# Regulation Best Execution

> Briefs, arguments, decisions, and more.

URL: https://www.frixlaw.com/law-library/documents/fr%3A2022-27644

## Record

- **Collection:** Federal Register
- **Document type:** Proposed Rule
- **Published:** January 27, 2023
- **Citation:** 88 FR 5440

## Text

SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 240 and 242
[Release No. 34-96496; File No. S7-32-22]
RIN 3235-AN24
Regulation Best Execution

AGENCY:

Securities and Exchange Commission.

ACTION:

Proposed rule.

SUMMARY:

The Securities and Exchange Commission (“Commission”) is proposing new rules under the Securities Exchange Act of 1934 (“Exchange Act”) relating to a broker-dealer's duty of best execution. Proposed Regulation Best Execution would enhance the existing regulatory framework concerning the duty of best execution by requiring detailed policies and procedures for all broker-dealers and more robust policies and procedures for broker-dealers engaging in certain conflicted transactions with retail customers, as well as related review and documentation requirements.

DATES:

Comments should be received on or before March 31, 2023.

ADDRESSES:

Comments may be submitted by any of the following methods:

Electronic Comments

• Use the Commission's internet comment form (
https://www.sec.gov/regulatory-actions/how-to-submit-comments
); or

• Send an email to
rule-comments@sec.gov
. Please include File Number S7-32-22 on the subject line.

Paper Comments

• Send paper comments to Secretary, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549-1090.

All submissions should refer to File Number S7-32-22. This file number should be included on the subject line if email is used. To help the Commission process and review your comments more efficiently, please use only one method of submission. The Commission will post all comments on the Commission's website (
https://www.sec.gov/rules/proposed.shtml
). Comments are also available for website viewing and printing in the Commission's Public Reference Room, 100 F Street NE, Washington, DC 20549, on official business days between the hours of 10 a.m. and 3 p.m. Operating conditions may limit access to the Commission's Public Reference Room. All comments received will be posted without change. Persons submitting comments are cautioned that the Commission does not redact or edit personal identifying information from comment submissions. You should submit only information that you wish to make available publicly.

Studies, memoranda, or other substantive items may be added by the Commission or staff to the comment file during this rulemaking. A notification of the inclusion in the comment file of any materials will be made available on the Commission's website. To ensure direct electronic receipt of such notifications, sign up through the “Stay Connected” option at
www.sec.gov
to receive notifications by email.

FOR FURTHER INFORMATION CONTACT:

David Dimitrious, Senior Special Counsel and Arisa Tinaves Kettig, Special Counsel at (202) 551-5500, Office of Market Supervision, Division of Trading and Markets, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549.

SUPPLEMENTARY INFORMATION:

The Commission is proposing to add the following new rules under the Exchange Act: (1) 17 CFR 242.1100 (Rule 1100 of Regulation Best Execution); (2) 17 CFR 242.1101 (Rule 1101 of Regulation Best Execution); and (3) 17 CFR 242.1102 (Rule 1102 of Regulation Best Execution). The Commission is also proposing to amend 17 CFR 240.17a-4 (Rule 17a-4 under the Exchange Act).

