
---------------------------------------------------------------------------
This alternative would not include the enhanced requirements within
proposed Rule 1101(b) related to transactions with broker-dealer
subject to specified conflicts of interest, which represent the
majority of retail transactions in the equity, options, and fixed
income markets.\605\ Proposed Rule 1101(b) would require a broker-
dealer engaging in conflicted transactions to address additional
considerations in its best execution policies and procedures, and to
document its compliance with the best execution standard for such
transactions. To the extent that the proposal would have resulted in
improved execution quality for the retail orders by reducing the
inefficiencies \606\ present in existing conflicted transactions, this
alternative would result in less improvement in retail investor
execution quality compared to the proposal.
---------------------------------------------------------------------------
\605\ See supra Section IV.C.1 and Section IV.C.2.
\606\ The inefficiencies associated with existing conflicts of
interest include, but are not limited to, the trade-off between
payment for order flow and price improvement for equities (See supra
Section V.B.3.a.iii.) and the less than fully competitive price
improvement auction mechanisms for options (See supra Section
V.B.3.a.II.b.).
---------------------------------------------------------------------------
Under this alternative, broker-dealers would still qualify for
relief under FINRA Rule 5310.09(c), instead of having to meet the
introducing broker requirements to qualify for the propose relief under
proposed Rule 1101(d). Broker-dealers that meet the requirements of
FINRA's relief but would not have met the requirements of proposed Rule
1101(d) would experience lower compliance costs under this alternative
because they would not have to develop or update their own policies or
procedures or adjust their business model to de-conflict from their
executing broker.\607\ The costs of the proposal could advantage larger
broker-dealers, increase barriers to entry for new broker-dealers, and
disadvantage smaller broker-dealers, which could potentially result in
some of them existing the market.\608\ The lower compliance costs under
this alternative would increase competition among broker-dealers
compared to the proposal by lowering barriers to entry for new broker
dealers and decreasing the likelihood that smaller broker-dealers would
exit the market.\609\
---------------------------------------------------------------------------
\607\ See supra Section V.C.1.
\608\ See supra Section V.C.3.(a).ii for a discussion of the
effects of the proposal on competition between broker-dealers.
\609\ See id.
---------------------------------------------------------------------------
2. Require Order Execution Quality Disclosure for Other Asset Classes
Standardized information on the execution quality available at
different market centers and for different executing brokers could aid
broker-dealers in their best execution reviews. However, only market
centers executing trades in NMS stocks are required to report
standardized execution quality statistics under Rule 605.\610\ This
alternative would require execution quality disclosures from market
centers and large broker-dealers in the options and fixed income
markets. In addition to execution quality data at the individual
security-level, similar to Rule 605 data, the execution quality
disclosures would include aggregated
[[Page 5538]]
standardized summary reports of key execution quality statistics, which
would allow smaller and less sophisticated investors to analyze and
make comparisons between their own broker-dealers and other broker-
dealers. Compared to the proposal, these disclosures may better allow
investors to evaluate execution quality for their orders within their
broker-dealer's overall executions in a given security and facilitate
broker-to-broker comparison of order execution beyond equities markets.
Although the proposed rule would require each broker-dealer to
establish policies and procedures with greater specificity, this does
not necessarily mean that the order handling practices reach the same
level of efficiency across the broker-dealers. It is possible that some
broker-dealers would handle the customer orders less efficiently than
others. Under the alternative, broker-dealers, which engage in less
efficient order handling practices may recognize the inadequacy when
comparing their own execution quality statistics with those disclosed
by the more efficient broker-dealers, and improve the order handling
practices accordingly to attract order flow. Therefore, increased
transparency may reduce differences in execution quality within
specific security-time intervals, particularly in the corporate and
municipal bond markets. Broker-dealers may be able to incorporate these
execution quality statistics into their best execution policies and
procedures, which could improve their ability to identify market
centers that offer better execution quality, resulting in potentially
greater improvements in order handling compared to proposal. This
alternative may increase competition among broker-dealers and trading
centers in asset classes other than NMS stocks compared to the proposal
by promoting competition based more on the basis of publicly available
execution quality and less on other inducements to attract more
customers/order flow.
---------------------------------------------------------------------------
\610\ The Commission also is proposing to amend the order
execution quality disclosures required by Rule 605. See Securities
Exchange Act Release No. 96494 (Dec. 14, 2022). The Commission
encourages commenters to review that proposal to determine whether
it might affect their comments on this proposing release.
---------------------------------------------------------------------------
However, developing these execution quality disclosures may cause
market centers and large broker-dealers in the options and fixed income
markets to incur higher startup costs relative to the proposal as
market centers would need to develop systems to produce and post such
reports. To the extent that certain market centers already have systems
or infrastructures in place to produce execution quality metrics, they
would incur costs to modify the current systems and/or the format of
the reports in order to comply with the standards set forth in the
execution quality disclosure requirements. Additionally, execution
quality disclosures for the options and fixed income markets may be
complex and difficult to produce for a number of reasons. First, the
number of individual securities in the options and fixed income markets
is significantly larger than in the equity markets. The corporate bond
market has approximately 58,000 outstanding issues, more than fourteen
times the number of NMS listed equities.\611\ This number is small in
comparison to the municipal bond market which has approximately one
million outstanding issues.\612\ Individual equities can have hundreds
of individual outstanding options contract identifiers. Second, fixed
income and options securities have defined maturities, which might be
shorter than a disclosure interval (i.e., a contract with a week
expiration relative to a monthly reporting period). This security-level
inconsistency may present complications in evaluating time series
changes in execution quality. Finally, a broad lack of pre-trade
information in fixed income markets make execution quality statistics
such as effective-quoted spread ratios difficult, if not impossible, to
calculate for many securities.
---------------------------------------------------------------------------
\611\ See O'Hara and Zhou, supra note 469.
\612\ See Muni Facts, Municipal Securities Rulemaking Board,
available at https://www.msrb.org/News-and-Events/Muni-Facts.
---------------------------------------------------------------------------
3. Utilize FINRA and MSRB Approach To Introducing Broker
The Commission could alternatively propose to remove the
requirements for introducing and executing brokers related to PFOF,
carrying firm status, and affiliation. This definition would more
closely align with FINRA and MSRB approach to introducing brokers.
FINRA Rule 5310.09(c) applies to a member that routes its order flow to
another member that has agreed to handle that order flow as agent for
the customer (e.g., a clearing firm or other executing broker-dealer),
whereas the proposal would additionally require the firm not to be a
carrying firm, accept PFOF from an executing broker, or route customer
orders to an affiliated executing broker. Under this alternative, it is
likely that most brokers that qualify under FINRA Rule 5310(c) would
qualify as introducing brokers under proposed Rule 1101(d). By
categorizing more broker-dealers as ``introducing brokers,'' the
overall compliance cost carried by the market would be lower as
compared to the proposed rule. This alternative would likely cause
fewer small broker-dealers, which currently qualify for relief under
FINRA Rule 5310.09(c) and MSRB Rule G-18.08(b) and wish to remain
conflicted or still carry customer accounts, to change business models
to comply with the alternative rule.\613\
---------------------------------------------------------------------------
\613\ See supra Section V.C.1.
---------------------------------------------------------------------------
The brokers who benefit under this alternative are those who
currently qualify for relief under FINRA Rule 5310.09(c) and MSRB Rule
G-18.08(b) but fail at least one of the following criteria include in
proposed Rule 1101(d): (i) does not carry customer accounts and does
not hold customer funds or securities, (ii) has entered into an
arrangement with an unaffiliated broker or dealer that has agreed to
handle and execute on an agency basis the introducing broker's customer
orders (``executing broker''), and (iii) 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. Thus, many current broker-dealers that qualify
for relief under the FINRA and MSRB rules, and to some extent their
executing brokers, would have lower costs of compliance since there
would be no need for those broker-dealers to change their business
models. Also, this alternative may lower barriers to entry for some
potential introducing brokers. However, under this alternative, the
benefits of the proposal would also be diminished. With more broker-
dealers meeting the proposal's definition of introducing broker, the
benefits compared to the proposal would be lower. Specifically under
this alternative, the Commission preliminarily believes that instead of
changing their business models to stop being conflicted, introducing
brokers and their executing brokers would be more likely to engage in
conflicted transactions, and more introducing brokers would receive
PFOF. Therefore, the execution quality benefits would be lower since
the incentive created by the PFOF would persist, potentially leading to
less efficient order routing which may benefit broker-dealers at the
expense of retail customers.
4. Ban or Restrict Off-Exchange PFOF
Rather than requiring heightened best execution standards for
transactions involving PFOF, alternatively the Commission could ban or
restrict off-exchange PFOF in the equity and options markets. Under
this alternative, registered exchanges would still be allowed to pay
rebates.
[[Page 5539]]
Compared to the proposal, this alternative may further reduce
conflicts of interest within and improve order handling practices by
retail broker-dealers. A 2016 study sponsored by CFA Institute examined
changes in equity market execution quality following the Financial
Services Authority (FSA) 2012 guidance banning PFOF in the United
Kingdom.\614\ The study describes internalization under PFOF as a
scenario that can increase the probability of conflicted equity and
options transactions, particularly for retail investors, in the United
Kingdom. The study finds that over the time period from 2010 to 2014,
the proportion of retail-sized trades executing at the best quoted
price increased from around 65% to more than 90%. The authors claim
these findings suggest that the integrity of the order book improved.
---------------------------------------------------------------------------
\614\ See Sviatoslav Rosov, Payment for Order Flow in the United
Kingdom: Internalisation [sic], Retail Trading, Trade-Through
Protection, and Implications for Market Structure, CFA Institute
(2016), available at https://www.cfainstitute.org/en/advocacy/policy-positions/payment-for-order-flow-in-the-united-kingdom.
---------------------------------------------------------------------------
Alternatively, rather than an outright ban on PFOF, the Commission
could impose specific restrictions on PFOF that could allow retail
broker-dealers to pass through payments to end customers in cases where
it would permit best execution. For example, a retail broker-dealer may
consider two order execution venues with different executable prices:
the first venue has a more favorable price, and the second venue
provides PFOF to the retail broker-dealer. If the difference in price
between the two venues is smaller than the PFOF for the order in
question, the retail-broker could return to the customer the portion of
PFOF, which is greater than the venue price difference.
A ban or restriction on PFOF would increase the likelihood of
higher commissions for retail investors or an increase in the cost of
other services offered by retail broker-dealers compared to the
proposal. It may also further reduce competition between broker-dealers
compared to the proposal. Larger broker-dealers with more diversified
business models may be more likely to expand their market share and
smaller broker-dealers who are more dependent on PFOF revenue streams
may be more likely to exit the market.
5. Require Broker-Dealers To Utilize Best Execution Committees
The Commission considered requiring each broker-dealer to maintain
a best execution committee to regularly review the broker-dealer's best
execution policies, procedures and the results of its efforts to secure
best execution for its customers.
Requiring such a committee and defining its membership might
improve execution quality by ensuring sufficient expertise is recruited
to establish and monitor the broker-dealer's best execution efforts.
Furthermore, requiring such a committee might increase executive
attention to best execution, potentially improving execution quality
for the broker-dealer's customers.
Requiring such a committee and defining its membership would entail
certain costs in addition to those resulting from the proposed rules.
First, if the Commission were to define the membership of the
committee, it is likely that individual broker-dealers' organizational
structures would vary in ways that would make a defined membership
structure a poor fit because of, for instance, a single employee
performing multiple roles, or individual roles handled by groups rather
than a single individual. In addition, broker-dealers are diverse in
their business plans and operations and a role that might be considered
critical at one broker-dealer (such as managing fixed income executing
brokers in thinly traded bonds) might be inapplicable at another
broker-dealer that does not trade in these instruments.
If the Commission were to require the committee and not define its
membership, broker-dealers might assign to the committee less senior
staff or staff whose roles are not germane to achieving best execution
for customer orders, significantly limiting the benefits of
establishing such a committee. Furthermore, based on the its
experience, the Commission believes that broker-dealers, particularly
large broker-dealers that are more likely to continue to engage in
conflicted transactions if the proposed rules are adopted, may have
such a committee already established, further limiting the potential
benefits of such a provision.
6. Require Order-by-Order Documentation for Conflicted or All
Transactions
The Commission considered requiring each broker-dealer to document
on an order-by-order basis, for conflicted or all transactions, the
data that it considered as it handled the order. Such a requirement
might offer two benefits beyond the benefits of the proposed rules.
First, it might improve the quality of the broker-dealer's regular
review of its execution practices compared to the proposed rules.
Because the broker-dealer would analyze orders on a case-by-case basis,
it might identify routing practices that could be changed to improve
customer order execution quality. Second, it might improve regulators'
ability to oversee the broker-dealer's efforts to provide best
execution to its customers relative to the proposed rules as such
records would be available to regulators during examinations of the
broker-dealer or upon request.
The Commission preliminarily believes that such a requirement would
offer greater potential benefits for conflicted transactions because
broker-dealers engaging in such transactions have greater incentives to
route orders in a manner that might not result in the best execution
for customers.
Based on its experience, the Commission believes that some broker-
dealers, particularly the largest broker-dealers that are likely to
continue to engage in conflicted transactions if the proposed rules are
adopted, already maintain this type of documentation for both internal
review and operational purposes. Nevertheless, the requirement would be
costly. Broker-dealers that do not already retain this data likely have
chosen not to do so because the data are not operationally valuable to
them for business purposes, and they believe that they are satisfying
their best-execution obligations based on other data that they have
available. For these broker-dealers, the requirement could impose
considerable costs. They would need to alter information technology
systems to capture this data, including contemporaneous pricing data
and routing records, some of which (such as prices offered in response
to a RFQ and much information related to fixed income and digital
crypto assets) is not incorporated into other regulatory data sources
such as CAT and thus might be stored on systems not integrated with
other order routing systems, or systems that capture regulatory data.
Processing this data might be computationally demanding, particularly
for options, that have very high quotation traffic. Furthermore,
creating and maintaining software to produce this documentation would
require significant effort by highly skilled programmers, which would
further increase the costs associated with such a requirement. As
discussed previously,\615\ the Commission preliminarily believes that
broker-dealers that elect to refrain from conflicted transactions if
the proposed rules are adopted are more likely to be smaller broker-
dealers and these costs, many of which are fixed, are more likely to
result in the broker-dealer changing
[[Page 5540]]
its business model or exiting the market, while the aggregate benefits
to investors of such a requirement for smaller broker-dealers is likely
to be smaller than for larger broker-dealers that handle more customer
orders.
