SEC Proposes New Regulation Best Execution — Brokers Must Achieve “Most Favorable Price” for Customers; Heightened Obligations for Conflicted Retail Transactions | Insights & Resources | Goodwin Procter
On December 14, 2022, the SEC proposed new Regulation Best Execution, encompassing new Trade Act Guidelines 1100, 1101, and 1102. Regulation Best Execution would codify a federal finest execution commonplace pursuant to which broker-dealers should obtain the “most favorable price” for patrons. Which means broker-dealers could be required to make use of affordable diligence to determine the very best marketplace for the safety, and purchase or promote in such market in order that the resultant worth to the shopper is as favorable as potential underneath prevailing market circumstances. Regulation Best Execution would additionally require broker-dealers to determine associated sturdy insurance policies and procedures, notably for companies partaking in “conflicted transactions” with or for retail prospects, together with principal buying and selling, routing buyer orders to associates, and receiving fee for order circulate (PFOF).
The operative phrases within the proposed finest execution commonplace are equivalent to these in FINRA Rule 5310. Nonetheless, and because the SEC acknowledges, key points depart from the present finest execution regulatory regime and would require vital business changes. Introducing brokers, brokers with PFOF preparations, and executing brokers accustomed to internalizing retail order circulate or executing retail trades for associates will really feel notably affected by this proposal.
Public feedback are due by March 31, 2023.
Regulation Best Execution at a Look
Regulation Best Execution would apply to transactions in “securities” merchandise (together with equities, choices, company and municipal bonds, authorities securities, and “crypto asset securities”) and would, amongst different issues:
Codify a federal rules-based finest execution commonplace for brokers, sellers, authorities securities brokers, authorities securities sellers, and municipal securities sellers (proposed Rule 1100 collection) and set up exceptions just like these accessible right now.
Require broker-dealers to determine, keep, and implement written insurance policies and procedures fairly designed to adjust to the very best execution commonplace (proposed Rule 1101) whereas offering a restricted exemption for introducing brokers (proposed Rule 1101(d)).
Require enhanced insurance policies and procedures for broker-dealers that have interaction in sure “conflicted transactions” for or with retail prospects (proposed Rule 1101(b)).
Require broker-dealers to evaluation the execution high quality of their buyer transactions a minimum of quarterly (proposed Rule 1101(c)).
Require broker-dealers to evaluation their finest execution insurance policies and procedures a minimum of yearly and current a report detailing the outcomes of such evaluation to their boards of administrators or equal governing our bodies (proposed Rule 1102).
The time period “market” is interpreted broadly for functions of present necessities and could be broadly outlined underneath Regulation Best Execution as properly, together with different broker-dealers, exchanges, different buying and selling techniques (ATSs), and different venues that change into identified. The scope might also embrace a wide range of mechanisms operated by markets utilized by broker-dealers to transact for or with prospects (together with public sale mechanics and different execution protocols).
Prime 10 Observations and Takeaways
The Fee famous within the proposal that “a broker-dealer’s failure to achieve the most favorable price for customer orders would not necessarily be a violation of the proposed best execution standard.” Nonetheless, Regulation Best Execution seems to deal with worth because the alpha and omega issues for companies, seemingly no matter different order routing and order execution variables accessible for consideration. The Fee devotes vital dialogue within the proposal to how broker-dealers ought to scour markets for the very best accessible worth, but considerably much less time serving to broker-dealers perceive establish and weigh different finest execution elements (like buying and selling traits of the safety, dimension of orders, probability of execution, and accessibility of the market).
Relating to worth, it looks like the SEC expects companies to realize executions for his or her prospects on the midpoint of the NBBO (the proposal mentions midpoint 173 occasions). By the use of instance, the Fee notes its perception “that customers would benefit from robust considerations by retail broker-dealers regarding, for example, the possibility of available liquidity priced at the midpoint of the NBBO at other markets.” The SEC doesn’t, nevertheless, explicitly say that companies ought to route orders to exchanges to hit midpoint liquidity previous to routing for execution by wholesalers. Nonetheless, the proposal feels slanted in that course (particularly when learn in tandem with the retail order public sale publicity rulemaking proposed by the Fee on the identical day). Transparency from the Fee right here is essential, if that’s what the company in the end wishes or expects.
Brokers engaged in conflicted transactions with or for retail buyers could must scour small, opaque markets with skinny and unreliable liquidity to search out what’s akin to tremendous finest execution. The Fee famous within the proposal “that customers would benefit from considerations by these retail broker-dealers of whether other markets may provide customer orders, or a portion of those orders, with potentially better executions than wholesalers.” Sadly, the Fee doesn’t sufficiently clarify the proverbial line between common and tremendous finest execution worth checks. Question, for instance, whether or not the Fee has in thoughts a particular quantity and sequencing of markets to be assessed and, even when these “better” executions are potential, at what value (pun supposed). The Fee itself even refers to “reasonably balancing the likelihood of obtaining better prices with the risk that delay could result in a worse price.”
