FINRA Rule 5310 imposes an obligation on broker-dealers to obtain the best execution of their customers’ orders. The rule requires that, in any transaction, a member and associated persons use reasonable diligence to ascertain the best market for a security and buy or sell in such market so that the price to the customer is as favorable as possible under prevailing market conditions.
Key factors in determining whether a broker-dealer has used “reasonable diligence” are as follows:
- The character of the market for the security (e.g., volatility, price, liquidity, etc.).
- Size and type of transaction.
- Number of markets checked.
- Accessibility of the quotation.
- The terms and conditions of the order.
Best execution obligations apply when firms receive, handle, route, or execute customer orders in equities, options, and fixed income securities.The Duty of Best Execution
Regulatory Notice 15-46 sets forth that a broker-dealer's obligation to obtain the best execution of a customer's order is partly based on the common law agency duty of loyalty. That is, an agent is obligated to act exclusively in the principal’s best interest. Any broker-dealer acting as a customer’s agent in a transaction is under a duty to exercise reasonable care to obtain the most favorable terms for the customer. Best execution duties also arise when a broker-dealer is trading as principal for its own account.
The best execution analysis generally involves the following factors:
- Size of the order.
- Trading characteristics of the security.
- Availability of accurate information regarding most favorable market center for execution and availability of technological aids to process the information.
- Cost and difficulty associated with achieving an execution in a particular market center.
Firms must make every effort to fully and promptly execute a marketable customer order that they receive.Regular and Rigorous Review for Best Execution
FINRA requires that broker-dealers regularly and rigorously examine execution quality likely to be obtained from the different markets trading a security. “Regular and rigorous” review includes the speed of execution, price improvement, and the likelihood of execution of limit orders.
When routing or internally executing larger-sized orders in any security, regular and rigorous review alone may not be sufficient to satisfy a firm’s best execution requirements. Order-by-order review may be more appropriate in executing larger-size orders requiring more judgment as to the capital commitment and market timing.
Firms that do not conduct an order-by-order review for some orders are required to have procedures to ensure that they periodically conduct a regular and rigorous review of execution quality for those orders. Periodic reviews of execution quality must be conducted on a security-by-security, type-of-order basis.
Firms conducting a “regular and rigorous” review must conduct the reviews, at a minimum, on a quarterly basis.Payment for Order Flow
Payments from trading firms in exchange for a broker-dealer sending customers’ orders to those firms for execution is known as “payment for order flow.”
Broker-dealers offering “commission-free” trading have been subject to fines in the past due to unusually high payment for order flow rates, which resulted in customer orders being executed at prices that were inferior to other brokers’ prices. This conduct is a clear violation of a broker-dealer’s duty of best execution. A broker-dealer’s receipt of payment for order flow should not interfere with a broker-dealer's duty of best execution.
A broker-dealer that routes all of its order flow to another broker-dealer without conducting an independent review of execution quality would also violate the duty of best execution.Directed v. Non-Directed Orders
Directed order flow occurs when a customer’s order to buy or sell a security is given specific instructions for the order to be routed to a particular exchange or venue for execution. Though a broker-dealer is not obligated to accept directed orders, once it does, it is required to process the customer’s order promptly and in accordance with the order’s terms. Non-directed orders are those in which the client does not specify a particular venue to execute their order.Extreme Market Conditions
Extreme market conditions can impact fixed income securities trading. Examples include liquidity shortages and divergent prices during periods of significant interest rate or rating changes. In such scenarios, FINRA has stated that broker-dealers should consider implementing procedures designed to preserve the continued execution of customers’ orders in a way that is consistent with the firm’s best execution obligations while limiting the exposure of the firm to extraordinary market risk.