---------------------------------------------------------------------------
\615\ See Section V.C.2.ii, supra.
---------------------------------------------------------------------------
7. Staggered Compliance Dates
The Commission considered an alternative approach where smaller
broker-dealers would be given more time to comply with the proposed
rules. Having longer to comply might ease implementation for smaller
broker-dealers that are less likely to have specialized staff to
conduct tasks required for compliance. However, the later compliance
date for smaller broker-dealers would also delay the realization of the
proposed rules' benefits for investors.
The Commission preliminarily believes that the cost savings of the
alternative could be small. Specifically, under the proposed rules,
smaller broker-dealers would likely qualify as introducing brokers and
would likely de-conflict rather than continue to engage in conflicted
transactions and incur the additional costs associated with the rule
requirements that introducing brokers are exempt from under Rule
1101(d).\616\ Consequently, the Commission preliminarily believes
smaller broker-dealers would have fewer requirements to implement under
the proposal, mitigating the burden of implementation relative to
larger broker-dealers. In addition, the Commission believes that
smaller broker-dealers would likely engage external parties for review
of proposed policies and procedures and for assistance in conducting
annual reviews; this reliance on external resources for implementation
activities would likely mitigate the burden of implementation on
current staff.\617\ These mitigations would limit the potential cost
savings of delaying implementation for smaller broker-dealers.
---------------------------------------------------------------------------
\616\ See supra section V.C.2.a for discussion of carrying and
conflicted broker-dealer costs.
\617\ See supra section V.C.2.a).ii for the discussion about the
cost associated with small broker-dealers utilizing external
sources.
---------------------------------------------------------------------------
E. Request for Comments
The Commission is sensitive to the potential economic effects,
including costs and benefits, of the proposed rule. The Commission has
identified certain costs and benefits associated with the proposal and
requests comment on all aspects of its preliminary economic analysis,
including with respect to the specific questions below. The Commission
encourages commenters to identify, discuss, analyze, and supply
relevant data, information, or statistics regarding any such costs or
benefits. In addition to our general request for comments on the
economic analysis associated with the proposed rules and proposed
amendments, we request specific comment on certain aspects of the
proposal:
159. What are commenters' views of the Commission's economic
rationale for the proposed rule?
160. What are commenters' views of the Commission's
characterization of the relevant baseline, against which it considered
the effects of the proposal?
161. What are commenters' views of the Commission's
characterization of the current legal and regulatory framework?
162. What are commenters' views of the Commission's
characterization of the conflicts of interest in order handling and a
need for heightened best execution requirements with respect to
conflicted transactions?
163. What are commenters' views of the Commission's
characterization of the conflicts of interest in order handling with
respect to PFOF?
164. What are commenters' views of the Commission's
characterization of the conflicts of interest in order handling with
respect to principal trading?
165. What are commenters' views of the Commission's
characterization of order handling and execution?
166. What are commenters' views of the Commission's
characterization of retail customer order handling and execution for
NMS stocks?
167. What are commenters' views of the Commission's
characterization of retail customer order handling and execution for
listed options? Do commenters believe that the majority of retail
orders are routed to the wholesalers in exchange of payment for order
flow by the retail brokers? Do commenters believe whether there is a
trade-off between price improvement received for those retail orders
and payment for order flow?
168. What are commenters' views of the Commission's
characterization of retail customer order handling and execution for
fixed income securities? The Commission requests information on the
number of trading venues (e.g., ATSs, RFQ platforms, broker's broker
platforms, single platforms), to which broker-dealers currently
maintain access, for the purpose of executing and exposing retail
customer orders. The Commission requests information with respect to
how broadly broker-dealers expose retail customer orders. The
Commission requests information with respect to how many executing
brokers, to which broker-dealers outsource their fixed income
securities trading services. The Commission requests information on
what broker-dealers currently document (e.g., efforts to apply its best
execution policies and procedures for conflicted transactions, the
basis and information relied on for its determinations that such
conflicted transactions would comply with the best execution standard,
identifying the markets checked, internal quotes, external quotes,
limit orders on trading venues) with respect to retail customer orders.
169. The Commission requests comments on retail customer order
handling and execution for non-NMS stock equity securities. Please
provide any relevant details and data on retail customer order handling
and execution of non-NMS stock equity securities for assessing the
effects of the proposal.
170. What are commenters' views of the Commission's
characterization of retail customer order handling and execution for
crypto asset securities?
171. What are commenters' views of the Commission's
characterization of best execution review process?
172. What are commenters' views of the Commission's
characterization of execution quality review?
173. What are commenters' views of the Commission's
characterization of best execution committees?
174. What are commenters' views of the Commission's
characterization of the competition in the market for broker-dealer
services?
175. What are commenters' views of the Commission's
characterization of the competition in the market for NMS stock trading
services?
176. What are commenters' views of the Commission's
characterization of the competition in the market for listed options
trading services? Do commenters believe that the current features of
price improvement auctions are favoring the wholesalers that bring the
order flow and therefore not competitive?
177. What are commenters' views of the Commission's
characterization of the competition in the market for fixed income
securities trading services?
178. What are commenters' views of the Commission's
characterization of the competition in the market for corporate debt
securities trading services?
179. What are commenters' views of the Commission's
characterization of the competition in the market for municipal
securities trading services?
180. What are commenters' views of the Commission's
characterization of
[[Page 5541]]
the competition in the market for U.S. Treasury securities trading
services?
181. What are commenters' views of the Commission's
characterization of the competition in the market for market access?
182. What are commenters' views of the Commission's assessment of
the benefits of the proposal?
183. To what extent do commenters believe that broker-dealers will
make changes to their order handling procedures due to regulatory risk?
What kind of changes might they make? Does the proposal adequately
reflect the costs they would bear? Please provide estimates of the
costs if possible.
184. To what extent do commenters believe conflicted broker-dealers
will add additional routing destinations to expose orders to venues
beyond those identified as material potential liquidity sources for
non-conflicted transactions?
185. Are there some markets, in which finding venues beyond those
identified as material potential liquidity sources for non-conflicted
transactions difficult? Please explain. To what extent will seeking
such additional sources of liquidity be cost efficient?
186. What are commenters' views on the Commission's discussion of
ATS connectivity charges?
187. What are commenters' views of the Commission's assessment of
the effects stemming from changes in order handling procedures?
188. What are commenters' views on the extent to which investor
execution quality will change under the proposal? Please explain.
189. To what extent will carrying broker-dealers face additional
challenges and bear additional costs to comply with the proposal beyond
those already discussed in the Economic Analysis? Will the additional
restrictions on carrying broker-dealers improve investor execution
quality?
190. To what extent do broker-dealers that would be categorized as
``conflicted'' under the proposal already comply with the heightened
standards described by the proposal? Will these broker-dealers face
additional challenges and bear additional costs complying with the
proposal beyond those already discussed in the Economic Analysis?
Please explain.
191. Do commenters agree with the Commission's preliminary belief
that broker-dealers that receive relatively small payments for order
flow or other incentives that would categorize them as conflicted, may
choose to stop receiving those incentives to comply with the proposal?
Does the Economic Analysis adequately reflect the cost of the proposal
to these broker-dealers? Is the Commission's assumption that broker-
dealers with less than $100MM in total assets are likely to de-conflict
to avoid the heightened standards associated with conflicted
transactions reasonable?
192. Are some broker-dealers likely to pass exchange rebates
through to customers in order to avoid being conflicted under the
proposal? Are there other ways for broker-dealers to deal with these
rebates that would be less costly to implement? What costs would
broker-dealers bear to pass exchange rebates through to their
customers?
193. When a broker-dealer makes changes to its order routing in
response to execution quality analysis, what costs does it incur? Are
the Commission's estimates of these costs reasonable?
194. Do commenters believe that broker-dealers that currently pay
to receive order flow may assist their broker-dealer clients in
complying with the proposal by providing additional information on
their policies and procedures to provide best execution? What
information would they need to provide and how proprietary is this
information?
195. Do commenters believe that broker-dealers that currently pay
to receive order flow are significant contributors to the market for
liquidity provision in thinly traded securities? Would the proposal
disrupt liquidity provision to securities that are thinly traded? In
which types of securities would these effects be most pronounced?
196. Do commenters believe that the proposal is likely to increase
the prevalence of commissions in retail trading? In which asset classes
would such changes be most likely?
197. What are commenters' views of the Commission's assessment of
the effects stemming from changes in order handling procedures for NMS
stocks?
198. What are commenters' views of the Commission's assessment of
the effects stemming from changes in order handling procedures for
listed options? Do commenters believe that more retail orders would be
routed to price improvement auctions for execution? Do commenters
believe that more retail orders would be routed to the exchanges that
offer price improvement order types on the limit order books?
199. What are commenters' views of the Commission's assessment of
the effects stemming from changes in order handling procedures for on-
the-run U.S. Treasury securities?
200. What are commenters' views of the Commission's assessment of
the effects stemming from changes in order handling procedures for
fixed income securities (excluding on-the-run U.S. Treasury
securities)?
201. With respect to fixed income securities trading, do commenters
believe that the proposal (e.g., the documentation requirement with
respect to conflicted transactions) would enhance internal review
(e.g., internal review by best execution committee) of execution
quality?
202. With respect to fixed income securities trading, do commenters
believe that the proposal would improve the execution quality of retail
customer trades by executing brokers? Please explain.
203. The Commission requests comments on the effects stemming from
changes in order handling procedures for non-NMS stock equity
securities.
204. What are commenters' views of the Commission's description of
the non-NMS stock equity market? Please highlight any omitted or
misunderstood elements on this market.
205. Do commenters agree with the Commission's characterization of
internalization in the non-NMS stock equities market?
206. Do commenters agree with the assertion that the non-NMS stock
equity market can offer a high degree of transparency in liquid
securities? Please list any sources of pre-trade and post-trade
information used when transacting in this market.
207. What are commenters' views on the necessity to connect to any
given ATS when transacting in non-NMS stock equities? Please explain
the rationale for connecting to an additional ATS in this market. If
there are other non-ATS sources of liquidity, please describe them.
208. Do commenters believe the effects of the proposed rule on the
non-NMS equity securities market will cause any brokers (introducing or
otherwise) to reduce participation in or to exit this market? Please
describe the rationale for any response.
209. Do commenters believe the requirements of this rule will have
effects on the liquidity in the market for non-NMS stock equities?
Please explain.
210. Do commenters believe that execution quality can be accurately
measured in the non-NMS equity securities market? If so, please
describe methods currently used to achieve execution quality analysis.
211. What are commenters' views of the Commission's assessment of
the effects stemming from changes in order handling procedures for
crypto asset securities?
212. The Commission requests more information regarding the
proportion of
[[Page 5542]]
crypto asset security trading that is facilitated by introducing
brokers.
213. The Commission requests more information regarding the level
and variation of payment for order flow (i.e., transaction rebates)
rates in crypto asset security markets.
214. The Commission requests more information regarding the
frequency of affiliated ATS routing in crypto asset security markets.
215. The Commission requests more information regarding the
frequency of principal trading in crypto asset security markets.
216. What are commenters' views of the Commission's assessment of
the costs of the proposal? Please provide as many quantitative
estimates to support your position on costs as possible.
217. Does the Economic Analysis account for all compliance costs?
If not, what other compliance costs would market participants incur?
Please provide as many quantitative estimates to support your position
on costs as possible.
218. With respect to fixed income securities trading, do commenters
believe that broker-dealers would alter business practices to execute
self-directed trades of retail customer on an agency basis rather than
riskless principal basis to avoid being subject to the proposed
requirements for conflicted transactions? If so, please provide
quantitative cost estimates for converting retail self-directed trading
business from riskless principal based to agency based.
219. The Commission requests comments on the costs associated with
subscribing to a fixed income ATS (e.g., subscription fees,
connectivity fees, API). Please provide quantitative cost estimates if
possible.
220. What are commenters' views of the Commission's assessment of
the effects of the proposal on efficiency, competition and capital
formation?
221. What are commenters' views of the Commission's assessment of
the proposal's effects on competition?
222. What are commenters' views of the Commission's assessment of
the proposal's effects on the competition in the market for trading
services?
223. What are commenters' views of the Commission's assessment of
the proposal's effects on the competition in the market for trading
services for NMS stocks?
224. What are commenters' views of the Commission's assessment of
the proposal's effects on the competition in the market for trading
services for listed options? In particular, would the proposed rule
result in the exchanges improving the level of competition and
efficiency of the price improvement auction mechanisms by offering more
symmetric fee schedule and allocation model? Would the proposed rule
result in certain options exchanges starting to introduce order types
to allow liquidity provision at the midpoint of the NBBO spread?
225. What are commenters' views of the Commission's assessment of
the proposal's effects on the competition in the market for trading
services for fixed income securities?
226. The Commission requests comments on the proposal's effects on
the competition in the market for trading services for non-NMS stock
equity securities.
227. What are commenters' views of the Commission's assessment of
the proposal's effects on the competition in the market for trading
services for crypto asset securities?
228. What are commenters' views of the Commission's assessment of
the proposal's effects on competition in the market for broker-dealer
services?
229. What are commenters' views of the Commission's assessment of
the proposal's effects on the competition in the market for broker-
dealer services for NMS stocks?
230. What are commenters' views of the Commission's assessment of
the proposal's effects on the competition in the market for broker-
dealer services for listed options?
231. What are commenters' views of the Commission's assessment of
the proposal's effects on the competition in the market for broker-
dealer services for fixed income securities?
232. The Commission requests comments on the proposal's effects on
the competition in the market for broker-dealer services for non-NMS
stock equity securities.
233. What are commenters' views of the Commission's assessment of
the proposal's effects on the competition in the market for broker-
dealer services for crypto asset securities?
234. What are commenters' views of the Commission's assessment of
the proposal's effects on the competition in the market for market
access?
235. What are commenters' views of the Commission's assessment of
the proposal's effects on the competition in the market for market
access for NMS stocks?
236. What are commenters' views of the Commission's assessment of
the proposal's effects on the competition in the market for market
access for listed options?
237. What are commenters' views of the Commission's assessment of
the proposal's effects on the competition in the market for market
access for fixed income securities?
238. The Commission requests comments on the proposal's effects on
the competition in the market for market access for non-NMS stock
equity securities.
