March 3, 2023

SEC Proposes New Regulation Best Execution — Brokers Must Achieve “Most Favorable Price” for Customers; Heightened Obligations for Conflicted Retail Transactions

The proposal would codify for the first time the federal-level best execution standard for brokers and related obligations. New Regulation Best Execution would result in a pivot from what has been a principles-based approach to achieving and regulating best execution, to a prescriptive, rules-based regime that heavily emphasizes brokers’ policies and procedures. If adopted, the regulation will reshape the landscape for order routing, execution, and broker economics. Despite that, the Commission seems to rely on significant conjecture to support the proposal, often referring to “may,” “could,” and “might” when describing concerns with existing practices and potential ameliorative effects of the proposed requirements. This could prove pivotal to the outcome of inevitable judicial challenges after likely adoption in late 2023.

On December 14, 2022, the SEC proposed new Regulation Best Execution, encompassing new Exchange Act Rules 1100, 1101, and 1102. Regulation Best Execution would codify a federal best execution standard pursuant to which broker-dealers must achieve the “most favorable price” for customers. This means that broker-dealers would be required to use reasonable diligence to ascertain the best market for the security, and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions. Regulation Best Execution would also require broker-dealers to establish related robust policies and procedures, particularly for firms engaging in “conflicted transactions” with or for retail customers, including principal trading, routing customer orders to affiliates, and receiving payment for order flow (PFOF).

The operative words in the proposed best execution standard are identical to those in FINRA Rule 5310. Nevertheless, and as the SEC acknowledges, key aspects depart from the current best execution regulatory regime and will require significant industry adjustments. Introducing brokers, brokers with PFOF arrangements, and executing brokers accustomed to internalizing retail order flow or executing retail trades for affiliates will feel particularly affected by this proposal.

Public comments are due by March 31, 2023.

Regulation Best Execution at a Glance

Regulation Best Execution would apply to transactions in “securities” products (including equities, options, corporate and municipal bonds, government securities, and “crypto asset securities”) and would, among other things:

  1. Codify a federal rules-based best execution standard for brokers, dealers, government securities brokers, government securities dealers, and municipal securities dealers (proposed Rule 1100 series) and establish exceptions similar to those available today.
  2. Require broker-dealers to establish, maintain, and enforce written policies and procedures reasonably designed to comply with the best execution standard (proposed Rule 1101) while providing a limited exemption for introducing brokers (proposed Rule 1101(d)).
  3. Require enhanced policies and procedures for broker-dealers that engage in certain “conflicted transactions” for or with retail customers (proposed Rule 1101(b)).
  4. Require broker-dealers to review the execution quality of their customer transactions at least quarterly (proposed Rule 1101(c)).
  5. Require broker-dealers to review their best execution policies and procedures at least annually and present a report detailing the results of such review to their boards of directors or equivalent governing bodies (proposed Rule 1102).

The term “market” is interpreted broadly for purposes of existing requirements and would be broadly defined under Regulation Best Execution as well, including other broker-dealers, exchanges, alternative trading systems (ATSs), and other venues that become known. The scope may also include a variety of mechanisms operated by markets used by broker-dealers to transact for or with customers (including auction mechanics and other execution protocols).

