The issue of Best Execution is not new and did not start with Robinhood or Gamestop. As best execution of customer orders is a key investor protection requirement, broker-dealers are required to continuously review their systems and procedures to regularly and rigorously examine execution quality. With the increasingly automated equity and options markets in the last few decades, FINRA issued a Regulatory Notice in 2015 to reiterate best execution obligations applicable to brokers that receive, handle, route or execute customer orders. The purpose of the Notice is to remind firms of their obligations to provide best execution, reiterate best execution principles particularly relevant in automated markets and provide guidance on conducting regular and rigorous reviews. The Notice provides both general guidance on best execution obligations for firms when handling customer orders.

The Duty of Best Execution

 The Notice discusses the origin of the best execution legal obligation and the derivative regulations coming out of the SEC and FINRA and the considerations and scope thereof. For example, The SEC has recognized 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. A non-exhaustive list of factors that firms should consider as part of their best execution analysis as markets evolve:

• the size of the order;

• 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.

 The SEC has indicated that simply obtaining the best bid or best offer (BBO) may not satisfy a firm's best execution obligation, particularly with respect to small orders. Conversely, while a firm is required to seek the most favorable terms reasonably available under the circumstances of the transaction, such terms may not necessarily in every case be the best price available. The best execution analysis may evolve due to changes in the market that give rise to improved executions, including the opportunity to trade at more advantageous prices. If different markets may be more suitable for different types of orders or particular securities, the broker-dealer will also need to consider such factors. For example, the routing decisions for non-marketable orders may require a different analysis (e.g., including fill rates in the analysis) than would be appropriate for marketable orders.

FINRA's best execution rule, Rule 5310, requires member firms to use “reasonable diligence to ascertain the best market for the subject security … as favorable as possible under prevailing market conditions." Factors that will be considered in determining whether a firm has used "reasonable diligence" are:

a. the character of the market for the security (e.g., price, volatility, relative liquidity and pressure on available communications);

b. the size and type of transaction;

c. the number of markets checked;

d. accessibility of the quotation; and

e. the terms and conditions of the order which result in the transaction, as communicated to the member and persons associated with the member.

Regular and Rigorous Review for Best Execution

Through various Releases, the SEC has signaled that a broker-dealer must "regularly and rigorously" examine the execution quality that is likely to be obtained from different venues. The "regular and rigorous review" requirement has also been incorporated by FINRA into its Rule 5310. However, 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."

FINRA believes that, given developments in order routing technology, order-by-order review of execution quality is increasingly possible for a range of orders in all equity securities and standardized options. A firm that chooses not to conduct an order-by-order review for some orders must have procedures in place to ensure that it periodically conducts a regular and rigorous review of execution quality for those orders. Such periodic reviews of execution quality must be conducted on a security-by-security, type-of-order basis (e.g., for equity securities, limit order, market order, and market on open order). Firms choosing to conduct a regular and rigorous review must conduct the reviews, at a minimum, on a quarterly basis. Supplementary Material .09 (FINRA Rule 5310) notes that firms should consider, based on the firm's business, whether more frequent reviews are needed.  FINRA has found that some firms, in reviewing their business, have determined that it is necessary to conduct their reviews more frequently than quarterly, with most of those firms conducting monthly reviews.

Although FINRA has noted that a regular and rigorous review can satisfy a firm's best execution obligation for firms that route orders and for firms that internalize orders, a firm's ability to rely on a regular and rigorous review applies only to the firm's initial determination whether to route an order and those orders ultimately routed outside of the firm. Any orders a firm determines to execute by internalizing would be subject to an order-by-order analysis of execution quality. Thus, while Supplementary Material .09 allows a firm to use a regular and rigorous review of execution quality, this standard only applies to a firm's initial determination whether to route an order and to its review of orders routed outside of the firm. Orders that a firm determines to execute internally are subject to an order-by-order best execution analysis.

When conducting its review of execution quality in any security, a firm should consider:

(1) the price obtained, including the extent to which an execution results in price disimprovement (i.e., instances where orders are executed at inferior prices);

(2) the extent to which an order may obtain price improvement at other venues;

(3) the likelihood that an order will be partially or fully executed;

(4) the speed of execution;

(5) the size of execution;

(6) transaction costs; and

(7) customer needs and expectations.

 In addition, a firm should consider the factors listed below, as applicable, when considering its best execution obligations in equities, options or fixed income securities. In the context of equity securities, FINRA notes that these requirements apply to customer non-marketable limit orders as well as market and marketable limit orders.

 - In conducting its regular and rigorous review, a firm must determine whether any material differences in execution quality exist among the markets trading the security. If so, a firm should take these differences into account in its customer routing arrangements or justify why it is not modifying its routing arrangements.

 - In formulating policies and procedures to review execution quality for customer transactions, firms should consider what procedures they use or would use for executing the same or similar transactions for their own firm accounts, even if such procedures are not required to be the same.