239. What are commenters' views of the Commission's assessment on
the competition in the market for market access for crypto asset
securities?
240. What are commenters' views on the likelihood of broker-dealers
reducing their participation in or leaving certain markets due to
compliance costs of the proposal? Which markets would be most affected?
Are there particular groups of investors that may be underserved by
these markets if the proposal is adopted?
241. What are commenters' views of the economic effects on the
market structure or order handling practices in the markets for
securities based swaps, asset-backed securities, and repurchase and
reverse repurchase agreements?
242. What are commenters' views of the Commission's assessment of
the effects of the proposal on efficiency?
243. What are commenters' views of the Commission's assessment of
the effects of the proposal on capital formation?
244. What are commenters' views of the Commission's assessment of
the effects of an alternative to adopt FINRA Rule 5310 and MSRB Rule G-
18 best execution rules?
245. What are commenters' views of the Commission's assessment of
the effects of an alternative to require order execution quality
disclosure for other asset classes?
246. What are commenters' views of the Commission's assessment of
the effects of an alternative to utilize FINRA's and MSRB's definition
of introducing brokers?
247. What are commenters' views of the Commission's assessment of
the effects of an alternative to ban or restrict off-exchange PFOF?
248. Are there any additional reasonable alternatives that the
Commission should consider? If so, please discuss that alternative and
provide the benefits and costs of that alternative relative to the
baseline and to the proposal.
VI. Paperwork Reduction Act
Certain provisions of proposed Rules 1101 and 1102, as well as
proposed Rule 17a-4(b)(17), contain ``collection of information
requirements'' within the meaning of the Paperwork Reduction Act of
1995 (``PRA'').\618\ The
[[Page 5543]]
Commission is submitting these collections of information to the Office
of Management and Budget (``OMB'') for review in accordance with 44
U.S.C. 3507(d) and 5 CFR 1320.11. The titles for these collections of
information are: (1) ``Regulation Best Execution''; and (2) Rule 17a-
4--Records to be Preserved by Certain Exchange Members, Brokers and
Dealers (OMB control number 3235-0279).\619\ An agency may not conduct
or sponsor, and a person is not required to respond to, a collection of
information unless the agency displays a currently valid control
number.
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\618\ 44 U.S.C. 3501 et seq.
\619\ See 17 CFR 240.17a-4. The proposed amendment to Rule 17a-
4(b)(17) would amend the existing PRA for Rule 17a-4.
---------------------------------------------------------------------------
A. Summary of Collection of Information
Proposed Rules 1101 and 1102, as well as proposed Rule 17a-
4(b)(17), would include a collection of information within the meaning
of the PRA for broker-dealers, as described below in this section VI.A.
Further, the proposed Rule 17a-4(b)(17) would impose new record
retention obligations on broker-dealers subject to Regulation Best
Execution.
1. Required Policies and Procedures and Related Obligations
As detailed above,\620\ proposed Rule 1101 would require that a
broker-dealer that engages in any transaction for or with a customer or
a customer of another broker-dealer establish, maintain, and enforce
written policies and procedures reasonably designed to comply with the
proposed best execution standard. These policies and procedures would
be required to address: (1) how a broker-dealer will comply with the
best execution standard; (2) how the broker-dealer will determine the
best market and make routing or execution decisions for customer
orders; (3) additional considerations applicable to conflicted
transactions with retail customers; and (4) to the extent applicable,
the obligations of introducing brokers that meet the definition in
proposed Rule 1101(d).
---------------------------------------------------------------------------
\620\ See supra sections IV.B-IV.E.
---------------------------------------------------------------------------
In particular, these policies and procedures must address how the
broker-dealer will comply with the best execution standard, including
by obtaining and assessing reasonably accessible information, including
information about price, volume, and execution quality, concerning the
markets trading the relevant securities; identifying markets that may
be reasonably likely to provide the most favorable prices for customer
orders; and incorporating these material potential liquidity sources
into the broker-dealer's order handling practices and ensuring that the
broker-dealer can efficiently access each such material potential
liquidity source.\621\ The policies and procedures must also address
how the broker-dealer will determine the best market and make routing
or execution decisions for customer orders, including by: (1) 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; (2) 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 (3) in determining the
number and sequencing of markets to be assessed, reasonably balancing
the likelihood of obtaining a better price with the risk that delay
could result in a worse price.\622\
---------------------------------------------------------------------------
\621\ See proposed Rule 1101(a)(1).
\622\ See proposed Rule 1101(a)(2).
---------------------------------------------------------------------------
For conflicted transactions, as described in more detail
above,\623\ proposed Rule 1101(b) would require written policies and
procedures to address additional considerations.\624\ The broker-
dealer's policies and procedures would need to additionally address:
(1) how the broker-dealer will obtain and assess information beyond
that required by proposed Rule 1101(a)(1)(i), including additional
information about price, volume, and execution quality, in identifying
a broader range of markets beyond those identified as material
potential liquidity sources and (2) how the broker-dealer will evaluate
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. The broker-
dealer must additionally document, in accordance with written
procedures, its compliance with the best execution standard for
conflicted transactions, including all efforts taken to enforce the
policies and procedures required by proposed Rule 1102(b) for
conflicted transactions, and the basis and information relied on for
its determination that such conflicted transactions would comply with
the best execution standard. The broker-dealer would also have to
document any arrangement, whether written or oral, concerning payment
for order flow, including the parties to the arrangement, all
qualitative and quantitative terms concerning the arrangement, and the
date and terms of any changes to the arrangement.
---------------------------------------------------------------------------
\623\ See supra section IV.C.
\624\ See proposed Rule 1101(b).
---------------------------------------------------------------------------
A broker-dealer would also have to, no less frequently than
quarterly, review the execution quality of its transactions for or with
customers or customers of another broker-dealer and how such execution
quality compares with the execution quality the broker-dealer might
have obtained from other markets, revise its best execution policies
and procedures, including its order handling practices, accordingly,
and document the results of this review.\625\
---------------------------------------------------------------------------
\625\ See proposed Rule 1101(c).
---------------------------------------------------------------------------
To the extent that it has an arrangement with an executing broker
for the handling of is customer orders, an introducing broker, as
defined in proposed Rule 1101(d), would not have to comply with all of
the requirements of proposed Rule 1101. Instead, as described
above,\626\ proposed Rule 1101(d) would provide that an introducing
broker that routes customer orders to an executing broker would not
need to separately comply with proposed Rules 1101(a), (b), and (c), so
long as the introducing broker establishes, maintains, and enforces
policies and procedures that require the introducing broker to
regularly review the execution quality obtained from its executing
broker, compare that execution quality with the execution quality it
might have obtained from other executing brokers, and revise its order
handling practices, accordingly. An introducing broker would
additionally be required to document the results of its review.
---------------------------------------------------------------------------
\626\ See supra section IV.E.
---------------------------------------------------------------------------
Finally, any broker-dealer subject to proposed Rule 1101 would be
required under proposed Rule 17a-4(b)(17) to preserve the records made
under proposed Rule 1101.\627\ Accordingly, a broker-dealer would be
required to preserve those records for a period of not less than three
years, the first two years in an easily accessible place.
---------------------------------------------------------------------------
\627\ Any written policies and procedures developed pursuant to
proposed Rule 1101 would be required to be preserved pursuant to
existing Rule 17a-4(e)(7).
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[[Page 5544]]
2. Annual Report
As detailed above,\628\ proposed Rule 1102 would require that a
broker-dealer that effects any transaction for or with a customer or a
customer of another broker-dealer, no less frequently than annually,
review and assess the design and overall effectiveness of its best
execution policies and procedures, including its order handling
practices. The broker-dealer must prepare a written report detailing
the results of such review and assessment, including a description of
all deficiencies found and any plan to address deficiencies, and the
report must be presented to the broker-dealer's board of directors (or
equivalent governing body). The broker-dealer would be required to
preserve a copy of each such report, and the documentation for each
such review and assessment, pursuant to proposed Rule 17a-
4(b)(17).\629\
---------------------------------------------------------------------------
\628\ See supra section IV.F.
\629\ Any written procedures developed pursuant to proposed Rule
1102 would be required to be preserved pursuant to existing Rule
17a-4(e)(7).
---------------------------------------------------------------------------
B. Proposed Use of Information
Generally, the collections of information required under proposed
Rules 1101 and 1102, as described below in this section VI.B, would
enable a broker-dealer to comply with its obligations under proposed
Regulation Best Execution, allow the broker-dealer to identify any
inadequacies and make any revisions to its policies and procedures,
including order handling practices, as appropriate to ensure the
broker-dealer's continued effective compliance with the best execution
standard, and create documentation that the Commission and SROs could
use for purposes of examinations and investigations.
Records retained in accordance with proposed Rule 17a-4(b)(17)
would assist a broker-dealer in supervising and assessing internal
compliance with Regulation Best Execution and assist the Commission and
SROs in connection with examinations and investigations.
1. Required Policies and Procedures and Related Obligations
The collection of information pursuant to proposed Rule 1101 would
require written documentation of a broker-dealer's policies and
procedures reasonably designed to comply with the best execution
standard in proposed Rule 1100. Generally, these policies and
procedures would provide a documented process for handling customer
orders that a broker-dealer would use to ensure its ongoing compliance
with the best execution standard. In addition, these written policies
and procedures would assist the Commission and SROs in conducting
examinations and investigations for compliance with the proposed rules,
including the proposed best execution standard. Any ongoing collections
of information pursuant to proposed Rule 1101, including a conflicted
broker-dealer's documentation of its best execution determinations and
its payment for order flow arrangements in accordance with written
procedures, a broker-dealer's documentation of the results of its
execution quality reviews, and an introducing broker's documentation of
its executing broker execution quality reviews, would assist the
broker-dealer in its ongoing efforts to transact for or with customers
consistent with its best execution policies and procedures, and in turn
ensure compliance with the best execution standard. Ongoing collections
of information would also assist the Commission and SROs in
examinations and investigations by ensuring that appropriate
documentation is available to determine whether a broker-dealer is
adhering to its best execution policies and procedures and otherwise in
compliance with all applicable requirements of proposed Regulation Best
Execution.
2. Annual Report
The collection of information pursuant to proposed Rule 1102 would
also provide appropriate documentation of a broker-dealer's continued
efforts to comply with the best execution standard and would help to
ensure that the broker-dealer's best execution policies and procedures
remain effective. In particular, the requirement of proposed Rule 1102
to document the results of a broker-dealer's annual review of its best
execution policies and procedures would enable the broker-dealer,
including its governing body, to identify any inadequacies and make any
changes to the broker-dealer's best execution policies and procedures,
including its order handling practices, as appropriate in order to
further its compliance with the proposed rules. The collection of
information pursuant to proposed Rule 1102 would also create
documentation of such compliance that the Commission and SROs could use
for purposes of investigations and examinations.
C. Respondents
The respondents to proposed Rules 1101, 1102, and 17a-4(b)(17)
would be broker-dealers that engage in securities transactions for or
with a customer, or a customer of another broker-dealer. Based on FOCUS
Report data,\630\ the Commission estimates that, as of June 30, 2022,
there were 3,498 broker-dealers.\631\ The Commission preliminarily
believes that nearly all of these broker-dealers would engage in
customer transactions and be subject to these rules. Accordingly, for
purposes of the PRA, the Commission estimates 3,498 respondents. The
Commission requests comment on the accuracy of these estimated figures.
---------------------------------------------------------------------------
\630\ FOCUS Reports, or ``Financial and Operational Combined
Uniform Single'' Reports, are monthly, quarterly, and annual reports
that broker-dealers are generally required to file with the
Commission and/or SROs pursuant to Exchange Act Rule 17a-5. See 17
CFR 240.17a-5.
\631\ The data are obtained from FOCUS Reports, Part II filed
for the second quarter of 2022.
---------------------------------------------------------------------------
D. Total Initial and Annual Reporting and Recordkeeping Burdens
1. Required Policies and Procedures and Related Obligations
(a) Initial Costs and Burdens
The Commission preliminarily believes that broker-dealers generally
already have policies and procedures in place to achieve compliance
with the best execution rules of FINRA and the MSRB, as applicable,
although these policies and procedures differ based on each broker-
dealer's business model. For purposes of the PRA, the Commission must
consider the burden on respondents to bring their best execution
policies and procedures into compliance with the proposed rule, which
in certain cases would impose additional and more specific obligations.
The extent to which a respondent would be burdened by the proposed
collection of information under the proposed rule would depend on the
best execution policies and procedures that have already been
established by a respondent as well as the respondent's business model.
To the extent broker-dealers' existing best execution policies and
procedures already substantially address the requirements of proposed
Rule 1101, these broker-dealers likely would only require limited
updates to their policies and procedures to meet the additional
obligations specified in the proposed rule. To initially comply with
this obligation, the Commission preliminarily believes that broker-
dealers would employ a combination of in-house and outside legal and
compliance counsel to update existing policies and procedures. The
Commission assumes that, for purposes of this analysis, the associated
costs and burdens would differ between small and large broker-dealers,
as large broker-
[[Page 5545]]
dealers generally offer more products and services and are more likely
to engage in conflicted transactions, and therefore would need to
develop a more extensive set of policies and procedures. Based on FOCUS
Report data, the Commission estimates that, as of June 30, 2022,
approximately 761 broker-dealers are small entities under the
Regulatory Flexibility Act.\632\ Therefore, the Commission estimates
that 2,737 broker-dealers would qualify as large broker-dealers for
purposes of this analysis.\633\
---------------------------------------------------------------------------
\632\ See infra note 691 (describing the definition of the term
``small entity'').
\633\ This calculation was made as follows: (3,498 total broker-
dealers) - (761 small broker-dealers) = 2,737 large broker-dealers.
---------------------------------------------------------------------------
Although the exact nature and extent of the policies and procedures
that a broker-dealer would be required to establish likely would vary
depending upon the business model of the broker-dealer,\634\ the
Commission broadly estimates that a large broker-dealer, which the
Commission assumes is more likely to need to satisfy the heightened
requirements applicable to conflicted transactions, would incur a one-
time average internal burden of 85 hours for in-house legal and in-
house compliance counsel to update existing policies and procedures to
comply with proposed Rule 1101.\635\ The Commission additionally
estimates a one-time burden of 12 hours for a general counsel at a
large broker-dealer and 12 hours for a Chief Compliance Officer to
review and approve the updated policies and procedures, for a total of
109 burden hours.\636\ In addition, the Commission estimates a cost of
approximately $7,936 for outside counsel to review the updated policies
and procedures on behalf of a large broker-dealer.\637\ The Commission
therefore estimates the aggregate burden for large broker-dealers to be
298,333 burden hours,\638\ and the aggregate cost for large broker-
dealers to be approximately $21.72 million.\639\
---------------------------------------------------------------------------
\634\ For purposes of the PRA, the burden to establish policies
and procedures means those a respondent is required to establish
pursuant to proposed Rules 1101(a), (b), and (d).