Top 10 Observations and Takeaways

  1. The Commission noted in 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.” However, Regulation Best Execution appears to focus on price as the alpha and omega considerations for firms, seemingly regardless of other order routing and order execution variables available for consideration. The Commission devotes significant discussion in the proposal to how broker-dealers should scour markets for the best available price, yet substantially less time helping broker-dealers understand how to identify and weigh other best execution factors (like trading characteristics of the security, size of orders, likelihood of execution, and accessibility of the market).  
  2. When it comes to price, it seems like the SEC expects firms to achieve executions for their customers at the midpoint of the NBBO (the proposal mentions midpoint 173 times). By way of example, the Commission notes its belief “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 does not, however, explicitly say that firms should route orders to exchanges to hit midpoint liquidity prior to routing for execution by wholesalers. Nevertheless, the proposal feels slanted in that direction (especially when read in tandem with the retail order auction exposure rulemaking proposed by the Commission on the same day). Transparency from the Commission here is critical, if that is what the agency ultimately desires or expects.
  3. Brokers engaged in conflicted transactions with or for retail investors may need to scour small, opaque markets with thin and unreliable liquidity to find what is akin to super best execution. The Commission noted in 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.” Unfortunately, the Commission does not sufficiently explain the proverbial line between regular and super best execution price checks. Query, for example, whether the Commission has in mind a specific number and sequencing of markets to be assessed and, even if those “better” executions are possible, at what cost (pun intended). The Commission itself even refers to “reasonably balancing the likelihood of obtaining better prices with the risk that delay could result in a worse price.”  
  4. On the one hand, the Commission 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.”  At the same time, the SEC refers to its belief “that the receipt of [PFOF] continues to warrant heightened attention by broker-dealers.” It was never a realistic outcome for the SEC to impose an outright ban on PFOF. Nevertheless, the proposal contains a consistent and recurring theme that, in our view, the Commission thinks (really, hopes) that the proposed super best execution obligation will cause most retail-focused firms to cease accepting these payments. The SEC does note, however, that passing PFOF along to customers would suffice to de-conflict a transaction.
  5. In determining the best market for customer orders received, brokers will need to consider reasonably accessible and timely pricing information and opportunities for price improvement.  The Commission notes in 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.”  
  6. The conflicted transaction regime would only apply to “retail customers,” which the SEC defines more broadly than under legacy FINRA rules and, curiously, even compared to Regulation Best Interest. The Commission should just use a single core definition of retail customer and scope it to apply to recommended transactions for best interest and more broadly for best execution. In particular, and unlike Regulation Best Interest, retail customers for best execution purposes would encompass accounts held in legal form on behalf of a natural person or a “group of related family members,” which the SEC intends to cover 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 explain the rationale for the diverging best interest and best 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 similar to that under Regulation Best Interest in that it captures individuals with $50 million of assets or more, which is the threshold FINRA uses to define institutional account.
  7. It was only a few years ago that the SEC was trying to encourage innovation to improve secondary market quality for thinly traded securities, which is retail-heavy. Instead, the market for thinly-traded securities has contracted significantly since the SEC amended Exchange Act Rule 15c2-11 in September 2020 by limiting the ability for brokers to quote and publish on these names. The Regulation Best Interest proposal is lean on discussion around OTC trading.  Nevertheless, the potential intersection of these rules would make it virtually impossible for brokers to satisfy the regular best execution standard, let alone super best execution for conflicted retail transactions. This will have the likely effect of eliminating retail investor access beyond the top 3,000 names. 
  8. Regulation Best Execution would impose the new requirements on introducing brokers that, until now, have complied with their best execution obligations by performing “regular and rigorous” reviews of execution quality (EQ) reports and other statistics from executing and clearing brokers with which they have contracted. The Rule 605 amendments proposed by the Commission on the same day as Regulation Best Execution would enhance broker disclosure of order execution information and seem designed to help in this regard. Given the rigorous requirement to review EQ and adjust order-handling practices based on that review, it is not clear why it is necessary also to narrow the definition of introducing broker to exclude, for example, those that execute through an affiliated broker. If their EQ review indicates that they can obtain better execution from another broker, they would implicitly be required to switch to the other broker.
  9. SEC staff will need to eventually provide significant guidance to the industry regarding how the proposed duty of best execution will be affected by age-old variables and pain points like access to and utilization of data feeds (including the use of proprietary exchange feeds versus the SIPs), exchange and ATS access fees, and the speed and means of access to quotes and latency considerations. This is particularly true regarding determining what is “reasonably accessible information” and whether brokers can “efficiently access each material potential liquidity source.”  
  10. The Regulation Best Execution proposal is one of three other significant “market structure” proposals announced on the same day in December 2022. These include an “Order Competition Rule” (new Exchange Act Rule 616, including requiring certain retail equity orders to be exposed in auctions before being internalized); amendments to Exchange Act Rule 605 (enhancing broker disclosure of order execution information); and amendments to Exchange Act Rules 610 and 612 (amending minimum pricing increments and exchange access fee caps and enhancing the transparency of better-priced orders). The Commission is already facing significant criticism for proposing all four of these at the same time, particularly given that each warrants careful consideration without effects from exogenous factors, like the adoption of the other proposals, that will certainly ensue. For example, beyond the proposed new retail order auction proposal, what does the agency expect from brokers regarding “order exposure opportunities that may result in the most favorable price”? Also, how will the anticipated new minimum tick sizes affect brokers’ consideration of pricing when making their order routing decisions? Finally, will the enhanced 605 reports yield the information the SEC anticipates they will and will firms be expected to ingest and factor those into their routing decisions immediately?  

