Best Execution Requirements

The best execution rule is a diligence standard, not a price guarantee. It asks what the member did to find the best market, and it applies the same way whether the firm crosses the trade as agent or fills it from its own account.

What Does Reasonable Diligence Require?

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. They must then buy or sell in that market so that the resultant price to the customer is as favorable as possible under prevailing market conditions.

The rule then opens its factor list with the words "Among the factors that will be considered," so the five it names are examples rather than a complete test.

Supplementary guidance adds a separate duty on marketable orders: a member must make every effort to execute a marketable customer order that it receives fully and promptly.

Exam Tip: Gotchas

• The factor list is open, and the five are the rule's own. An answer that presents execution-quality statistics as the rule's factors is describing a different measurement. The rule's five are the character of the market, size and type, markets checked, accessibility, and the order's terms and conditions.
• The duty binds associated persons, not only the firm. The rule names "a member and persons associated with a member," so an individual trader is inside the obligation.
• The standard is a relative one. It asks for a price as favorable as possible under prevailing market conditions, which is not the same claim as the best price in absolute terms.

Does the Duty Change When the Member Acts as Principal?

The obligations described in the rule's first four paragraphs exist not only where the member acts as agent for the account of its customer but also where transactions are executed as principal.

Those obligations are distinct from the reasonableness of commission rates, mark-ups or mark-downs, which the fair prices and commissions rule and its Supplementary Material govern.

Exam Tip: Gotchas

• A fair mark-up does not answer a best execution question. The two duties are stated as distinct, so a principal trade can carry a defensible mark-up and still fail the diligence standard, and the reverse is also possible.

When Is Interpositioning a Violation?

In any transaction for or with a customer or a customer of another broker-dealer, no member or person associated with a member shall interject a third party between the member and the best market for the subject security in a manner inconsistent with the reasonable diligence duty.

That closing qualifier is the rule. Using an intermediary is not banned outright; it is banned where it is inconsistent with reasonable diligence.

When a member 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 member. The rule's guidance gives two examples of acceptable circumstances:

• A customer's order is "crossed" with another firm that has a corresponding order on the other side.
• The identity of the firm, if known, would likely cause undue price movements adversely affecting the cost or proceeds to the customer.

Two circumstances are ruled out as justifications:

• Failure to maintain or adequately staff an over-the-counter order room or other department assigned to execute customers' orders cannot justify executing away from the best available market.
• Channeling orders through a third party as reciprocation for service or business does not relieve a member of its obligations under the rule.

A member through which an order is channeled and that knowingly is a party to an arrangement whereby the initiating member has not fulfilled its obligations will also be deemed to have violated the rule.

Exam Tip: Gotchas

• The receiving firm can violate a duty it does not owe the customer. The channeled-through member is liable when it knowingly participates in the arrangement, even though the customer belongs to the initiating member.
• Thin staffing is an excuse the rule names and rejects. So is routing as payback for business received. Both are written into the rule as things that cannot justify an inferior execution.
• The burden sits on the member. Where a broker's broker was used, the firm has to show the acceptable circumstances rather than the regulator having to disprove them.

How Broadly Is the Word "Market" Read?

The term "market" or "markets" is to be construed broadly. It encompasses a variety of different venues, including, but not limited to, market centers that are trading a particular security.

That expansive reading is deliberate. It tells firms how wide the field of venues they must consider is, and it promotes fair competition among broker-dealers, exchange markets, markets other than exchange markets, and any other venue that may emerge, by not mandating that some trading venues have less relevance than others.

Exam Tip: Gotchas

• The venue list is explicitly open. Market centers trading the security are named as an example, so an answer that limits the search to registered exchanges reads the term more narrowly than the rule does.

What Does Accessibility Mean for a Debt Quotation?

Accessibility of the quotation is one of the listed reasonable diligence factors. In the context of the debt market, that means FINRA will consider the accessibility of quotations when quotations are available.

For purposes of debt securities, the term "quotation" refers to either dollar (or other currency) pricing or yield pricing.

Accessibility is only one of the non-exhaustive factors. 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.

Exam Tip: Gotchas

• No accessible quotation does not mean no duty. The guidance says the opposite: with nothing accessible, the member still owes reasonable steps and its own market expertise.
• A debt quotation can be a yield. Dollar pricing and yield pricing both count, so an answer that recognizes only a dollar price misses half the definition.

When Is the Duty Owed to Another Broker-Dealer's Customer?

A member's duty to provide best execution in any transaction "for or with a customer of another broker-dealer" does not apply when another broker-dealer is simply executing a customer order against the member's quote.

The 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.

The distinction is between acting solely as the buyer or seller against the member's quote, and accepting order flow from another broker-dealer in order to handle and execute it.