\635\ This estimate would be broken down as follows: 67 hours
for in-house legal counsel + 18 hours for in-house compliance
counsel to update existing policies and procedures = 85 burden
hours.
\636\ This estimate is based on the following calculation: (85
hours of review for in-house legal and in-house compliance counsel)
+ (12 hours of review for general counsel) + (12 hours of review for
Chief Compliance Officer) = 109 burden hours.
\637\ The Commission's estimates of the relevant wage rates for
outside legal services of $496/hour take into account staff
experience, a variety of sources including general information
websites, and adjustments for inflation. This cost estimate is
therefore based on the following calculation: (16 hours of review) x
($496/hour for outside counsel services) = $7,936 in outside counsel
costs.
\638\ This estimate is based on the following calculation: (109
burden hours of review per large broker-dealer) x (2,737 large
broker-dealers) = 298,333 aggregate burden hours.
\639\ This estimate is based on the following calculation:
($7,936 for outside counsel costs per large broker-dealer) x (2,737
large broker-dealers) = $21.72 million in outside counsel costs.
---------------------------------------------------------------------------
In contrast, the Commission preliminarily believes small broker-
dealers would primarily rely on outside counsel to update existing
policies and procedures, as small broker-dealers generally have fewer
in-house legal and compliance personnel. Moreover, the Commission
believes small broker-dealers would be less likely to engage in
conflicted transactions subject to the additional procedural
obligations of proposed Rule 1101(b), and would be more likely to
qualify as introducing brokers and be exempt from complying with
proposed Rule 1101(a), (b), and (c), and therefore would need to
develop a less extensive set of policies and procedures. Accordingly,
the Commission estimates that only 65 hours of outside legal counsel
services would be required to update such small broker-dealers'
policies and procedures, for a total one-time cost of approximately
$32,240 per small broker-dealer,\640\ and an aggregate cost of
approximately $24.53 million for all small broker-dealers.\641\ The
Commission additionally estimates in-house compliance personnel would
require 18 hours to review and approve the updated policies and
procedures, for an aggregate burden of 13,698 hours.\642\
---------------------------------------------------------------------------
\640\ This cost estimate is based on the following calculation:
(65 hours of review) x ($496/hour for outside counsel services) =
$32,240 in outside counsel costs.
\641\ This cost estimate is based on the following calculation:
($32,240 for outside attorney costs per small broker-dealer) x (761
small broker-dealers) = $24.53 million in outside counsel costs.
\642\ This estimate is based on the following calculation: (18
burden hours) x (761 small broker-dealers) = 13,698 aggregate burden
hours.
---------------------------------------------------------------------------
The Commission preliminarily believes that broker-dealers would
utilize their existing recordkeeping systems to preserve any documents
necessary to comply with proposed Rule 17a-4(b)(17). Accordingly, the
Commission estimates that broker-dealers will incur no new initial
burdens or costs to retain the records made pursuant to proposed Rule
17a-4(b)(17). Nevertheless, the Commission requests comment on this
assumption and whether the requirements of proposed Rule 17a-4(b)(17)
would pose additional initial burdens or costs on broker-dealers.
The Commission therefore estimates the total initial aggregate
burden to be 312,031 hours,\643\ and the total initial aggregate cost
to be approximately $46.25 million.\644\
---------------------------------------------------------------------------
\643\ This estimate is based on the following calculation:
(298,333 aggregate burden hours for large broker-dealers) + (13,698
aggregate burden hours for small broker-dealers) = 312,031 total
aggregate burden hours.
\644\ This estimate is based on the following calculation:
($21.72 million in aggregate costs for large broker-dealers) +
($24.53 million in aggregate costs for small broker-dealers) =
$46.25 million total aggregate costs.
---------------------------------------------------------------------------
(b) Ongoing Costs and Burdens
On an ongoing basis, a respondent would have to maintain and review
its best execution policies and procedures to ensure their
effectiveness as well as to address any deficiencies found and to
accommodate the addition of, among other things, new products or
services, new business lines, or new markets or trading characteristics
for a particular security. Proposed Rule 1101(c) would also require a
broker-dealer to, no less frequently than quarterly, review the
execution quality of its transactions for or with customers or
customers of another broker-dealer, and how such execution quality
compares with the execution quality the broker-dealer might have
obtained from other markets, and to revise is best execution policies
and procedures accordingly. Broker-dealers would also have to document
the results of this review. Additionally, proposed Rule 1101(b) would
require broker-dealers that engage in conflicted transactions to
document, in accordance with written procedures, their compliance with
the best execution standard for conflicted transactions, including all
efforts to enforce their best execution policies and procedures for
conflicted transactions and the basis and information relied on for
their determinations that such conflicted transactions would comply
with the best execution standard, as well as to document their payment
for order flow arrangements. Moreover, in lieu of the requirements of
proposed Rules 1101(a), (b), and (c), proposed Rule 1101(d) would
require an introducing broker relying on that rule to establish,
maintain, and enforce policies and procedures that require the
introducing broker to regularly review the execution quality obtained
from its executing broker, compare it with the execution quality it
might have obtained from other executing brokers, and revise its order
handling practices, accordingly. The introducing broker would have to
document the results of this review.
Once a broker-dealer has established written policies and
procedures reasonably designed to achieve best execution, the
Commission estimates
[[Page 5546]]
that large broker-dealers would each annually incur an internal burden
of 25 hours to review and update existing policies and procedures:
\645\ 9 hours for legal personnel, 8 hours for compliance personnel,
and 8 hours for business-line personnel. The Commission further
estimates that large broker-dealers would each annually incur an
internal burden of 100 hours to conduct and document their reviews of
execution quality pursuant to proposed Rule 1101(c) and document their
efforts to obtain best execution for any conflicted transactions and
their payment for order flow arrangements pursuant to proposed Rule
1101(b): 10 hours for legal personnel, 20 hours for compliance
personnel, and 70 hours for business-line personnel. The Commission
therefore estimates an ongoing, aggregate burden for large broker-
dealers of approximately 342,125 hours.\646\ Because the Commission
assumes that large broker-dealers would rely on internal personnel,
rather than outside counsel, to update their policies and procedures on
an ongoing basis, to conduct and document their execution quality
reviews, and to document their efforts to obtain best execution for
conflicted transactions, the Commission estimates large broker-dealers
would not incur additional ongoing costs.
---------------------------------------------------------------------------
\645\ See supra note 634.
\646\ This estimate is based on the following calculation: (125
burden hours per large broker-dealer) x (2,737 large broker-dealers)
= 342,125 aggregate ongoing burden hours.
---------------------------------------------------------------------------
The Commission assumes for purposes of this analysis that small
broker-dealers would mostly rely on outside legal counsel and outside
compliance consultants for review and update of their policies and
procedures.\647\ The Commission preliminarily estimates that outside
legal counsel would require approximately 11 hours per year to update
policies and procedures, for an annual cost of approximately $5,456 for
each small broker-dealer.\648\ The estimated aggregate, annual ongoing
cost for outside legal counsel to update policies and procedures for
all small broker-dealers would be approximately $4.15 million.\649\ In
addition, the Commission estimates that small broker-dealers would
require 11 hours of outside compliance services per year to update
their policies and procedures, for an ongoing cost of approximately
$3,344 per year,\650\ and an aggregate ongoing cost of approximately
$2.54 million.\651\ The Commission further estimates that small broker-
dealers would require 20 hours of outside compliance services per year
to conduct and document their reviews of execution quality and document
their efforts to obtain best execution for conflicted transactions and
payment for order flow arrangements, for an ongoing cost of
approximately $6,080 per year,\652\ and an aggregate ongoing cost of
approximately $4.63 million.\653\ The total aggregate, ongoing cost for
small broker-dealers is therefore estimated at approximately $11.32
million per year.\654\ For purposes of this analysis, the Commission
assumes that small broker-dealers would engage in fewer conflicted
transactions than large broker-dealers and be more likely to comply
with the regular review required by proposed Rule 1101(d) for
introducing brokers in lieu of the regular review required by proposed
Rule 1101(c).
---------------------------------------------------------------------------
\647\ See supra note 640.
\648\ This estimate is based on the following calculation: (11
hours per small broker-dealer) x ($496/hour for outside counsel
services) = $5,456 in outside counsel costs.
\649\ This estimate is based on the following calculation:
($5,456 in outside counsel costs per small broker-dealer) x (761
small broker-dealers) = $4.15 million in aggregate, ongoing outside
legal costs.
\650\ The Commission believes that performance of this function
will most likely be equally allocated between a senior compliance
examiner and a compliance manager. Based on industry sources,
Commission staff preliminarily estimates that the costs for these
positions in the securities industry are $264 and $344 per hour,
respectively, for an average of $304 per hour. This cost estimate is
based on the following calculation: (11 hours of review) x ($304/
hour for outside compliance services) = $3,344 in outside compliance
service costs.
\651\ This estimate is based on the following calculation:
($3,344 in outside compliance costs per small broker-dealer) x (761
small broker-dealers) = $2.54 million in aggregate, ongoing outside
compliance costs.
\652\ This cost estimate is based on the following calculation:
(20 hours of review) x ($304/hour for outside compliance services) =
$6,080 in outside compliance service costs.
\653\ This estimate is based on the following calculation:
($6,080 in outside compliance costs per small broker-dealer) x (761
small broker-dealers) = $4.63 million in aggregate, ongoing outside
compliance costs.
\654\ This estimate is based on the following calculation:
($4.15 million for outside legal counsel costs) + ($2.54 million for
outside compliance costs for policies and procedures) + ($4.63
million for outside compliance costs for regular reviews and
documentation) = $11.32 million total aggregate ongoing costs.
---------------------------------------------------------------------------
In addition to the ongoing costs described above, the Commission
additionally estimates small broker-dealers would incur an internal
burden of approximately 6 hours for an in-house compliance manager to
review and approve the updated policies and procedures per year. The
Commission further estimates that small broker-dealers would incur an
internal burden of approximately 30 hours per year for in-house
business-line personnel to conduct and document their reviews of
execution quality and document their efforts to obtain best execution
for conflicted transactions and payment for order flow arrangements. In
addition, the Commission estimates that small-broker dealers would
incur an internal burden of approximately 8 hours per year for in-house
compliance personnel to review the execution quality reviews and
documentation of efforts to obtain best execution for conflicted
transactions and payment for order flow arrangements. The Commission
estimates that the ongoing burden for business-line personnel, in-house
compliance personnel and in-house compliance manager review for each
small broker dealer would be 44 hours and the ongoing, aggregate burden
for all small broker-dealers would be 33,484 hours for business-line
personnel, in-house compliance personnel, and in-house compliance
manager review.\655\
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\655\ This estimate is based on the following calculation: (6
hours in-house compliance manager review per small broker-dealer) +
(30 hours business-line personnel review per small broker-dealer) +
(8 hours in-house compliance personnel review per small broker-
dealer) = 44 hours per small broker dealer x (761 small broker-
dealers) = 33,484 aggregate ongoing burden hours.
---------------------------------------------------------------------------
The Commission estimates that the approximate ongoing burden
associated with the recordkeeping requirements of proposed Rule 17a-
4(b)(17) for any records made in compliance with proposed Rule 1101
would be 15,968 burden hours per year.\656\ The Commission does not
believe that the ongoing costs associated with ensuring compliance with
the retention schedule would change from the current costs of ensuring
compliance with existing Rule 17a-4. However, the Commission requests
comment regarding whether there would be additional costs relating to
ensuring compliance with record retention and retention schedules
pursuant to Rule 17a-4.
---------------------------------------------------------------------------
\656\ Because the Commission assumes broker-dealers would
utilize their existing recordkeeping systems to preserve any records
made in compliance with proposed Rule 1101, the Commission estimates
that the burdens associated with such record retention would be
minimal. Accordingly, the Commission estimates the aggregate ongoing
burden based on the following calculation: (5 burden hours in-house
compliance personnel per large broker-dealer x 2,737 large broker-
dealers) + (3 burden hours in-house compliance personnel per small
broker-dealer x 761 small broker-dealers) = 15,968 aggregate ongoing
burden hours.
---------------------------------------------------------------------------
The Commission therefore estimates the total ongoing aggregate
burden to be 391,577 hours,\657\ and the total ongoing
[[Page 5547]]
aggregate cost to be approximately $11.32 million per year.\658\
---------------------------------------------------------------------------
\657\ This estimate is based on the following calculation:
(342,125 aggregate ongoing burden hours for large broker-dealers for
proposed Rule 1101) + (33,484 aggregate ongoing burden hours for
small broker-dealers for proposed Rule 1101) + (15,968 aggregate
ongoing burden hours for all broker-dealers for proposed Rule 17a-
4(b)(17)) = 391,577 total aggregate ongoing burden hours.
\658\ This estimate is based on the following calculation:
($11.32 million per year in total aggregate ongoing costs for small
broker-dealers) + ($0 ongoing costs for large broker-dealers) =
$11.32 million per year in total aggregate ongoing costs.
---------------------------------------------------------------------------
The Commission acknowledges that policies and procedures required
by proposed Rule 1101 may vary greatly by broker-dealer, given the
differences in size and the complexity of broker-dealer business
models. Accordingly, the need to update policies and procedures might
also vary greatly. The Commission requests comment regarding the
accuracy of the estimated burden hours and costs necessary to comply
with the proposal.
2. Annual Report
(a) Initial Costs and Burdens
Proposed Rule 1102 would require a broker-dealer to, no less
frequently than annually, review and assess the design and overall
effectiveness of its best execution policies and procedures, including
its order handling practices. A broker-dealer would be required to
conduct the review and assessment in accordance with written
procedures, as well as document the review and assessment. The broker-
dealer would also have to prepare a written report detailing the
results of such review and assessment, including a description of all
deficiencies found any plan to address deficiencies, and the report
would be required to be presented to the board of directors (or
equivalent governing body) of the broker-dealer. The broker-dealer
would be required to preserve a copy of each such report and
documentation for each such review and assessment pursuant to proposed
Rule 17a-4(b)(17).