On the one hand, the Fee acknowledged “the importance of providing a broker-dealer flexibility to exercise its expertise and judgment when executing customer orders, and proposed Regulation Best Execution primarily would be a policies and procedures-based rule.” On the identical time, the SEC refers to its perception “that the receipt of [PFOF] continues to warrant heightened attention by broker-dealers.” It was by no means a sensible end result for the SEC to impose an outright ban on PFOF. Nonetheless, the proposal incorporates a constant and recurring theme that, in our view, the Fee thinks (actually, hopes) that the proposed tremendous finest execution obligation will trigger most retail-focused companies to stop accepting these funds. The SEC does notice, nevertheless, that passing PFOF alongside to prospects would suffice to de-conflict a transaction.
In figuring out the very best marketplace for buyer orders acquired, brokers might want to think about fairly accessible and well timed pricing info and alternatives for worth enchancment. The Fee notes within the proposal that it “has also stated the importance of price improvement opportunities in the context of listed and [OTC] equities. Simply routing customer order flow for automated executions or internalizing customer orders on an automated basis at the best bid or offer would not necessarily satisfy a broker-dealer’s duty of best execution for small orders in listed and OTC equities. Rather, broker-dealers handling small orders in listed and OTC equities should look for price improvement opportunities when executing these orders. And the expectation of price improvement for customer orders is particularly important when broker-dealers receive payments in return for routing their customer orders.”
The conflicted transaction regime would solely apply to “retail customers,” which the SEC defines extra broadly than underneath legacy FINRA guidelines and, curiously, even in comparison with Regulation Best Curiosity. The Fee ought to simply use a single core definition of retail buyer and scope it to use to beneficial transactions for finest curiosity and extra broadly for finest execution. Specifically, and in contrast to Regulation Best Curiosity, retail prospects for finest execution functions would embody accounts held in authorized type on behalf of a pure individual or a “group of related family members,” which the SEC intends to cowl the “types of arrangements that may be set up to benefit family groups, including individual retirement accounts, corporations, and limited liability companies for the benefit of related family members.” The SEC tries to elucidate the rationale for the diverging finest curiosity and finest execution scopes, stating that “[p]roposed Rule 1101(b) does not incorporate all of the definition of ‘retail customer’ in Regulation Best Interest because that definition is limited to scenarios where a person receives and uses a recommendation. In contrast, proposed Rule 1101(b) and the proposed standard of best execution are not limited to scenarios where a person receives and uses a recommendation.” The proposed new definition is just like that underneath Regulation Best Curiosity in that it captures people with $50 million of belongings or extra, which is the brink FINRA makes use of to outline institutional account.
It was only some years in the past that the SEC was trying to encourage innovation to enhance secondary market high quality for thinly traded securities, which is retail-heavy. As a substitute, the marketplace for thinly-traded securities has contracted considerably for the reason that SEC amended Trade Act Rule 15c2-11 in September 2020 by limiting the power for brokers to cite and publish on these names. The Regulation Best Curiosity proposal is lean on dialogue round OTC buying and selling. Nonetheless, the potential intersection of those guidelines would make it just about not possible for brokers to fulfill the common finest execution commonplace, not to mention tremendous finest execution for conflicted retail transactions. It will have the possible impact of eliminating retail investor entry past the highest 3,000 names.
Regulation Best Execution would impose the brand new necessities on introducing brokers that, till now, have complied with their finest execution obligations by performing “regular and rigorous” critiques of execution high quality (EQ) reviews and different statistics from executing and clearing brokers with which they’ve contracted. The Rule 605 amendments proposed by the Fee on the identical day as Regulation Best Execution would improve dealer disclosure of order execution info and appear designed to assist on this regard. Given the rigorous requirement to evaluation EQ and regulate order-handling practices based mostly on that evaluation, it isn’t clear why it’s crucial additionally to slender the definition of introducing dealer to exclude, for instance, people who execute by way of an affiliated dealer. If their EQ evaluation signifies that they’ll get hold of higher execution from one other dealer, they might implicitly be required to modify to the opposite dealer.
SEC employees might want to ultimately present vital steering to the business relating to how the proposed obligation of finest execution shall be affected by age-old variables and ache factors like entry to and utilization of information feeds (together with using proprietary alternate feeds versus the SIPs), alternate and ATS entry charges, and the velocity and technique of entry to quotes and latency issues. That is notably true relating to figuring out what’s “reasonably accessible information” and whether or not brokers can “efficiently access each material potential liquidity source.”
