Regulation NMS and Best Execution
Quick Answer
The FINRA best-execution rule requires a member to use reasonable diligence to ascertain the best market and execute customer orders at a price as favorable as possible under prevailing conditions. A firm that does not do order-by-order best-execution review must conduct a regular and rigorous review at least quarterly, security-by-security and order-type-by-order-type. Regulation NMS is the SEC framework for the national market system: it requires market centers to publish monthly execution-quality reports and broker-dealers to publish quarterly order-routing reports; the Order Protection Rule prohibits trade-throughs of automated protected quotations at the NBBO; and the sub-penny rule sets minimum pricing increments ($0.01 above
Quick Answer: The FINRA best-execution rule requires a member to use reasonable diligence to ascertain the best market and execute customer orders at a price as favorable as possible under prevailing conditions. A firm that does not do order-by-order best-execution review must conduct a regular and rigorous review at least quarterly, security-by-security and order-type-by-order-type. Regulation NMS is the SEC framework for the national market system: it requires market centers to publish monthly execution-quality reports and broker-dealers to publish quarterly order-routing reports; the Order Protection Rule prohibits trade-throughs of automated protected quotations at the NBBO; and the sub-penny rule sets minimum pricing increments ($0.01 above $1.00, $0.0001 below $1.00).
.00, $0.0001 belowQuick Answer: The FINRA best-execution rule requires a member to use reasonable diligence to ascertain the best market and execute customer orders at a price as favorable as possible under prevailing conditions. A firm that does not do order-by-order best-execution review must conduct a regular and rigorous review at least quarterly, security-by-security and order-type-by-order-type. Regulation NMS is the SEC framework for the national market system: it requires market centers to publish monthly execution-quality reports and broker-dealers to publish quarterly order-routing reports; the Order Protection Rule prohibits trade-throughs of automated protected quotations at the NBBO; and the sub-penny rule sets minimum pricing increments ($0.01 above $1.00, $0.0001 below $1.00).
.00).A broker-dealer routing customer orders has two parallel duties: a fiduciary-style best-execution duty under FINRA's best-execution rule, and a regulatory duty under Reg NMS to respect protected quotations and disclose routing practices. The Series 24 supervisor sits between a firm's order-routing logic and the regulatory framework that constrains it.
Execution Venues
A broker-dealer may route a customer order to one of several venue types:
| Venue | Description |
|---|---|
| National Securities Exchange | A registered exchange (NYSE, Nasdaq, Cboe BZX, etc.): operates under SEC oversight as a self-regulatory organization (SRO) |
| Alternative Trading System (ATS) | An electronic system that matches orders but is not a registered exchange (governed by SEC Regulation ATS); includes dark pools and ECNs |
| Alternative Display Facility (ADF) | A FINRA quotation/trade-reporting facility for non-exchange trades |
| OTC Market | OTC Markets Group tiers (OTCQX, OTCQB, Pink, Expert) for non-exchange OTC equities |
| Internal Crossing | The member's own ATS or principal book |
The principal supervising routing decisions must be able to justify why orders are routed to one venue over another, both for individual orders and on a systematic basis.
The FINRA Best-Execution Rule
A member must use reasonable diligence to ascertain the best market for a security and execute the customer order at a price as favorable as possible under prevailing market conditions.
The factors in best-execution analysis:
- Character of the market: price, volatility, liquidity, communications/data quality
- Size and type of transaction: market order vs. limit, large block vs. retail size
- Number of markets checked
- Accessibility of quotations at competing venues
- Terms and conditions of the customer order itself
Regular and Rigorous Review
If a firm does not review every order individually for best execution, it must conduct a regular and rigorous review of execution quality:
| Element | Requirement |
|---|---|
| Frequency | At least quarterly |
| Granularity | Security-by-security AND type-of-order (market, limit, market-on-open, etc.) |
| Comparison | Compare the firm's executions against competing markets |
| Action | Modify routing if material differences are found, OR document the rationale for not modifying |
A firm that finds a venue is providing materially worse executions than a competing venue and continues routing without explanation has failed the rule.
Think of it this way: The regular-and-rigorous review is best-execution-by-statistics. Instead of evaluating every customer order one by one, the firm samples enough executions to identify patterns. If Venue A is consistently worse than Venue B for limit orders in mid-cap stocks, the firm must either reroute or document why the choice is justified (e.g., A pays more for order flow and the rebate funds zero-commission for retail customers).
Exam Tip: Gotchas
- Regular and rigorous review must be at least quarterly, security-by-security AND order-type-by-order-type. A firm-wide annual review of overall execution stats does not satisfy the best-execution rule.
- The firm must either modify routing OR document why not. Finding that Venue A is worse and continuing to route there silently is a best-execution violation. Documentation of the rationale is required.
Interpositioning
A firm may NOT interpose a third party between itself and the best market unless doing so demonstrably benefits the customer (lower price, better fill, or some other quantifiable advantage).
The classic interpositioning violation: a firm routes a customer order through an affiliate broker that adds a markup, with no improvement in execution quality. The customer pays more without receiving anything in return.
Exam Tip: Gotchas
- Interpositioning requires demonstrable benefit, not just plausible benefit. A firm cannot route through an affiliate "in case it helps" without measurable evidence it does help.
- Layering an affiliate that takes a markup but adds no execution quality is a best-execution violation. Affiliate routing must improve the customer's outcome.