The Commission preliminarily believes that a respondent should
currently have written compliance procedures reasonably designed to
review its business activity. Proposed Rule 1102 would initially
require a respondent to update such written compliance procedures to
document the method in which the respondent plans to conduct its review
and assessment pursuant to proposed Rule 1102.
The Commission broadly estimates that a large broker-dealer would
incur a one-time average internal burden of 15 hours for in-house legal
and in-house compliance counsel to update its existing compliance
procedures for reviewing and assessing the design and overall
effectiveness of its best execution policies and procedures.\659\ The
Commission additionally estimates a one-time burden of 2 hours for a
general counsel at a large broker-dealer and 1 hour for a Chief
Compliance Officer to review and approve the updated compliance
procedures, for a total of 18 burden hours per large broker-
dealer.\660\ In addition, the Commission estimates a cost of
approximately $1,488 for outside counsel to review the updated
compliance procedures on behalf of a large broker-dealer.\661\ The
Commission therefore estimates the aggregate burden for large broker-
dealers to be 49,266 burden hours,\662\ and the aggregate cost for
large broker-dealers to be approximately $4.1 million.\663\
---------------------------------------------------------------------------
\659\ This estimate would be broken down as follows: 10 hours
for in-house legal counsel + 5 hours for in-house compliance counsel
to update existing policies and procedures = 15 burden hours.
\660\ This estimate is based on the following calculation: (15
hours of review for in-house legal and in-house compliance counsel)
+ (2 hours of review for general counsel) + (1 hour of review for
Chief Compliance Officer) = 18 burden hours.
\661\ The Commission's estimates of the relevant wage rates for
outside legal services of $496/hour take into account staff
experience, a variety of sources including general information
websites, and adjustments for inflation.'' This cost estimate is
therefore based on the following calculation: (3 hours of review) x
($496/hour for outside counsel services) = $1,488 in outside counsel
costs.
\662\ This estimate is based on the following calculation: (18
burden hours of review per large broker-dealer) x (2,737 large
broker-dealers) = 49,266 aggregate burden hours.
\663\ This estimate is based on the following calculation:
($1,488 for outside counsel costs per large broker-dealer) x (2,737
large broker-dealers) = $4.1 million in outside counsel costs.
---------------------------------------------------------------------------
In contrast, the Commission believes small broker-dealers would
primarily rely on outside counsel to update existing compliance
procedures, as small broker-dealers generally have fewer in-house legal
and compliance personnel. The Commission estimates that a small broker-
dealer would require an average of 10 hours of outside legal counsel
services to update the compliance procedures, for a total one-time cost
of approximately $4,960 per small broker-dealer,\664\ and an aggregate
cost of approximately $3.77 million for all small broker-dealers.\665\
The Commission additionally believes in-house compliance personnel at
each small broker-dealer would require 5 hours to review and approve
the updated compliance procedures, for an aggregate burden of 3,805
hours.\666\
---------------------------------------------------------------------------
\664\ This cost estimate is based on the following calculation:
(10 hours of review) x ($496/hour for outside counsel services) =
$4,960 in outside counsel costs.
\665\ This cost estimate is based on the following calculation:
($4,960 for outside attorney costs per small broker-dealer) x (761
small broker-dealers) = $3.77 million in outside counsel costs.
\666\ This estimate is based on the following calculation: (5
burden hours) x (761 small broker-dealers) = 3,805 aggregate burden
hours.
---------------------------------------------------------------------------
The Commission preliminarily believes that both large and small
broker-dealers would utilize their existing recordkeeping systems to
preserve any documents necessary to comply with proposed Rule 17a-
4(b)(17). Accordingly, the Commission estimates that broker-dealers
will incur no new initial burdens or costs to retain the records made
pursuant to proposed Rule 1102. Nevertheless, the Commission requests
comment on this assumption and whether the requirements of proposed
Rule 17a-4(b)(17) would pose additional initial burdens or costs on
broker-dealers.
The Commission therefore estimates the total initial aggregate
burden to be 53,071 hours,\667\ and the total initial aggregate cost to
be approximately $7.87 million.\668\
---------------------------------------------------------------------------
\667\ This estimate is based on the following calculation:
(49,266 aggregate burden hours for large broker-dealers) + (3,805
aggregate burden hours for small broker-dealers) = 53,071 total
aggregate burden hours.
\668\ This estimate is based on the following calculation: ($4.1
million in aggregate costs for large broker-dealers) + ($3.77
million in aggregate costs for small broker-dealers) = $7.87 million
total aggregate costs.
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(b) Ongoing Costs and Burdens
Proposed Rule 1102 would require a broker-dealer to review and
assess, no less frequently than annually, the design and overall
effectiveness of its best execution policies and procedures, including
its order handling and routing practices. Such review and assessment
would be required to be conducted in accordance with written procedures
and would be required to be documented. A broker-dealer would be
required to prepare a written report detailing the results of such
review and assessment, including a description of all deficiencies
found and any plan to address deficiencies, and the report would have
to be presented to the board of directors (or equivalent governing
body) of the broker-dealer. The broker-dealer would be required to
preserve a copy of each such report and documentation for each such
review and assessment pursuant to proposed Rule 17a-4(b)(17).
The ongoing burden of complying with proposed Rule 1102 would
include a respondent's documentation of its reviews and assessments of
the design and overall effectiveness of its best execution policies and
procedures and the preparation of its written reports.
[[Page 5548]]
The Commission estimates that large broker-dealers would each
annually incur an internal burden of 40 hours to conduct and document
its annual reviews and assessments (5 hours for legal personnel, 15
hours for compliance personnel, and 20 hours for business-line
personnel). The Commission estimates that large broker-dealers would
each annually incur an internal burden of 8 hours to prepare the annual
report (4 hours for legal personnel and 4 hours for compliance
personnel) for a total ongoing burden of 48 hours per large broker-
dealer. The Commission therefore estimates an ongoing, aggregate burden
for large broker-dealers of approximately 131,376 hours.\669\ Because
the Commission assumes that large broker-dealers would rely on internal
personnel to prepare the annual report, the Commission estimates that
large broker-dealers would incur no ongoing costs.
---------------------------------------------------------------------------
\669\ This estimate is based on the following calculation: (48
burden hours per large broker-dealer) x (2,737 large broker-dealers)
= 131,376 aggregate ongoing burden hours.
---------------------------------------------------------------------------
The Commission assumes for purposes of this analysis that small
broker-dealers would mostly rely on outside legal counsel and outside
compliance consultants to conduct the annual reviews and assessments
and prepare the annual report, with final review and approval from an
in-house compliance manager. The Commission preliminarily estimates
that outside counsel would require approximately 5 hours per year to
conduct and document its annual reviews and assessments, for an annual
cost of approximately $2,480 for each small broker-dealer.\670\ The
estimated aggregate, annual ongoing cost for outside legal counsel to
conduct and document the annual reviews and assessments for small
broker-dealers would be approximately $1.88 million.\671\ In addition,
the Commission expects that small broker-dealers would require 10 hours
of outside compliance services per year to conduct and document its
annual reviews and assessments, for an ongoing cost of approximately
$3,040 per small broker-dealer per year,\672\ and an aggregate ongoing
cost of approximately $2.31 million.\673\ The Commission preliminarily
estimates that outside counsel would require approximately 3 hours per
year to prepare the annual report, for an annual cost of approximately
$1,488 for each small broker-dealer.\674\ The estimated aggregate,
annual ongoing cost for outside legal counsel to prepare the annual
report for small broker-dealers would be approximately $1.13
million.\675\ In addition, the Commission preliminarily estimates that
each small broker-dealer would require 3 hours of outside compliance
services per year to prepare the annual report, for an ongoing cost of
approximately $912 per year,\676\ and an aggregate ongoing cost of
approximately $694,032 for all small broker-dealers.\677\ The total
aggregate, ongoing cost for small broker-dealers is therefore estimated
at approximately $6.01 million per year.\678\
---------------------------------------------------------------------------
\670\ This estimate is based on the following calculation: (5
hours per small broker-dealer) x ($496/hour for outside counsel
services) = $2,480 in outside counsel costs.
\671\ This estimate is based on the following calculation:
($2,480 in outside counsel costs per small broker-dealer) x (761
small broker-dealers) = $1.88 million in aggregate, ongoing outside
legal costs.
\672\ This cost estimate is based on the following calculation:
(10 hours per small broker-dealer) x ($304/hour for outside
compliance services) = $3,040 in outside compliance service costs.
\673\ This estimate is based on the following calculation:
($3,040 in outside compliance costs per small broker-dealer) x (761
small broker-dealers) = $2.31 million in aggregate, ongoing outside
compliance costs.
\674\ This estimate is based on the following calculation: (3
hours per small broker-dealer) x ($496/hour for outside counsel
services) = $1,488 in outside counsel costs.
\675\ This estimate is based on the following calculation:
($1,488 in outside counsel costs per small broker-dealer) x (761
small broker-dealers) = $1.13 million in aggregate, ongoing outside
legal costs.
\676\ This cost estimate is based on the following calculation:
(3 hours per small broker-dealer) x ($304/hour for outside
compliance services) = $912 in outside compliance service costs.
\677\ This estimate is based on the following calculation: ($912
in outside compliance costs per small broker-dealer) x (761 small
broker-dealers) = $694,032 in aggregate, ongoing outside compliance
costs.
\678\ This estimate is based on the following calculation:
($1.88 million for outside legal counsel costs to conduct and
document the annual review and assessment) + ($2.31 million for
outside compliance costs to conduct and document the annual review
and assessment) + ($1.13 million for outside legal counsel to
prepare the annual report) + ($694,032 for outside compliance costs
to prepare the annual report) = $6.01 million total aggregate
ongoing costs.
---------------------------------------------------------------------------
In addition to the costs described above, the Commission
additionally estimates each small broker-dealer would incur an internal
burden of approximately 12 hours for business-line personnel to conduct
and document the annual reviews and assessments, and 4 hours per year
for in-house compliance personnel to review the reviews and assessments
and preparation of the annual report. The Commission further estimates
small broker-dealers would incur an internal burden of approximately 2
hours for an in-house compliance manager to review and approve the
annual report. The ongoing, aggregate burden for small broker-dealers
would be 13,698 hours for in-house business-line personnel, compliance
personnel, and compliance manager review.\679\
---------------------------------------------------------------------------
\679\ This estimate is based on the following calculation: (12
hours business-line personnel review per small broker-dealer) + (4
hours compliance personnel review per small broker-dealer) + (2
hours compliance manager review per small broker-dealer) x (761
small broker-dealers) = 13,698 aggregate ongoing burden hours.
---------------------------------------------------------------------------
The Commission estimates that the approximate ongoing burden
associated with the recordkeeping requirement of proposed Rule 17a-
4(b)(17) for any records made in compliance with proposed Rule 1102
would be 6,235 burden hours per year.\680\ The Commission does not
believe that the ongoing costs associated with ensuring compliance with
the retention schedule would change from the current costs of ensuring
compliance with existing Rule 17a-4. However, the Commission requests
comment regarding whether there would be additional costs relating to
ensuring compliance with record retention and retention schedules
pursuant to Rule 17a-4.
---------------------------------------------------------------------------
\680\ Because the Commission assumes broker-dealers would
utilize their existing recordkeeping systems to preserve any records
made in compliance with proposed Rule 1102, the Commission estimates
that the burdens associated with such record retention would be
minimal. Accordingly, the Commission estimates the aggregate ongoing
burden based on the following calculation: (2 burden hours in-house
compliance personnel per large broker-dealer x 2,737 large broker-
dealers) + (1 burden hour in-house compliance personnel per small
broker-dealer x 761 small broker-dealers) = 6,235 aggregate ongoing
burden hours.
---------------------------------------------------------------------------
The Commission therefore estimates the total ongoing aggregate
burden to be 151,309 hours,\681\ and the total ongoing aggregate cost
to be approximately $6.01 million per year.\682\
---------------------------------------------------------------------------
\681\ This estimate is based on the following calculation:
(131,376 aggregate ongoing burden hours for large broker-dealers for
proposed Rule 1102) + (13,698 aggregate ongoing burden hours for
small broker-dealers for proposed Rule 1102) + (6,235 aggregate
ongoing burden hours for all broker-dealers for proposed Rule 17a-
4(b)(17)) = 151,309 total aggregate ongoing burden hours.
\682\ This estimate is based on the following calculation:
($6.01 million per year in total aggregate ongoing costs for small
broker-dealers) + ($0 ongoing costs for large broker-dealers) =
$6.01 million per year in total aggregate ongoing costs.
---------------------------------------------------------------------------
The Commission acknowledges that policies and procedures may vary
greatly by broker-dealer, given the differences in size and the
complexity of broker-dealer business models. Accordingly, the need to
update policies and procedures and conduct an annual review and
assessment might also vary greatly. The Commission requests comment
regarding the accuracy of the estimated burden hours and costs
necessary to comply with the proposal.
[[Page 5549]]
A. Total Paperwork Burden
Based on the foregoing, the Commission preliminarily estimates that
the total initial aggregate burden for all broker-dealers to comply
with proposed Rules 1101 and 1102, as well as proposed Rule 17a-
4(b)(17), would be 365,102 hours,\683\ and the total initial aggregate
cost would be approximately $54.12 million.\684\ The Commission
preliminarily estimates that the total ongoing aggregate burden for all
broker-dealers to comply with proposed Rules 1101 and 1102, as well as
proposed Rule 17a-4(b)(17), would be 558,854 hours per year,\685\ and
the total ongoing aggregate cost would be approximately $17.33 million
per year.\686\
---------------------------------------------------------------------------
\683\ 365,102 hours = 312,031 hours (Required policies and
procedures) + 53,071 hours (Annual review).
\684\ $54.12 million = $46.25 million (Required policies and
procedures) + $7.87 million (Annual review).
\685\ 558,854 hours = 391,577 (Required policies and procedures)
+ 145,074 hours (Annual review) + 22,203 hours (Rule 17a-4(b)(17)).
\686\ $17.33 million = $11.32 million (Required policies and
procedures) + $6.01 million (Annual review).