Table of Contents

I. Introduction

II. Duty of Best Execution

A. Current Regulatory Framework

B. Prior Commission Statements

C. FINRA and MSRB Best Execution Rules

III. Existing Order Handling Practices and Overview of Proposed Regulation Best Execution

A. Existing Order Handling Practices

1. General Broker-Dealer Practices

2. Order Handling Conflicts of Interest

3. Crypto Asset Securities

B. Overview of Proposed Regulation Best Execution

IV. Discussion of Proposed Regulation Best Execution

A. Proposed Rule 1100—The Best Execution Standard

B. Proposed Rule 1101(a)—Best Execution Policies and Procedures

1. Proposed Rule 1101(a)(1)—Framework for Compliance With the Best Execution Standard

2. Proposed Rule 1101(a)(2)—Best Market Determination

C. Proposed Rule 1101(b)—Policies and Procedures and Documentation for Conflicted Transactions

1. Proposed Rules 1101(b)(1) and (2)—Policies and Procedures for Conflicted Transactions

2. Proposed Rule 1101(b)(3)—Documentation for Conflicted Transactions

3. Application of Proposed Rule 1101(b) to NMS Stock Market Conflicts of Interest

4. Application of Proposed Rule 1101(b) to the Options Market

5. Application of Proposed Rule 1101(b) to the Corporate and Municipal Bond Markets and Government Securities Markets

D. Proposed Rule 1101(c)—Regular Review of Execution Quality

E. Proposed Rule 1101(d)—Introducing Brokers

1. Definition of Introducing Broker and Executing Broker

2. Review of Executing Broker's Execution Quality

F. Proposed Rule 1102—Annual Report

G. Recordkeeping Requirements Under Rule 17a-4

V. Economic Analysis

A. Introduction

B. Baseline

1. Current Legal and Regulatory Framework

2. Best Execution Review Processes

3. Description of Markets and Broker-Dealer Order Handling and Execution Practices

4. Broker-Dealer Services and Revenue

C. Economic Effects and Effects on Efficiency, Competition, and Capital Formation

1. Benefits

2. Costs

3. Efficiency, Competition, and Capital Formation

D. Reasonable Alternatives

1. SEC Adopts FINRA Rule 5310 and MSRB Rule G-18 Best Execution Rules

2. Require Order Execution Quality Disclosure for Other Asset Classes

3. Utilize FINRA and MSRB Approach to Introducing Broker

4. Ban or Restrict Off-Exchange PFOF

5. Require Broker-Dealers To Utilize Best Execution Committees

6. Require Order-by-Order Documentation for Conflicted or All Transactions

7. Staggered Compliance Dates

E. Request for Comments

VI. Paperwork Reduction Act

A. Summary of Collection of Information

1. Required Policies and Procedures and Related Obligations

2. Annual Report

B. Proposed Use of Information

1. Required Policies and Procedures and Related Obligations

2. Annual Report

C. Respondents

D. Total Initial and Annual Reporting and Recordkeeping Burdens

1. Required Policies and Procedures and Related Obligations

2. Annual Report

E. Total Paperwork Burden

F. Collection of Information Is Mandatory

G. Confidentiality of Responses to Collection of Information

H. Retention Period for Recordkeeping Requirements

I. Request for Comment

VII. Consideration of Impact on the Economy

VIII. Initial Regulatory Flexibility Act Analysis

A. Reasons for and Objectives of the Proposed Action

B. Legal Basis

C. Small Entities Subject to the Proposed Rule

D. Projected Compliance Requirements of the Proposed Rule for Small Entities

1. Required Policies and Procedures and Related Obligations

2. Annual Report

E. Duplicative, Overlapping, or Conflicting Federal Rules

F. Significant Alternatives

1. Adopt FINRA Rule 5310 and MSRB Rule G-18 Concerning Best Execution

2. Require Order Execution Quality Disclosure for Other Asset Classes

3. Define “Introducing Broker” To Include Those Entities That Qualify for Relief Under FINRA and MSRB Rules

4. Ban or Restrict Off-Exchange Payment for Order Flow

5. Require Broker-Dealers To Utilize Best Execution Committees

6. Require Order-by-Order Documentation for Conflicted or All Transactions

7. Staggered Compliance Dates

G. General Request for Comment

Statutory Authority and Text of the Proposed Rule

I. Introduction

The duty of best execution requires a broker-dealer to execute customers' trades at the most favorable terms reasonably available under the circumstances,
1

and customers benefit from broker-dealers' robust considerations of execution opportunities that may provide customers with the most favorable terms. Accordingly, promoting the best execution of customer orders is of fundamental importance to investors and the markets, and is an important aspect of investor protection. The Financial Industry Regulatory Authority, Inc. (“FINRA”), a national securities association, and the Municipal Securities Rulemaking Board (“MSRB”) currently have rules and guidance directly addressing the duty of best execution. The Commission has made statements concerning the duty over the years, but has never itself established a rule addressing best execution. While the Commission believes the existing regulatory framework concerning the duty of best execution has helped broker-dealers fulfill their duty to their customers, the Commission believes this regulatory framework can be made more effective. In particular, while FINRA and the MSRB have established best execution rules and provided guidance on how broker-dealers should achieve best execution in a variety of contexts, and generally require broker-dealers to have procedures for compliance with relevant laws and rules, the Commission believes it is appropriate to propose its own comprehensive and detailed best execution requirements. The Commission understands that, currently, broker-dealers' best execution policies and procedures, and the documentation relating to their best execution practices, may vary. However, as described in section III.A below, the Commission believes that customers would benefit from consistently robust best execution practices by broker-dealers, and the execution of retail customer orders by broker-dealers that have certain order handling conflicts of interest warrants heightened attention by those broker-dealers.
2

1

See infra
note 21 and accompanying text.

2

See infra
Section V.A (describing the “principal—agent” problem that may exist between a broker-dealer and its customer and how that can be exacerbated by other conflicts of interest).