 - A firm that routinely routes a customer order to multiple trading centers (internal or external) should regularly review the execution quality that results from this practice. For example, the firm should evaluate the latency attendant in routing a customer order (or portion of a customer order) to multiple ATSs, a practice of routing to a particular trading center (e.g., an internal ATS) before other routing decisions are made, or repeated routing to the same ATS, and whether such practices may result in latency that impacts fill rates or the overall quality of execution. The firm should also examine whether any of these practices may result in information leakage, and the impact of any information leakage on execution quality. 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.

 - A firm that limits its review of execution quality only to those markets to which it currently routes customer order flow without considering competing markets would not satisfy the duty of best execution.30 Accordingly, the firm must compare the quality of the executions it is obtaining via current order routing and execution arrangements (including the internalization of order flow) to the quality of the executions that it could obtain from competing markets. This obligation would include reviewing new markets and trading centers that become available as potential markets to which the firm may route orders; thus, a firm should regularly consider execution quality at venues to which it is not connected and assess whether it should connect to such venues.

 - Some firms may employ "filters," which generally refers to automated tools that allow the firm to limit its trading, with, for example, specific parties or parties with specified attributes with which it does not want to interact. If a firm 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 customers, and should be reviewed on a periodic basis and adjusted as needed. The firm, accordingly, should have policies and procedures in place that govern when and how to reasonably use filters without negatively impacting the quality of execution; periodically reevaluate their use; and determine whether to lift them upon request.

 - A firm must take into account market and technology changes that might alter its best execution analysis.

 - With respect to customer limit orders for equity securities, a firm must consider any material differences in execution quality (e.g., the likelihood of execution) among the various markets to which orders may be routed.

 - An introducing firm may rely on the executing firm's regular and rigorous review of execution quality for any security, so long as the executing firm fully discloses the statistical results and rationale of its review to the introducing firm, and the introducing firm reviews both the methodology and the results of that review.

Best Execution and Payment for Order Flow

The SEC has also addressed the concept of best execution and its relationship to the practice of payment for order flow in connection with equity securities and options. For example, while the SEC has previously stated that bulk order routing "based, in part, on the receipt of payment for order flow is not, in and of itself, a violation of" a broker-dealer's duty of best execution, the SEC also has emphasized that payment for order flow may "raise concerns about whether a firm is meeting its obligation of best execution to its customer." The SEC has stated that an order routing inducement, such as receipt of payment for order flow, cannot be allowed to interfere with a broker-dealer's duty of best execution. Similarly, firms should not allow access fees charged by particular venues to inappropriately affect their routing decisions, and, in general, a firm's routing decisions should not be unduly influenced by a particular venue's fee or rebate structure. Rule 5310 also addresses the practice of payment for order flow as it relates to best execution. Specifically, Supplementary Material .09 states that a firm should consider the existence of internalization or payment for order flow arrangements when conducting its regular and rigorous review of execution quality.

The SEC has stated that the possibility of obtaining price improvement on an order is a heightened consideration when the broker-dealer is receiving payment for order flow. Payment for order flow may encompass a broad variety of rebate and payment structures and practices. Specifically, SEA Rule 10b-10 defines payment for order flow to include "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." Given the potential conflict between the receipt of payment for order flow, which is broadly defined under Rule 10b-10, and the duty of best execution, a firm should carefully evaluate its receipt of payment for order flow and the impact of such practices on execution quality.

Directed Orders

 Firms may receive unsolicited orders for equity securities from customers that instruct the firm to route the orders to a particular market, often referred to as "directed orders." A firm's best execution obligations are somewhat different with respect to the execution of directed orders because the customer has provided the firm with a specific instruction as to where to route the order for execution. Under Supplementary Material .08 to Rule 5310, a firm that is handling an unsolicited directed order is not required to undertake a best execution determination regarding the market of execution beyond the customer's specific instruction. However, the firm is still required to process that customer's order promptly and in accordance with the terms of the order. Furthermore, if a customer has directed that an order be routed to another specific broker-dealer that is also a FINRA member, the receiving broker-dealer to which the order was directed would be required to meet the requirements of Rule 5310 with respect to its handling of the order.

FINRA notes that, as a general matter, a firm is not obligated to accept directed orders. If a firm accepts a directed order from a customer, however, and has access to a trading center to which the customer requests that its order be directed, then the firm is obligated to act in accordance with the customer's instructions. If the firm is unable to route the order to the specific market in accordance with the customer's instructions, the customer must be informed of that fact and have been provided the opportunity to revise or cancel the order. Just as with a firm's regular and rigorous review, a firm has an obligation to periodically assess whether it should establish connectivity to trading centers, or terminate connectivity, when handling customer orders.

Source: FINRA Regulatory Notice 15-46