PRA Summary Table
--------------------------------------------------------------------------------------------------------------------------------------------------------
Ongoing annual PRA Total PRA Initial PRA Ongoing annual PRA Total PRA
Initial PRA burden hours (after burden hours costs costs (after first costs in first
burden hours first year) in first year (million) year) (million) year (million)
--------------------------------------------------------------------------------------------------------------------------------------------------------
Industry-Wide Burden due to Policies and 312,031 72,991 385,022 $46.25 $6.69 $52.94
Procedures under Proposed Rule 1101........
Industry-Wide Burden due to Regular Review 0 302,618 302,618 0 4.63 4.63
and Documentation under Proposed Rule 1101.
-----------------------------------------------------------------------------------------------------------
Total Industry-Wide Burden due to Proposed 312,031 375,609 687,640 46.25 11.32 57.57
Rule 1101..................................
-----------------------------------------------------------------------------------------------------------
Industry-Wide Burden due to Compliance 53,071 0 53,071 7.87 0 7.87
Procedures under Proposed Rule 1102........
Industry-Wide Burden due to Annual Review 0 118,612 118,612 0 4.19 4.19
and Documentation, under Proposed Rule 1102
Industry-Wide Burden due to Annual Report 0 26,462 26,462 0 1.82 1.82
under Proposed Rule 1102...................
-----------------------------------------------------------------------------------------------------------
Total Industry-Wide Burden due to Proposed 53,071 145,074 198,145 7.87 6.01 13.88
Rule 1102..................................
-----------------------------------------------------------------------------------------------------------
Total Industry-Wide Burden due to Proposed 0 22,203 22,203 0 0 0
Rule 17a-4(b)(17)..........................
--------------------------------------------------------------------------------------------------------------------------------------------------------
B. Collection of Information is Mandatory
All of the collection of information would be mandatory.
C. Confidentiality of Responses to Collection of Information
The collection of information would not be required to be made
public but would not be confidential.
D. Retention Period for Recordkeeping Requirements
A broker-dealer would be required to preserve a copy of its
policies and procedures under proposed Regulation Best Execution in a
manner consistent with, and for the periods specified in, Rule 17a-
4(e)(7). A broker-dealer would be required to preserve a copy of its
other records under proposed Regulation Best Execution in a manner
consistent with, and for the periods specified in, the proposed
amendments to Rule 17a-4(b).
E. Request for Comment
Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits
comments to:
Evaluate whether the proposed collections of information
are necessary for the proper performance of the functions of the
agency, including whether the information shall have practical utility;
Evaluate the accuracy of our estimates of the burden of
the proposed collection of information;
Determine whether there are ways to enhance the quality,
utility, and clarity of the information to be collected; and
Evaluate whether there are ways to minimize the burden of
collection of information on those who are to respond, including
through the use of automated collection techniques or other forms of
information technology.
Persons submitting comments on the collection of information
requirements should direct them to the Office of Management and Budget,
Attention: Desk Officer for the Securities and Exchange Commission,
Office of Information and Regulatory Affairs, Washington, DC 20503, and
should also send a copy of their comments to Secretary, Securities and
Exchange Commission, 100 F Street NE, Washington, DC 20549-1090, with
reference to File Number S7-32-22. Requests for materials submitted to
OMB by the Commission with regard to this collection of information
should be in writing, with reference to File Number S7-32-22 and be
submitted to the Securities and Exchange Commission, Office of FOIA/PA
Services, 100 F Street NE, Washington, DC 20549-2736. As OMB is
required to make a decision concerning the collection of information
between 30 and 60 days after publication, a comment to OMB is best
assured of having its full effect if OMB receives it within 30 days of
publication.
VII. Consideration of Impact on the Economy
For purposes of the Small Business Regulatory Enforcement Fairness
Act of 1996 (``SBREFA''),\687\ the Commission must advise the OMB as to
whether the proposed regulation constitutes a ``major'' rule. Under
SBREFA, a rule is considered ``major'' where, if adopted, it results or
is likely to result in: (1) an annual effect on the economy of $100
million or more (either in the form of an
[[Page 5550]]
increase or decrease); (2) a major increase in costs or prices for
consumers or individual industries; or (3) significant adverse effect
on competition, investment, or innovation. If a rule is ``major,'' its
effectiveness will generally be delayed for 60 days pending
Congressional review. The Commission requests comment on the potential
impact of Regulation Best Execution on the United States economy on an
annual basis, on any potential increases in costs or prices for
consumers or individual industries, and any potential effect on
competition, investment, or innovation. Commenters are requested to
provide empirical data and other factual support for their views to the
extent possible.
---------------------------------------------------------------------------
\687\ Public Law 104-121, Title II, 110 Stat. 857 (1996)
(codified in various sections of 5 U.S.C., 15 U.S.C., and as a note
5 U.S.C. 601).
---------------------------------------------------------------------------
VIII. Initial Regulatory Flexibility Act Analysis
The Regulatory Flexibility Act (``RFA'') \688\ requires Federal
agencies, in promulgating rules, to consider the impact of those rules
on small entities. Section 603(a) \689\ of the Administrative Procedure
Act,\690\ as amended by the RFA, generally requires the Commission to
undertake a regulatory flexibility analysis of all proposed rules, or
proposed rule amendments, to determine the impact of such rulemaking on
``small entities.'' \691\ Under Section 605(b) of the RFA, a Federal
agency need not undertake a regulatory flexibility analysis of proposed
rules where, if adopted, they would not have a significant economic
impact on a substantial number of small entities.\692\
---------------------------------------------------------------------------
\688\ 5 U.S.C. 601 et seq.
\689\ 5 U.S.C. 603(a).
\690\ 5 U.S.C. 551 et. seq.
\691\ Although section 601(b) of the RFA defines the term
``small entity,'' the statute permits agencies to formulate their
own definitions. The Commission has adopted definitions for the term
small entity for the purposes of Commission rulemaking in accordance
with the RFA. Those definitions, as relevant to this proposed
rulemaking, are set forth in Rule 0-10 under the Exchange Act, 17
CFR 240.0-10.
\692\ See 5 U.S.C. 605(b).
---------------------------------------------------------------------------
A. Reasons for and Objectives of the Proposed Action
As discussed above in section III.B, the Commission is proposing
Regulation Best Execution to further the goals of the national market
system and reinforce broker-dealer best execution obligations.
The proposed rule would set forth the standard of best execution,
and proposed Rule 1101 would require a broker-dealer to establish,
maintain, and enforce written policies and procedures that address
specific elements that are designed to promote the best execution of
customer orders, and comply with certain execution quality review and
documentation requirements.\693\ More specifically, proposed Rule
1101(a)(1) would require that a broker-dealer's policies and procedures
address how it will: (1) obtain and assess reasonably accessible
information concerning the markets trading the relevant securities; (2)
identify markets that may be material potential liquidity sources; and
(3) incorporate the material potential liquidity sources into its order
handling practices and ensure efficient access to each such material
potential liquidity source. Proposed Rule 1101(a)(2) would require a
broker-dealer's policies and procedures to address how it will: (1)
assess reasonably accessible and timely information, including
information with respect to the best displayed prices, opportunities
for price improvement, and order exposure opportunities that may result
in the most favorable price; (2) assess the attributes of customer
orders and consider 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 (3) reasonably balance
the likelihood of obtaining a better price with the risk that delay
could result in a worse price when determining the number and
sequencing of markets to be assessed.
---------------------------------------------------------------------------
\693\ See supra section III.B.
---------------------------------------------------------------------------
Proposed Rule 1101(b) would require a broker-dealer's policies and
procedures for conflicted transactions to address how it will: (1)
obtain and assess information beyond that required by proposed Rule
1101(a)(1)(i) in identifying a broader range of markets beyond the
material potential liquidity sources; and (2) evaluate a broader range
of markets beyond the material potential liquidity sources. Proposed
Rule 1101(b) would also require broker-dealers that engage in
conflicted transactions with retail customers to document in accordance
with their written procedures their compliance with the best execution
standard for conflicted transactions, including all efforts to enforce
their best execution policies and procedures for conflicted
transactions and the basis and information relied on for its
determinations that such conflicted transactions would comply with the
best execution standard. Additionally, proposed Rule 1101(b)(3) would
require broker-dealers that engage in conflicted transactions to
document their payment for order flow arrangements.
Proposed Rule 1101(c) would require broker-dealers to no less
frequently than quarterly review the execution quality of customer
orders, and how such execution quality compares with the execution
quality that might have been obtained from other markets, and revise
their best execution policies and procedures, including order handling
practices, accordingly.
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), so long as the introducing
broker establishes, maintains, and enforces policies and procedures
that require the introducing broker to regularly review the execution
quality obtained from its executing broker, compare it with the
execution quality it might have obtained from other executing brokers,
and revise its order handling practices accordingly. An introducing
broker would additionally be required to document the results of its
review.
Proposed Rule 1102 would require each broker-dealer no less
frequently than annually to conduct a review and assessment of the
design and overall effectiveness of its best execution policies and
procedures, and document such review and assessment in a report that
would be provided to the broker-dealer's governing body.
Proposed amendments to Rule 17a-4 under the Exchange Act would
specify the record preservation requirements for records made under
proposed Regulation Best Execution.
B. Legal Basis
Pursuant to the Exchange Act, 15 U.S.C. 78a et seq., and
particularly sections 2, 3(b), 5, 10, 11A, 15, 15A, 17, 23(a), 24, and
36 thereof, 15 U.S.C. 78b, 78c(b), 78e, 78j, 78k-1, 78o, 78o-1, 78q,
78w(a), 78x, and 78mm, the Commission is proposing amendments to Sec.
240.17a-4 and new Sec. Sec. [thinsp]242.1100 through 242.1102.
C. Small Entities Subject to the Proposed Rule
For purposes of a Commission rulemaking in connection with the RFA,
a broker-dealer will be a small entity if it: (1) had total capital
(net worth plus subordinated liabilities) of less than $500,000 on the
date in the prior fiscal year as of which its audited financial
statements were prepared pursuant to Rule 17a-5(d) under the Exchange
Act,\694\ or, if not required to file such statements, had total
capital (net worth plus subordinated liabilities) of less than $500,000
on the last business day of the preceding fiscal year (or in the
[[Page 5551]]
time that it has been in business, if shorter); and (2) is not
affiliated with any person (other than a natural person) that is not a
small business or small organization.\695\
---------------------------------------------------------------------------
\694\ See 17 CFR 240.17a-5(d).
\695\ See 17 CFR 240.0-10(c).
---------------------------------------------------------------------------
As discussed in section VI, the Commission estimates that
approximately 3,498 broker-dealers would be subject to proposed
Regulation Best Execution. Based on FOCUS Report data, the Commission
estimates that as of June 30, 2022, approximately 761 of those broker-
dealers might be small entities for purposes of this analysis. For
purposes of this RFA analysis, the Commission refers to broker-dealers
that might be small entities under the RFA as ``small entities,'' and
the Commission continues to use the term ``broker-dealers'' to refer to
broker-dealers generally, as the term is used elsewhere in this
release.
D. Projected Compliance Requirements of the Proposed Rule for Small
Entities
The RFA requires a description of the projected reporting,
recordkeeping, and other compliance requirements of proposed Regulation
Best Execution, including an estimate of the classes of small entities
that would be subject to the requirements and the type of professional
skill necessary to prepare the required reports and records. Following
is a discussion of the associated costs and burdens of compliance with
proposed Regulation Best Execution, as incurred by small entities. As
described above in section IV, the proposed rules would require a
broker-dealer to establish, maintain, and enforce written policies and
procedures reasonably designed to comply with the proposed best
execution standard, as well as additional policies and procedures for
conflicted transactions and tailored policies and procedures applicable
to introducing brokers. The proposed rules would also set forth
documentation requirements related to conflicted transactions and
execution quality reviews. Moreover, the proposed rules would require a
broker-dealer to review and assess, no less frequently than annually,
the design and overall effectiveness of its best execution policies and
procedures, including its order handling practices, and prepare a
written report that is provided to its board of directors or equivalent
governing body detailing the results. Finally, proposed amendments to
Rule 17a-4 would set forth record preservation requirements for records
made under proposed Regulation Best Execution.
1. Required Policies and Procedures and Related Obligations
To initially comply with these requirements, the Commission
preliminarily believes that small entities would primarily rely on
outside counsel to update existing policies and procedures, as small
broker-dealers generally have fewer in-house legal and compliance
personnel. As discussed in section VI above, the Commission
preliminarily believes the initial costs associated with this
requirement for small entities would be $32,240 per small entity
(reflecting an estimated 65 hours of outside legal counsel services),
and an aggregate cost of $24.53 million for all small entities.\696\
The Commission additionally estimates in-house compliance personnel
would require 18 hours to review and approve the updated policies and
procedures, for an aggregate burden of 13,698 hours.\697\
---------------------------------------------------------------------------
\696\ See supra notes 640-641.
\697\ See supra note 642.
---------------------------------------------------------------------------
The Commission preliminarily believes that small broker-dealers
would mostly rely on outside legal counsel and outside compliance
consultants to review and update their policies and procedures on a
periodic basis. The Commission preliminarily estimates that outside
legal counsel would require approximately 11 hours per year, totaling
approximately $5,456 annually for each small entity for an estimated
aggregate ongoing cost of approximately $4.15 million. In addition, the
Commission estimates that small entities would require 11 hours of
outside compliance services per year to update their policies and
procedures for an ongoing cost of approximately $3,344 per year, and
the estimated aggregate ongoing cost to be $2.54 million. In addition,
the Commission estimates that small entities would require 20 hours of
outside compliance services per year to conduct and document their
review of execution quality and document all their efforts to obtain
best execution for conflicted transactions, including the basis and
information relied on for its determinations, and payment for order
flow arrangement for an ongoing cost of approximately $6,080 per year,
and an aggregate ongoing cost of approximately $4.63 million. The total
aggregate ongoing cost for small entities is therefore estimated at
approximately $11.32 million per year. Separately, the Commission
estimates that small entities would incur approximately six internal
burden hours for an in-house compliance manager to review and approve
the updated policies and procedures per year and incur an internal
burden of approximately 30 hours per year for in-house business-line
personnel to conduct and document their execution quality reviews and
document all their efforts to obtain best execution for conflicted
transactions and payment for order flow arrangements. The Commission
further estimates that small entities would incur an internal burden of
approximately 8 hours per year for in-house compliance personnel to
review the regular reviews of execution quality and documentation of
efforts to obtain best execution for conflicted transactions and
payment for order flow arrangements. Thus, the Commission estimates
that the ongoing burden for each small entity would be 44 hours and the
ongoing, aggregate annual burden for all small entities to be 33,484
hours.\698\
---------------------------------------------------------------------------
\698\ See supra note 655.