Required Policies and Procedures and Related Obligations

Regulation Best Execution would require broker-dealers to establish, maintain, and enforce written policies and procedures reasonably designed to comply with the best execution standard, including:

Obtaining, identifying, and incorporating certain information

  • Obtaining and assessing reasonably accessible information, including information about price, volume, and EQ, concerning the markets trading the relevant securities;
  • Identifying markets that may be reasonably likely to provide the most favorable prices for customer orders (so-called “material potential liquidity sources”); and
  • Incorporating material potential liquidity sources into their order handling practices, and ensuring that the firm can efficiently access each such material potential liquidity source.

Assessing and determining the best market and making customer order routing or execution decisions 

  • Assessing reasonably accessible and timely information with respect to the best displayed prices, opportunities for price improvement, including midpoint executions, and order exposure opportunities that may result in the most favorable price; 
  • Assessing the attributes of customer orders and considering the trading characteristics of the security, the size of the order, the likelihood of execution, the accessibility of the market, and any customer instructions in selecting the market most likely to provide the most favorable price; and 
  • In determining the number and sequencing of markets to be assessed, reasonably balancing the likelihood of obtaining better prices with the risk that delay could result in a worse price.

A “conflicted transaction” would be any transaction for or with a retail customer where a broker-dealer (1) executes an order as principal, including riskless principal, (2) routes an order to or receives an order from an affiliate for execution, or (3) provides or receives PFOF. Required policies and procedures would need to specifically document compliance with the best execution standard for conflicted retail transactions in light of any PFOF, including:

  • Obtaining and assessing enhanced information, including additional information about price, volume, and EQ, in identifying a broader range of markets beyond those identified as material potential liquidity sources;
  • Evaluating a broader range of markets, beyond those identified as material potential liquidity sources, that might provide the most favorable price for customer orders, including a broader range of order exposure opportunities and markets that may be smaller or less accessible than those identified as material potential liquidity sources; 
  • Documenting compliance with the best execution standard (in accordance with written procedures), including all efforts to enforce the firm’s best execution policies and procedures for conflicted transactions and the basis and information relied on for its compliance determinations; and 
  • Documenting any PFOF arrangement, whether written or oral, including the parties, all qualitative and quantitative terms, and the date and terms of any changes.

Regulation Best Execution would require that broker-dealers, at least quarterly:

  • Review the EQ of their transactions for or with customers or customers of another broker-dealer, and how such EQ compares with the EQ the broker-dealer might have obtained from other markets;
  • Revise their best execution policies and procedures, including order handling practices, accordingly; and
  • Document the results of this review.

Introducing brokers that route customer orders to an executing broker would not need to comply with the requirements above if they:

  • Establish, maintain, and enforce policies and procedures for regularly reviewing the EQ obtained from the executing broker;
  • Compare it with the EQ the introducing broker might have obtained from other executing brokers; 
  • Revise their order handling practices accordingly; and
  • Document the results of their review. 

Areas for Closer Examination

Implications for Introducing Brokers

“Introducing broker” would mean a broker-dealer that (1) does not carry customer accounts and does not hold customer funds or securities, (2) has entered into an arrangement with an unaffiliated executing broker-dealer that has agreed to handle and execute on an agency basis all of the introducing broker’s customer orders, and (3) has not accepted any monetary payment, service, property, or other benefit that results in remuneration, compensation, or consideration from the executing broker in return for the routing of the introducing broker’s customer orders to the executing broker. 