Exam Tip: Gotchas

• Quoting is not order handling. A market maker that is hit on its own quote by another firm has not taken on that firm's customer, so the best execution duty does not attach to the fill.

What Happens When the Customer Directs the Order?

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.

Members are, however, still required to process that order promptly and in accordance with the terms of the order.

Where a customer has directed that an order be routed to another specific broker-dealer that is also a FINRA member, the receiving broker-dealer is required to meet the best execution requirements with respect to its own handling of the order.

Exam Tip: Gotchas

• The relief turns on the word unsolicited. An instruction the firm suggested does not switch off the best execution determination.
• Directed does not mean unattended. The prompt handling duty and the terms of the order still bind the member that took the instruction.

What Written Procedures Do Thin and Foreign Markets Require?

Best execution applies to orders in all securities, and two situations get their own written-procedure requirement.

• Securities with limited quotations or pricing information. Each member must have written policies and procedures addressing how it 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.
• Foreign securities that do not trade in the United States. A member handling those orders must have specific written policies and procedures for them, reasonably designed to obtain the most favorable terms available for the customer, taking into account differences that may exist between United States and foreign markets.
  • The member must regularly review those policies and procedures to assess the quality of executions received, and update or revise them as necessary.

The guidance also suggests what diligence looks like in a thin market: a member should analyze pricing information based on other data, such as previous trades in the security, to determine whether the customer's resultant price is as favorable as possible under prevailing market conditions.

The member should also generally seek out other sources of pricing information or potential liquidity, which may include obtaining quotations from other sources, such as other firms it has previously traded with in the security.

Reasonable diligence applies to customer orders in both domestic and foreign securities, and whether a member has satisfied the duty is a facts-and-circumstances analysis measured through factors such as the character of the market and the accessibility of the quotation.

Exam Tip: Gotchas

• The thin-market trigger includes a security with one quotation. The procedures address the absence of pricing information or of multiple quotations, so a single available quote does not put the security outside the requirement.
• Documentation is part of the requirement, not a best practice. The member must document its compliance with its own policies and procedures.
• A foreign market with weaker local standards does not lower the duty. The member still owes best execution, and needs procedures reasonably designed to obtain the most favorable terms available.

How Often Must a Member Review Execution Quality?

No member can transfer to another person its obligation to provide best execution to its customers' orders.

Two populations must have procedures to ensure the firm 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:

• A member that routes customer orders to other broker-dealers for execution on an automated, non-discretionary basis.
• A member that internalizes customer order flow.

The review must be conducted on a security-by-security, type-of-order basis, the rule's examples being limit order, market order, and market-on-open (MOO) order. At a minimum, a member must conduct such reviews quarterly; members should consider, based on the firm's business, whether more frequent reviews are needed.

Exam Tip: Gotchas

• Quarterly is a floor. The rule sets it as a minimum and asks the member to consider whether its own business calls for more frequent reviews.
• An order-by-order review removes the need for the periodic one. The regular and rigorous review requirement is written to apply where the member does not review order by order.
• Routing the flow away does not move the duty. The obligation to provide best execution cannot be transferred to another person.

What Must the Regular and Rigorous Review Compare?

In conducting the review, a member must 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 them.

The member must compare, among other things, the quality of the executions it is obtaining through current order routing and execution arrangements, including the internalization of order flow, against the quality of executions it could obtain from competing markets. In making that comparison a member should consider eight factors:

A member that routes its order flow to another member that has agreed to handle that order flow as agent for the customer, a clearing firm or other executing broker-dealer for example, can rely on that member's regular and rigorous review.

That reliance carries two conditions. The statistical results and rationale of the review must be fully disclosed to the routing member, and the routing member must periodically review how the review is conducted, as well as the results.

Exam Tip: Gotchas

• Finding a material difference does not force a routing change. The member must modify its routing or justify why it is not modifying it, and the justification is an option the rule states.
• Reliance on another member's review carries two conditions, both required. Full disclosure of the statistical results and rationale, and the routing member's own periodic review of how that review is conducted and what it found.
• The reliance route needs an agency agreement. It is available where the other member has agreed to handle the order flow as agent for the customer.

What Should You Check on Exam Day?

• Name the rule's own five diligence factors, and treat the list as open. Execution-quality statistics are review inputs, not the rule's factors.
• On an interpositioning fact pattern, ask whether the third party was interjected inconsistently with reasonable diligence, and who carries the burden of showing acceptable circumstances.
• Check whether the order arrived against the member's quote or was routed to it for handling and execution. Only the second attaches the duty.
• On a customer-directed order, confirm the instruction was unsolicited, then confirm the member still processed it promptly and on the order's terms.
• Confirm the review frequency is at least quarterly and runs security by security and order type by order type.