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Finally, the Commission preliminarily believes that small entities
would utilize their existing recordkeeping systems to preserve any
documents necessary to comply with proposed Rule 1101. Thus, the
Commission estimates that broker-dealers will incur no new initial
burdens or costs to retain the records made pursuant to proposed
Regulation Best Execution. Separately, the Commission estimates that
the approximate ongoing burden associated with the recordkeeping
requirements of proposed Rule 17a-4(b)(17) for any records made in
compliance will proposed Rule 1101 pursuant to the proposed rule would
be three burden hours per small entity for an ongoing aggregate annual
burden for all small entities of approximately 2,283 hours. The
Commission does not believe that the ongoing costs associated with
ensuring compliance with retention schedule would change from the
current costs of ensuring compliance with existing Rule 17a-4.
2. Annual Report
As discussed above in sections VI, the Commission believes small
entities would primarily rely on outside counsel to update their
existing compliance procedures for the annual reviews and assessments
under proposed Rule 1102. The Commission estimates that small entities
would require approximately 10 hours of outside legal counsel services
to update the compliance procedures, for total one-time costs of $4,960
per small entity, and an aggregate cost of $3.77 million for all small
entities.\699\
---------------------------------------------------------------------------
\699\ See supra notes 664-665.
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Additionally, the Commission believes that the in-house compliance
personnel would require approximately
[[Page 5552]]
five hours to review and approve the updated compliance procedure for
an aggregate burden of 3,805 hours.\700\
---------------------------------------------------------------------------
\700\ See supra note 666.
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The Commission preliminarily estimates that outside legal counsel
would require approximately five hours to conduct and document annual
reviews and assessments for an approximate cost of $2,480 per year for
each small entity.\701\ The estimated aggregate, ongoing cost for
outside legal counsel to conduct and document the annual reviews and
assessments would be approximately $1.88 million.\702\ Additionally,
the Commission expects that an additional 10 hours of outside
compliance services would be required to conduct and document its
annual reviews and assessments, for an ongoing cost of approximately
$3,040 per small entity each year and an aggregate ongoing cost of
approximately $2.31 million.\703\ Separately, the Commission
preliminarily estimates that outside counsel would require
approximately three hours to prepare the annual report, resulting in an
annual cost of $1,488 per year, and an aggregate ongoing cost of
approximately $1.13 million per year.\704\ In addition, the Commission
preliminarily estimates that outside compliance services would require
three hours per year to prepare the annual report, for an ongoing cost
of approximately $912 per small entity each year and an aggregate
ongoing cost of approximately $694,032 per year.\705\ Together the
aggregate, ongoing cost for small entities subject to the proposed rule
is estimated at approximately $6.01 million per year.\706\
---------------------------------------------------------------------------
\701\ See supra note 670.
\702\ See supra note 671.
\703\ See supra note 672-673.
\704\ See supra notes 674-675.
\705\ See supra notes 676-677.
\706\ See supra note 678.
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In addition to these costs, the Commission additionally estimates
each small entity would incur an internal burden of approximately 12
hours for business-line personnel to conduct and document the annual
reviews and assessments, and four hours per year for in-house
compliance personnel to review the reviews and assessments and
preparation of the annual report. The Commission further estimates an
internal burden of approximately two hours for an in-house compliance
manager to review and approval the annual report for an ongoing,
aggregate burden of 13,698 hours.
Finally, the Commission estimates that small entities would incur
no new initial burdens or costs to retain the records made pursuant to
proposed Rule 1102. Additionally, the Commission estimates that the
approximate ongoing burden associated with the recordkeeping
requirement of proposed Rule 17a-4(b)(17) for any records made in
compliance with proposed Rule 1102 would be one burden hour per small
entity for an ongoing aggregate burden of 761 hours.
E. Duplicative, Overlapping, or Conflicting Federal Rules
An analysis under the RFA requires a Federal agency to identify, to
the extent practicable, all relevant Federal rules that may duplicate,
overlap, or conflict with the proposed rules. The Commission believes
that there are no Federal rules that duplicate, overlap, or conflict
with proposed Regulation Best Execution and the proposed amendments to
Rule 17a-4.
F. Significant Alternatives
An RFA analysis requires a discussion of alternatives to the
proposed rule that would minimize the impact of small entities while
accomplishing the stated objectives of the applicable statutes. The
analysis should include: (1) the establishment of differing compliance
or reporting requirements or timetables that take into account the
resources available to small entities; (2) the clarification,
consolidation, or simplification of compliance and reporting under the
rule for such small entities; (3) the use of performance rather than
design standards; and (4) an exemption from coverage of the rule, or
any part thereof, for such small entities.
The Commission considered whether it would be necessary or
appropriate to establish different compliance or reporting requirements
or timetables; or to clarify, consolidate, or simplify compliance and
reporting requirements under the proposed rule for small entities.
Because proposed Regulation Best Execution is designed to further
enhance broker-dealers' ability to maintain robust best execution
practices and result in more vigorous efforts by broker-dealers to
achieve best execution, including in situations where broker-dealers
have order handling conflicts of interest with retail customers, the
Commission preliminarily believes that small entities should be covered
by the proposed rules. The proposed rule includes performance
standards. The Commission also preliminarily believes that the proposed
rules are flexible enough for small broker-dealers to comply without
the need for the establishment of different compliance or reporting
requirements or timetables\707\ for small entities, or exempting them
from the proposed rule's requirements.
---------------------------------------------------------------------------
\707\ Proposed Regulation Best Execution does not include
different timetables for small broker-dealers because the Commission
preliminarily believes that customers of small broker-dealers would
benefit from the protections offered by proposed Regulation Best
Execution, just as customers of broker-dealers that are not small
entities.
---------------------------------------------------------------------------
However, the Commission is proposing that broker-dealers that meet
the definition of introducing broker would be subject to different and
more tailored requirements under proposed Rule 1101. Specifically,
under proposed Rule 1101(d), an entity that meets the definition of
introducing broker and routes customer orders to an executing broker
would not need to separately comply with proposed Rules 1101(a), (b),
and (c), so long as the introducing broker establishes, maintains, and
enforces policies and procedures that require the introducing broker to
regularly review the execution quality obtained from such executing
broker, compare it with the execution quality it might have obtained
from other executing brokers, and revise its order handling practices
accordingly. As discussed above,\708\ the Commission believes that
small broker-dealers would be more likely to qualify as introducing
brokers. As such, certain small entities would be exempt from complying
with proposed Rules 1101(a), (b), and (c). To the extent a small
broker-dealer does not qualify as an introducing broker, the Commission
believes a small broker-dealer would be less likely to engage in
conflicted transactions and be subject to the additional obligations of
proposed Rule 1101(b) than a large broker-dealer.
---------------------------------------------------------------------------
\708\ See supra section VI.
---------------------------------------------------------------------------
The Commission also considered a number of potential regulatory
alternatives to proposed Regulation Best Execution, including: (1)
adoption of FINRA Rule 5310 and MSRB Rule G-18 best execution rules;
(2) requiring order execution quality disclosure for other asset
classes; (3) defining ``introducing broker'' to include those entities
that quality for relief under FINRA and MSRB rules; (4) banning or
restricting off-exchange payment for order flow; (5) requiring broker-
dealers to utilize best execution committees; (6) requiring order-by-
order documentation for conflicted or all transactions; and (7)
providing staggered compliance dates for certain broker-dealers. For a
more detailed discussion of these regulatory alternatives, see Section
V, supra.
[[Page 5553]]
1. Adopt FINRA Rule 5310 and MSRB Rule G-18 Concerning Best Execution
As discussed above, the Commission considered adopting FINRA Rule
5310 and MSRB Rule G-18 regarding best execution and their associated
guidance.\709\ Under this alternative, the overall costs and benefits
to small entities would be lower than compared to the proposal. This
alternative would not include the additional requirements related to
transactions with broker-dealer conflicts of interest, which represent
the majority of retail transactions in the equity, options, and fixed
income markets.\710\ Under this alternative, conflicted broker-dealers
that would qualify for relief under the current FINRA rule would
experience lower compliance costs as they would not be required to
develop or update their own policies and procedures or adjust their
business model to de-conflict from their executing broker. The cost of
the proposal could provide an advantage to larger broker-dealers as
compared to smaller broker-dealers. The lower compliance cost under
this alternative would increase competition among broker-dealers
compared to the proposed rule by lowering barriers to entry for new
broker-dealers and decrease the likelihood that smaller broker-dealers
would exit the market.
---------------------------------------------------------------------------
\709\ See supra section V.
\710\ See section IV.C.2.a.
---------------------------------------------------------------------------
The Commission preliminarily believes that adopting FINRA or the
MSRB's best execution rules would be less effective than the proposed
rule because broker-dealers (including small entities) would not be
required to establish the comprehensive and detailed policies and
procedures relating to all aspects of a broker-dealer's best execution
practices, including additional requirements for broker-dealers with
conflicts of interest, that would be required under the proposal. The
Commission preliminarily believes that the proposed policies and
procedures-based best execution framework, along with regular reviews
and related documentation, would help broker-dealers maintain robust
best execution practices and result in vigorous efforts by broker-
dealers to achieve best execution, including in situations where
broker-dealers have order handling conflicts of interest with retail
customers. The Commission also preliminarily believes that detailed
policies and procedures, regular reviews, and related documentations
would allow broker-dealers to effectively assess their best execution
practices and assist the Commission and SROs to effectively examine and
enforce broker-dealers' compliance with the proposed rules.
2. Require Order Execution Quality Disclosure for Other Asset Classes
As discussed in section V, as an alternative, the Commission could
require execution quality disclosures from market centers and broker-
dealers in the options and fixed income markets. In addition to
execution quality data at the individual security-level, similar to
Rule 605 data, the execution quality disclosures could include
aggregated standardized summary reports of key execution quality
statistics, which could permit smaller and less sophisticated investors
to analyze and compare their broker-dealers against other broker-
dealers. This alternative may permit investors to better evaluate
execution quality for their orders within their broker-dealer's overall
executions in a given security and facilitate broker-to-broker
comparisons of order execution beyond just the equities markets.
Under the alternative, broker-dealers that engage in less efficient
order handling practices may recognize the inadequacy when comparing
their own execution quality statistics with those disclosed by more
efficient broker-dealers, and improve the order handling practices
accordingly to attract order flow.
However, developing these execution quality disclosures may cause
market centers and broker-dealers in the options and fixed income
markets to incur higher startup costs relative to the proposal as
market centers would need to develop systems to produce and post such
reports. To the extent that certain market centers already have systems
or infrastructures in place to produce execution quality metrics, they
would incur costs to modify their current systems and/or the format of
their current reports in order to comply with the potential execution
quality disclosure requirements. Additionally, execution quality
disclosures for the options and fixed income markets may be complex and
difficult to produce for a number of reasons.\711\
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\711\ See supra section V.
---------------------------------------------------------------------------
3. Define ``Introducing Broker'' To Include Those Entities That Qualify
for Relief Under FINRA and MSRB Rules
The Commission could alternatively propose to remove the
requirements for introducing and executing brokers related to
remuneration, carrying firm status, and affiliation.\712\ This
alternative would more closely align with the FINRA and MSRB rules
concerning a broker-dealer that routes its order flow to another
broker-dealer that has agreed to handle that order flow as agent or
riskless principal for the customer. Under this alternative, it is
likely that most broker-dealers that currently qualify for relief under
the FINRA and MSRB rules would continue to do so. By categorizing to
allow more broker-dealers to be classified as ``introducing brokers,''
the overall compliance cost carried by the market would be lower as
compared to the proposal. This alternative would likely cause fewer
small broker-dealers that currently qualify for relief under the FINRA
or MSRB rule, and wish to continue to receive remuneration, carry
customer accounts, or route to affiliates, to incur the expenses
associated with the full obligations of proposed Regulation Best
Execution.
---------------------------------------------------------------------------
\712\ See supra section IV.E.
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The broker-dealers who could benefit under this alternative are
those that currently qualify for relief under the FINRA and MSRB rules
but fail at least one of the criteria in proposed Rule 1101(d). Thus,
current ``introducing brokers,'' and to some extent their executing
brokers, would have lower compliance costs since there would be no
requirement to change their business models or set-up their own best
execution policies and procedures to comply with the proposal.
Additionally, this alternative may lower barriers to entry for some
potential introducing brokers. However, under this alternative, as
discussed in section V above, the benefits of the proposed rule would
be diminished. The Commission preliminarily believes that instead of
changing their business models, introducing brokers would be more
likely to receive payment for order flow from their executing brokers
or route customer orders to affiliated executing brokers. Therefore,
the benefits of the alternative would be lower since the incentive
created by the payment for order flow or routing to an affiliated
executing broker would still exist, leading to order routing which may
benefit the broker-dealers at the expense of retail customers.
4. Ban or Restrict Off-Exchange Payment for Order Flow
Rather than requiring heightened best execution standards for
transactions involving payment for order flow, alternatively the
Commission could ban or restrict off-exchange payment for order flow in
the equity and options markets. Under this alternative, registered
securities exchanges would still be allowed to pay rebates. In
[[Page 5554]]
contrast to the proposed rule, this alternative may reduce conflicts of
interest and improve order handling practices by retail broker-dealers.
Separately, the Commission could impose specific restrictions on
payment for order flow that could allow retail broker-dealers to pass
through payments to end customers in cases where it would permit best
execution. A ban or restriction on payment for order flow could
increase the likelihood of higher commissions for retail investors or
an increase in the cost of other services offered by retail broker-
dealers. It may also reduce competition between broker-dealers as
larger broker-dealers with more diversified business models may be more
likely to expand their market share and smaller broker-dealers who are
more dependent on payment for order flow revenue streams may be more
likely to exit the market.
5. Require Broker-Dealers To Utilize Best Execution Committees
The Commission considered requiring each broker-dealer to maintain
a best execution committee to regularly review the broker-dealers' best
execution policies, procedures and the results of its efforts to secure
best execution for its customers. Requiring such a committee and
defining its membership might improve execution quality by ensuring
sufficient expertise is recruited to establish and monitor the broker-
dealer's best execution efforts. Furthermore, requiring such a
committee might increase executive attention on best execution,
potentially improving execution quality for the broker-dealer's
customers.