The Regulation Best Execution proposal is considered one of three different vital “market structure” proposals introduced on the identical day in December 2022. These embrace an “Order Competition Rule” (new Trade Act Rule 616, together with requiring sure retail fairness orders to be uncovered in auctions earlier than being internalized); amendments to Trade Act Rule 605 (enhancing dealer disclosure of order execution info); and amendments to Trade Act Guidelines 610 and 612 (amending minimal pricing increments and alternate entry charge caps and enhancing the transparency of better-priced orders). The Fee is already dealing with vital criticism for proposing all 4 of those on the identical time, notably given that every warrants cautious consideration with out results from exogenous elements, just like the adoption of the opposite proposals, that can actually ensue. For instance, past the proposed new retail order public sale proposal, what does the company anticipate from brokers relating to “order exposure opportunities that may result in the most favorable price”? Additionally, how will the anticipated new minimal tick sizes have an effect on brokers’ consideration of pricing when making their order routing selections? Lastly, will the improved 605 reviews yield the data the SEC anticipates they may and can companies be anticipated to ingest and issue these into their routing selections instantly?
Required Insurance policies and Procedures and Associated Obligations
Regulation Best Execution would require broker-dealers to determine, keep, and implement written insurance policies and procedures fairly designed to adjust to the very best execution commonplace, together with:
Acquiring, figuring out, and incorporating sure info
Acquiring and assessing fairly accessible info, together with details about worth, quantity, and EQ, in regards to the markets buying and selling the related securities;
Figuring out markets that could be fairly possible to supply probably the most favorable costs for buyer orders (so-called “material potential liquidity sources”); and
Incorporating materials potential liquidity sources into their order dealing with practices, and guaranteeing that the agency can effectively entry every such materials potential liquidity supply.
Assessing and figuring out the very best market and making buyer order routing or execution selections
Assessing fairly accessible and well timed info with respect to the very best displayed costs, alternatives for worth enchancment, together with midpoint executions, and order publicity alternatives that will end in probably the most favorable worth;
Assessing the attributes of buyer orders and contemplating the buying and selling traits of the safety, the dimensions of the order, the probability of execution, the accessibility of the market, and any buyer directions in choosing the market most definitely to supply probably the most favorable worth; and
In figuring out the quantity and sequencing of markets to be assessed, fairly balancing the probability of acquiring higher costs with the chance that delay might end in a worse worth.
A “conflicted transaction” could be any transaction for or with a retail buyer the place a broker-dealer (1) executes an order as principal, together with riskless principal, (2) routes an order to or receives an order from an affiliate for execution, or (3) gives or receives PFOF. Required insurance policies and procedures would wish to particularly doc compliance with the very best execution commonplace for conflicted retail transactions in mild of any PFOF, together with:
Acquiring and assessing enhanced info, together with further details about worth, quantity, and EQ, in figuring out a broader vary of markets past these recognized as materials potential liquidity sources;
Evaluating a broader vary of markets, past these recognized as materials potential liquidity sources, which may present probably the most favorable worth for buyer orders, together with a broader vary of order publicity alternatives and markets that could be smaller or much less accessible than these recognized as materials potential liquidity sources;
Documenting compliance with the very best execution commonplace (in accordance with written procedures), together with all efforts to implement the agency’s finest execution insurance policies and procedures for conflicted transactions and the premise and data relied on for its compliance determinations; and
Documenting any PFOF association, whether or not written or oral, together with the events, all qualitative and quantitative phrases, and the date and phrases of any modifications.
Regulation Best Execution would require that broker-dealers, a minimum of quarterly:
Overview the EQ of their transactions for or with prospects or prospects of one other broker-dealer, and the way such EQ compares with the EQ the broker-dealer may need obtained from different markets;
Revise their finest execution insurance policies and procedures, together with order dealing with practices, accordingly; and
Doc the outcomes of this evaluation.
Introducing brokers that route buyer orders to an executing dealer wouldn’t must adjust to the necessities above in the event that they:
Set up, keep, and implement insurance policies and procedures for commonly reviewing the EQ obtained from the executing dealer;
Evaluate it with the EQ the introducing dealer may need obtained from different executing brokers;
Revise their order dealing with practices accordingly; and
Doc the outcomes of their evaluation.