Regulation NMS: The Core Components
| Component | Substance |
|---|---|
| NMS security definitions | Defines an NMS security (exchange-listed equity or option), protected quotation, trading center, and other key terms |
| Dissemination of quotations | Exchanges and OTC market makers must furnish quotations to a securities information processor (SIP) so the public market data feed reflects all displayed quotes |
| Display of customer limit orders | A market maker holding a customer limit order priced better than its own quote (or with size that would improve its own size) must display the order in its quote |
| Execution-quality reports | Market centers must publish monthly execution-quality stats, organized by security and order type |
| Order-routing reports | Broker-dealers must publish quarterly routing reports disclosing the venues to which they route customer orders and any payment for order flow received |
| Order Protection Rule (Trade-Through Rule) | Trading centers must establish written policies to prevent trade-throughs of protected quotations displayed by automated trading centers at the NBBO |
| Sub-Penny Rule | Quotations in NMS stocks priced at $1.00 or more must be in increments of $0.01; quotations below $1.00 in $0.0001 increments |
Execution-Quality vs. Order-Routing Reports: Who Owes What
This is one of the most-tested distinctions on the Series 24:
| Report | Filer | Frequency | Content |
|---|---|---|---|
| Execution-quality report | Market center (the venue) | Monthly | Execution-quality statistics by security and order type |
| Order-routing report | Broker-dealer (the order router) | Quarterly | Routing destinations + payment-for-order-flow disclosure |
A principal supervising routing decisions uses the firm's own routing report. A principal evaluating execution venue performance uses the venues' execution-quality reports.
Exam Tip: Gotchas
- The execution-quality report is the MARKET CENTER's obligation; the order-routing report is the BROKER-DEALER's obligation. The exam tests this as a "who owes the report?" question constantly.
- The order-routing report is quarterly; the execution-quality report is monthly. Different cadences for different purposes.
- The order-routing report includes payment-for-order-flow disclosure. A firm that receives PFOF must say so in its routing report.
The Order Protection Rule
A trading center may not execute a trade at a price worse than a protected quotation at another center. A "protected quotation" is the top-of-book best bid or offer at an automated trading center.
Two key qualifiers:
- Top-of-book only: depth-of-book quotations are not protected
- Automated only: manual quotations (legacy specialist quotes that require human action to access) are NOT protected
A trade-through of a manual quote is permitted under the Order Protection Rule. A trade-through of an automated top-of-book quote is prohibited unless an exception applies (Intermarket Sweep Order, ISO, being the most common).
Exam Tip: Gotchas
- The Order Protection Rule protects only AUTOMATED, TOP-OF-BOOK quotations. Manual quotations and depth-of-book quotations are not protected. A trade-through of a manual quote does not violate the rule.
- The protected-quote benchmark is the NBBO, not the local best. A firm trading on Exchange A must not trade through Exchange B's better-priced automated quote.
The Sub-Penny Rule
| Stock Price | Minimum Pricing Increment |
|---|---|
| $1.00 or more | $0.01 (one penny) |
| Below $1.00 | $0.0001 (one hundredth of a cent) |
The sub-penny rule prevents tiny price improvements (e.g., bidding $10.0001 to step ahead of a $10.00 limit order) for stocks at or above $1.00. Below $1.00, sub-penny pricing is permitted because the percentage increment matters more for low-priced stocks.
Exam Tip: Gotchas
- The $1.00 threshold is the price of the stock, not the order size. A 100-share order in a $5.00 stock must be quoted in penny increments; a 100-share order in a $0.50 stock can be quoted in $0.0001 increments.
- Stepping ahead of a customer limit order by less than a penny on a $1.00+ stock is prohibited under the sub-penny rule. This is a separate violation from the Manning rule, which addresses trading ahead generally.
Locked and Crossed Quotations
A "locked" quotation occurs when the bid equals the offer (e.g., bid $10.00 / offer $10.00). A "crossed" quotation occurs when the bid is higher than the offer (bid $10.05 / offer $10.00). Both indicate market dysfunction: a locked or crossed quote is theoretically executable on its face but no execution is occurring.
Trading centers must have written policies to avoid displaying locking or crossing quotes, and market makers must promptly remove their quotes if they lock or cross another market.
Exam Tip: Gotchas
- Locked = bid equals offer; crossed = bid above offer. Both are abnormal and must be addressed by the market maker who creates them.
- The market maker who LOCKS or CROSSES must promptly remove the offending quote. The duty is on the market maker who created the locked/crossed condition, not the market maker on the other side.
How the Pieces Fit Together
A best-execution and routing analysis under Series 24 has two layers:
- The FINRA best-execution rule (the firm's duty to its customer): use reasonable diligence, conduct regular and rigorous review, do not interpose third parties without benefit
- SEC Reg NMS (the regulatory floor for the national market system): respect protected quotations under the Order Protection Rule, file order-routing reports, comply with sub-penny minimum increments, support display of customer limit orders
A firm that satisfies Reg NMS but fails the best-execution rule has still violated FINRA's best-execution standard. A firm that satisfies the best-execution rule but trades through a protected quote has violated Reg NMS. The supervisor must enforce both.
Exam Tip: Gotchas
- Reg NMS is the SEC's regulatory floor; the FINRA best-execution rule is the conduct duty above it. Compliance with both is required; one does not satisfy the other.
- The firm's quarterly routing report is the principal's primary tool to evaluate routing decisions. Routine review of routing data must be documented as part of the supervisory process.