Requiring such a committee and defining its membership would entail
certain costs. First, if the Commission were to define the membership
of the committee, it is likely that individual broker-dealers'
organizational structures would vary in ways that would make a defined
membership structure a poor fit because of, for instance, a single
employee performing multiple roles, or individual roles handled by
groups rather than a single individual. In addition, broker-dealers are
diverse in their business plans and operations and a role that might be
considered critical at one broker-dealer (such as managing fixed income
executing brokers in thinly traded bonds) might be inapplicable at
another broker-dealer that does not trade in these instruments. If the
Commission were to require the committee and not define its membership,
broker-dealers might assign to the committee less senior staff or staff
whose roles are not germane to achieving best execution for customer
orders, significantly limiting the benefits of establishing such a
committee. Furthermore, based on its experience, the Commission
believes that many broker-dealers, particularly large broker-dealers
that are more likely to continue to engage in conflicted transactions
if the proposed rules are adopted, often have such a committee already
established, further limiting the potential benefits of such a
provision.
6. Require Order-by-Order Documentation for Conflicted or All
Transactions
The Commission considered requiring each broker-dealer to document,
for conflicted or all transactions, the data that it considered as it
handled the order. Such a requirement might offer two benefits. First,
it might improve the quality of the broker-dealer's regular review of
its execution practices compared to the proposed rules. Because the
broker-dealer could analyze orders on a case-by-case basis, it might
identify routing practices that could be changed to improve customer
order execution quality. Second, it might improve regulators' ability
to supervise the broker-dealers efforts to provide best execution to
its customers relative to the proposed rules as such records would be
available to regulators during examinations of the broker-dealer or
upon request for other regulatory purposes.
The Commission preliminarily believes that such a requirement would
offer greater potential benefits for conflicted transactions because
broker-dealers engaging in such transactions have greater incentives to
route orders in a manner that might not result in the best prices for
customers. Based on its experience, the Commission believes that some
broker-dealers, particularly the largest broker-dealers that are likely
to continue to engage in conflicted transactions if the proposed rules
are adopted, already maintain this type of documentation for both
internal review and operational purposes. Nevertheless, the requirement
would be costly. Broker-dealers that do not already retain this data
likely have chosen not to do so because the data are not operationally
valuable to them for business purposes, and they believe that they are
satisfying their best-execution obligations based on other data that
they have available for review. For these broker-dealers, the
requirement could impose considerable costs. For example, they would
need to alter their information technology systems to capture this
data, including contemporaneous pricing data and routing records, some
of which (such as prices offered in response to a RFQ and information
related to fixed income and crypto asset securities) is not
incorporated into other regulatory data sources such as CAT and thus
might be stored on systems not integrated with other order routing
systems, or systems that capture regulatory data. Processing this data
might be computationally demanding, particularly for broker-dealers who
trade options, as they have very high quotation traffic. Furthermore,
creating and maintaining software to produce this documentation would
require significant effort by highly skilled programmers which would
further increase the costs associated with such a requirement. As
discussed previously,\713\ the Commission preliminarily believes that
broker-dealers that elect to refrain from conflicted transactions if
the proposed rules are adopted are more likely to be smaller broker-
dealers and these costs, many of which are fixed, are more likely to
result in the broker-dealer changing its business model or exiting the
market, while the aggregate benefits to investors of such a requirement
for smaller broker-dealers is likely to be smaller than for larger
broker-dealers that handle more customer orders.
---------------------------------------------------------------------------
\713\ See supra section V.C.2.ii.
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7. Staggered Compliance Dates
The Commission also considered whether there should be staggered
compliance dates that take into consideration the concerns of smaller
broker-dealers that may need additional time to comply with the
proposed rule. Because the Commission preliminarily believes that
smaller broker-dealers would primarily rely on outside legal counsel to
update existing policies and procedures and outside compliance services
to conduct and document their quarterly reviews of execution quality
and document their efforts to obtain best execution for conflicted
transactions and payment for order flow arrangements, the Commission
does not believe that the proposal would unduly burden a smaller
broker-dealer's internal resources. Furthermore, the Commission
believes small broker-dealers would be less likely to engage in
conflicted transactions subject to the additional procedural
obligations of proposed Rule 1101(b), and would be more likely to
qualify as introducing brokers and be exempt from complying with
proposed Rules 1101(a), (b), and (c), and therefore would need to
develop a less extensive set of policies and procedures.
[[Page 5555]]
G. General Request for Comment
The Commission encourages written comments regarding this initial
regulatory flexibility analysis. In particular, the Commission seeks
comment on the number of small entities that would be affected by
proposed Regulation Best Execution, and whether the effect on small
entities would be economically significant. The Commission requests
that commenters describe the nature of any impact on small entities and
provide empirical data to support the extent of such impact. The
Commission also requests comment on the proposed compliance burdens and
the effects these burdens would have on small entities.
Statutory Authority and Text of the Proposed Rule
Pursuant to the Exchange Act, 15 U.S.C. 78a et seq., and
particularly sections 2, 3(b), 5, 10, 11A, 15, 15A, 17, 23(a), 24, and
36 thereof, 15 U.S.C. 78b, 78c(b), 78e, 78j, 78k-1, 78o, 78o-1, 78q,
78w(a), 78x, and 78mm, the Commission is proposing amendments to Sec.
240.17a-4 and new Sec. Sec. [thinsp]242.1100 through 242.1102.
List of Subjects in 17 CFR Parts 240 and 242
Brokers, Reporting and recordkeeping requirements, Securities.
Text of the Proposed Rules
In accordance with the foregoing, Title 17, Chapter II of the Code
of Federal Regulations is proposed to be amended as follows:
PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934
0
1. The authority citation for part 240 continues to read as follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3,
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78c-3, 78c-5, 78d, 78e, 78f,
78g, 78i, 78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78n-1, 78o, 78o-4,
78o-10, 78p, 78q, 78q-1, 78s, 78u-5, 78w, 78x, 78dd, 78ll, 78mm,
80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4, 80b-11, and 7201 et
seq., and 8302; 7 U.S.C. 2(c)(2)(E); 12 U.S.C. 5221(e)(3); 18 U.S.C.
1350; Pub. L. 111-203, 939A, 124 Stat. 1376 (2010); and Pub. L. 112-
106, sec. 503 and 602, 126 Stat. 326 (2012), unless otherwise noted.
0
2. Amend Sec. 240.17a-4 by adding a new paragraph (b)(17) to read as
follows:
Sec. 240.17a-4 Records to be preserved by certain exchange members,
brokers and dealers.
* * * * *
(b) * * *
(17) All records made pursuant to Sec. Sec. 242.1101 and 242.1102,
other than required policies and procedures, as applicable.
* * * * *
PART 242--REGULATIONS M, SHO, ATS, AC, NMS, SBSR, AND BEST
EXECUTION, AND CUSTOMER MARGIN REQUIREMENTS FOR SECURITY FUTURES
0
3. The authority citation for part 242 is amended to read as follows:
Authority: 15 U.S.C. 77g, 77q(a), 77s(a), 78b, 78c(b), 78e,
78g(c)(2), 78i(a), 78j, 78k-1, 78l, 78m, 78n, 78o(b), 78o(c),
78o(g), 78o-1, 78q, 78w(a), 78x, 78dd-1, 78mm, 80a-23, 80a-29, and
80a-37.
0
4. The heading of part 242 is revised to read as set forth above.
0
5. Part 242 is amended by adding Regulation Best Execution, Sec. Sec.
[thinsp]242.1100 through 242.1102, to read as follows:
Regulation Best Execution
Sec.
242.1100 The best execution standard.
242.1101 Required policies and procedures; related obligations.
242.1102 Annual report.
Sec. 242.1100 The best execution standard.
In any transaction for or with a customer, or a customer of another
broker, dealer, government securities broker, government securities
dealer, or municipal securities dealer (collectively, for purposes of
Regulation Best Execution, ``broker or dealer''), a broker or dealer,
or a natural person who is an associated person of a broker or dealer,
shall 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 (for purposes of Regulation Best Execution, ``most favorable
price''). A broker or dealer, or a natural person who is an associated
person of a broker or dealer, is not subject to this standard when:
(a) Another broker or dealer is executing a customer order against
the broker or dealer's quotation;
(b) An institutional customer, exercising independent judgment,
executes its order against the broker or dealer's quotation; or
(c) The broker or dealer receives an unsolicited instruction from a
customer to route that customer's order to a particular market for
execution and the broker or dealer processes that customer's order
promptly and in accordance with the terms of the order.
Sec. 242.1101 Required policies and procedures; related obligations.
A broker or dealer that engages in any transaction for or with a
customer or a customer of another broker or dealer shall establish,
maintain, and enforce written policies and procedures reasonably
designed to comply with the best execution standard as set forth in
Sec. 242.1100 (for purposes of Regulation Best Execution, ``best
execution policies and procedures'').
(a) Requirements. Such policies and procedures shall address:
(1) How the broker or dealer will comply with the best execution
standard by:
(i) Obtaining and assessing reasonably accessible information,
including information about price, volume, and execution quality,
concerning the markets trading the relevant securities;
(ii) Identifying markets that may be reasonably likely to provide
the most favorable prices for customer orders (``material potential
liquidity sources''); and
(iii) Incorporating material potential liquidity sources into its
order handling practices, and ensuring that the broker or dealer can
efficiently access each such material potential liquidity source.
(2) How the broker or dealer will determine the best market and
make routing or execution decisions for customer orders that it
receives by:
(i) 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;
(ii) 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
(iii) 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.
(b) Conflicts of Interest. In any transaction for or with a retail
customer, where the broker or dealer executes an order as principal,
including riskless principal; routes an order to, or receives an order
from, an affiliate for execution; or provides or receives payment for
order flow as defined in Sec. 240.10b-10(d)(8) of this chapter (each,
a ``conflicted transaction''):
(1) The broker or dealer's best execution policies and procedures
additionally shall address how the
[[Page 5556]]
broker or dealer will obtain and assess information beyond that
required by paragraph (a)(1)(i) of this section, including additional
information about price, volume, and execution quality, in identifying
a broader range of markets beyond those identified as material
potential liquidity sources;
(2) The broker or dealer's best execution policies and procedures
additionally shall address how the broker or dealer will evaluate 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; and
(3) The broker or dealer shall document its compliance with the
best execution standard for conflicted transactions, including all
efforts to enforce its best execution policies and procedures for
conflicted transactions and the basis and information relied on for its
determinations that such conflicted transactions would comply with the
best execution standard. Such documentation shall be done in accordance
with written procedures. The broker or dealer shall also document any
arrangement, whether written or oral, concerning payment for order
flow, including the parties to the arrangement, all qualitative and
quantitative terms concerning the arrangement, and the date and terms
of any changes to the arrangement.
(4) For purposes of this paragraph (b):
(i) ``Any transaction for or with a retail customer'' means any
transaction for or with the account of a natural person or held in
legal form on behalf of a natural person or group of related family
members. For purposes of this definition, a ``group of related family
members'' means a group of natural persons with any of the following
relationships: child, stepchild, grandchild, great grandchild, parent,
stepparent, grandparent, great grandparent, spouse, domestic partner,
sibling, stepbrother, stepsister, niece, nephew, aunt, uncle, mother-
in-law, father-in-law, son-in-law, daughter-in-law, brother-in-law, or
sister-in-law, including adoptive and foster relationships; and any
other natural person (other than a tenant or employee) sharing a
household with any of the foregoing natural persons;
(ii) A broker or dealer executes an order as ``riskless principal''
if, after having received an order to buy from a customer, the broker
or dealer purchases the security from another person to offset a
contemporaneous sale to the customer or, after having received an order
to sell, the broker or dealer sells the security to another person to
offset a contemporaneous purchase from the customer; and
(iii) ``Affiliate'' means, with respect to a specified person, any
person that, directly or indirectly, controls, is under common control
with, or is controlled by, the specified person. For purposes of this
definition, ``control'' means the power, directly or indirectly, to
direct the management or policies of the broker or dealer whether
through ownership of securities, by contract, or otherwise. A person is
presumed to control a broker or dealer if that person is a director,
general partner, or officer exercising executive responsibility (or
having similar status or performing similar functions); directly or
indirectly has the right to vote 25 percent or more of a class of
voting securities or has the power to sell or direct the sale of 25
percent or more of a class of voting securities of the broker or
dealer; or in the case of a partnership, has contributed, or has the
right to receive upon dissolution, 25 percent or more of the capital of
the broker or dealer.
(c) Regular Review of Execution Quality. A broker or dealer shall,
no less frequently than quarterly, review the execution quality of its
transactions for or with customers or customers of another broker or
dealer, and how such execution quality compares with the execution
quality the broker or dealer might have obtained from other markets,
and revise its best execution policies and procedures, including its
order handling practices, accordingly. The broker or dealer shall
document the results of this review.
(d) Introducing Brokers. An introducing broker that routes customer
orders to an executing broker does not need to separately comply with
paragraphs (a), (b), and (c) of this section so long as the introducing
broker establishes, maintains, and enforces policies and procedures
that require the introducing broker to regularly review the execution
quality obtained from such executing broker, compare it with the
execution quality it might have obtained from other executing brokers,
and revise its order handling practices accordingly. The introducing
broker shall document the results of this review. For purposes of this
provision, introducing broker means a broker or 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 broker or
dealer that has agreed to handle and execute on an agency basis all of
the introducing broker's customer orders (``executing broker'') (For
purposes of this paragraph, principal trades by an executing broker
with the introducing broker's customer to fill fractional share orders
in NMS stocks and riskless principal trades (as defined in paragraph
(b)) by an executing broker in fixed income securities will be
considered to be handled on an agency basis); 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.
Sec. 242.1102 Annual report.
A broker or dealer that effects any transaction for or with a
customer or a customer of another broker or dealer shall, no less
frequently than annually, review and assess the design and overall
effectiveness of its best execution policies and procedures, including
its order handling practices. Such review and assessment shall be
conducted in accordance with written procedures and shall be
documented. The broker or dealer shall prepare a written report
detailing the results of such review and assessment, including a
description of all deficiencies found and any plan to address
deficiencies. The report shall be presented to the board of directors
(or equivalent governing body) of the broker or dealer.
By the Commission.
December 14, 2022.
J. Matthew DeLesDernier,
Deputy Secretary.
[FR Doc. 2022-27644 Filed 1-26-23; 8:45 am]
BILLING CODE 8011-01-P