Areas for Nearer Examination
Implications for Introducing Brokers
“Introducing broker” would imply a broker-dealer that (1) doesn’t carry buyer accounts and doesn’t maintain buyer funds or securities, (2) has entered into an association with an unaffiliated executing broker-dealer that has agreed to deal with and execute on an company foundation all the introducing dealer’s buyer orders, and (3) has not accepted any financial fee, service, property, or different profit that leads to remuneration, compensation, or consideration from the executing dealer in return for the routing of the introducing dealer’s buyer orders to the executing dealer.
We anticipate the Fee to make clear {that a} single introducing dealer is ready to use a number of unaffiliated executing brokers to deal with orders on an company foundation (regardless of the textual content suggesting in any other case). Examples of “other benefits” introducing brokers couldn’t obtain from executing brokers embrace analysis, clearance, or custody services or products; reciprocal agreements for the availability of order circulate; adjustment of a broker-dealers unfavorable buying and selling errors; presents to take part as underwriter in public choices; inventory loans or shared curiosity accrued thereon; and reductions, rebates, or another reductions of or credit in opposition to any charge to, or expense or different monetary obligation of, the broker-dealer routing a buyer order that exceeds that charge, expense, or monetary obligation.
Proposed Rule 1101(d) would exempt an introducing dealer that routes buyer orders to an executing dealer from individually complying with proposed Guidelines 1101(a), (b), and (c) if the introducing dealer establishes, maintains, and enforces insurance policies and procedures that require the introducing dealer to commonly evaluation the EQ obtained from its executing dealer, evaluate it with the execution high quality it might have obtained from different executing brokers, and revise its routing practices accordingly. This would supply a tailor-made exemption from sure provisions of proposed Regulation Best Execution for companies that don’t make selections or train discretion relating to the style through which their buyer orders are dealt with and executed (apart from the dedication to have interaction the executing dealer). The Fee factors out that this exemption could be supplied to a narrower group of companies in comparison with comparable exemptions supplied by FINRA and the MSRB, and would require further particular insurance policies and procedures that aren’t required underneath the FINRA and MSRB guidelines.
A broker-dealer that results any transaction for or with a buyer or a buyer of one other dealer or supplier should a minimum of yearly evaluation and assess the design and total effectiveness of its finest execution insurance policies and procedures, together with its order dealing with practices, conduct the evaluation and evaluation in accordance with written procedures, and doc the evaluation and evaluation. The broker-dealer should additionally put together a written report detailing the outcomes of the evaluation and evaluation, together with an outline of all deficiencies discovered and any plan to deal with deficiencies, and current the report back to the agency’s board of administrators (or equal governing physique).
The SEC excludes two principal buying and selling situations from its new introducing dealer prohibitions: (i) fractional share buying and selling in NMS shares; and (ii) riskless principal buying and selling in company and municipal bonds and authorities securities. In each situations, the SEC believes that present market observe necessitates these exemptions. We expect it’s a provided that the business will establish others that warrant comparable carve-outs.
Exemptions for Institutional-Solely Dealer-Sellers
Proposed Rule 1100 would exempt from the very best execution commonplace broker-dealers with enterprise restricted to (i) quoting a worth for a safety the place one other broker-dealer routes a buyer order for execution in opposition to that quote; and (ii) transacting with institutional prospects that train impartial judgment and execute an order in opposition to the broker-dealer’s citation. The primary exemption is included in FINRA’s present finest execution rule. The second could also be according to FINRA’s finest execution rule, however shouldn’t be expressly mentioned therein. Proposed Regulation Best Execution doesn’t outline the time period “institutional customer” for functions of this exemption however asks commenters if a definition is acceptable.
Protection for Digital Asset Securities
Regulation Best Execution would apply to crypto belongings that qualify as securities or authorities securities. The SEC notes within the proposal a number of occasions that it “has limited information about the order handling and best execution practices” of contributors within the crypto asset market. The SEC nonetheless concludes that regardless of its personal lack of ability to evaluate execution high quality within the crypto markets, broker-dealers facilitating transactions in crypto asset securities should assess execution high quality and totally adjust to Regulation Best Execution. It’s unclear, nevertheless, how the SEC expects digital asset safety broker-dealers to do what the SEC itself can’t. The SEC refers to “digital asset” as an asset that’s issued and/or transferred utilizing distributed ledger or blockchain expertise (“distributed ledger technology”), together with, however not restricted to, so-called “virtual currencies,” “coins,” and “tokens.”
Subsequent Steps
Regardless of being fairly lengthy (440 pages), the proposal is brief on particulars and definitions and would profit from clear statements of SEC expectations. We anticipate continued sturdy remark and criticism as much as and after the March 31, 2023 remark deadline. Though the SEC stays in full distant work standing, engagement with the Chairman and Commissioners, their staffs, and employees within the Division of Buying and selling and Markets ought to stay a excessive precedence for business stakeholders.
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