  • We expect the Commission to clarify that a single introducing broker is able to use multiple unaffiliated executing brokers to handle orders on an agency basis (despite the text suggesting otherwise). Examples of “other benefits” introducing brokers could not receive from executing brokers include research, clearance, or custody products or services; reciprocal agreements for the provision of order flow; adjustment of a broker-dealers unfavorable trading errors; offers to participate as underwriter in public offerings; stock loans or shared interest accrued thereon; and discounts, rebates, or any other reductions of or credits against any fee to, or expense or other financial obligation of, the broker-dealer routing a customer order that exceeds that fee, expense, or financial obligation.
  • Proposed Rule 1101(d) would exempt an introducing broker that routes customer orders to an executing broker from separately complying with proposed Rules 1101(a), (b), and (c) if the introducing broker establishes, maintains, and enforces policies and procedures that require the introducing broker to regularly review the EQ obtained from its executing broker, compare it with the execution quality it could have obtained from other executing brokers, and revise its routing practices accordingly. This would provide a tailored exemption from certain provisions of proposed Regulation Best Execution for firms that do not make decisions or exercise discretion regarding the manner in which their customer orders are handled and executed (other than the determination to engage the executing broker). The Commission points out that this exemption would be provided to a narrower group of firms compared to similar exemptions provided by FINRA and the MSRB, and would require additional specific policies and procedures that are not required under the FINRA and MSRB rules.
  • A broker-dealer that effects any transaction for or with a customer or a customer of another broker or dealer must at least annually review and assess the design and overall effectiveness of its best execution policies and procedures, including its order handling practices, conduct the review and assessment in accordance with written procedures, and document the review and assessment. The broker-dealer must also prepare a written report detailing the results of the review and assessment, including a description of all deficiencies found and any plan to address deficiencies, and present the report to the firm’s board of directors (or equivalent governing body).
  • The SEC excludes two principal trading scenarios from its new introducing broker prohibitions: (i) fractional share trading in NMS stocks; and (ii) riskless principal trading in corporate and municipal bonds and government securities. In both scenarios, the SEC believes that current market practice necessitates these exemptions. We think it is a given that the industry will identify others that warrant similar carve-outs.

Exemptions for Institutional-Only Broker-Dealers 

Proposed Rule 1100 would exempt from the best execution standard broker-dealers with business limited to (i) quoting a price for a security where another broker-dealer routes a customer order for execution against that quote; and (ii) transacting with institutional customers that exercise independent judgment and execute an order against the broker-dealer’s quotation. The first exemption is included in FINRA’s existing best execution rule. The second may be consistent with FINRA’s best execution rule, but is not expressly discussed therein. Proposed Regulation Best Execution does not define the term “institutional customer” for purposes of this exemption but asks commenters if a definition is appropriate.  

Coverage for Digital Asset Securities

Regulation Best Execution would apply to crypto assets that qualify as securities or government securities. The SEC notes in the proposal multiple times that it “has limited information about the order handling and best execution practices” of participants in the crypto asset market. The SEC nevertheless concludes that despite its own inability to assess execution quality in the crypto markets, broker-dealers facilitating transactions in crypto asset securities must assess execution quality and fully comply with Regulation Best Execution. It is unclear, however, how the SEC expects digital asset security broker-dealers to do what the SEC itself cannot. The SEC refers to “digital asset” as an asset that is issued and/or transferred using distributed ledger or blockchain technology (“distributed ledger technology”), including, but not limited to, so-called “virtual currencies,” “coins,” and “tokens.”

Next Steps

Despite being quite long (440 pages), the proposal is short on details and definitions and would benefit from clear statements of SEC expectations. We expect continued robust comment and criticism up to and after the March 31, 2023 comment deadline. Even though the SEC remains in full remote work status, engagement with the Chairman and Commissioners, their staffs, and staff in the Division of Trading and Markets should remain a high priority for industry stakeholders.