The Commission believes that having Commission rules providing a policies and procedures-based best execution framework, along with regular reviews and related documentation, would help broker-dealers maintain consistently robust best execution practices and result in vigorous efforts by broker-dealers to achieve best execution, including in situations where broker-dealers have order handling conflicts of interest with retail customers. The Commission also believes that detailed policies and procedures, regular reviews, and related documentations would allow broker-dealers to effectively assess their best execution practices and assist the Commission and self-regulatory organizations (“SROs”) to effectively examine and enforce broker-dealers' compliance with the proposed rules.

Proposed Regulation Best Execution would establish through a Commission rule a best execution standard for broker-dealers.
3

Proposed Regulation Best Execution would also specifically require broker-dealers to establish, maintain, and enforce written policies and procedures reasonably designed to comply with that best execution standard. Those policies and procedures would be required to address: (1) how the broker-dealer will comply with the proposed standard of best execution, including by identifying material potential liquidity sources, incorporating material potential liquidity sources into its order handling practices, and ensuring that the broker-dealer can efficiently access each source, and (2) how the broker-dealer will determine the best market for customer orders received, including by assessing reasonably accessible and timely pricing information and opportunities for price improvement.

3
The proposed best execution standard is consistent with the best execution standards set forth in FINRA and MSRB rules.

In addition, for retail customer transactions that present conflicts of interest, such as payment for order flow or internalization, that could create incentives for a broker-dealer to be less diligent in its search for better executions and potentially result in broker-dealers not providing best execution to customer orders, proposed Regulation Best Execution would require the broker-dealer's policies and procedures to address how it will comply with the best execution standard in light of such conflicts, including how it would assess a broader range of markets than it would for non-conflicted transactions. Proposed Regulation Best Execution would also require broker-dealers to document their compliance with the best execution standard and the basis for their determinations that best execution would be achieved through conflicted transactions.

Proposed Regulation Best Execution would also require broker-dealers to review the execution quality of their customer orders at least quarterly, compare it with the execution quality that might have been obtained from other markets, and revise their best execution policies and procedures accordingly.

Proposed Regulation Best Execution would exempt from specified requirements under the proposed rules an introducing broker (as defined in the proposed rules) that establishes, maintains, and enforces policies and procedures that require it to regularly review the execution quality obtained from its executing broker, compares that execution quality with the execution quality it might have obtained from other executing brokers, and revises its order handling practices accordingly.

Finally, proposed Regulation Best Execution would require broker-dealers to review and assess the overall effectiveness of their best execution policies and procedures, including their order handling practices, on at least an annual basis, and prepare a report detailing the results of such review and assessment that would be presented to the broker-dealer's board of directors (or equivalent governing body).

The Commission recognizes 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, similar to

the Order Protection Rule,
4

the Risk Management Controls for Brokers or Dealers with Market Access Rule,
5

and Regulation Systems Compliance and Integrity.
6

Under proposed Regulation Best Execution, a broker-dealer's failure to achieve the most favorable price possible under prevailing market conditions (“most favorable price”) for customer orders would be part of the consideration of whether the broker-dealer's policies and procedures are reasonably designed and whether the broker-dealer is enforcing its policies and procedures. 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, because it may not be the result of a failure by the broker-dealer to use reasonable diligence to ascertain the best market and to buy or sell in such market so that the customer receives the most favorable price.
7

However, a failure to establish and maintain reasonably designed policies and procedures applicable to all customer orders, or a failure to enforce those policies and procedures, would be a violation of the policies and procedures requirement under proposed Regulation Best Execution.

4

See
17 CFR 242.611.

5

See
17 CFR 240.15c3-5.

6

See
17 CFR 242.1001.

7

See also
MSRB Rule G-18.01 (“A failure to have actually obtained the most favorable price possible will not necessarily mean that the dealer failed to use reasonable diligence.”). Whether a broker-dealer has met the proposed best execution standard would turn on an objective assessment of the facts and circumstances at the time of the broker-dealer's transactions for or with the customer (and not in hindsight).

II. Duty of Best Execution

A. Current Regulatory Framework

A broker-dealer has a legal duty to seek best execution of customer orders. The duty of best execution predates the Federal securities laws and is derived from an implied representation that a broker-dealer makes to its customers.
8

The duty is established from “common law agency obligations of undivided loyalty and reasonable care that an agent owes to [its] principal.”
9

This obligation requires that a “broker-dealer seek to obtain for its customer orders the most favorable terms reasonably available under the circumstances.”
10

While there is no Commission rule or standard addressing a broker-dealer's duty of best execution, the duty is addressed in FINRA and MSRB rules, as described in sections II.C and IV below.
11

8

See, e.g.,

Newton
v.
Merrill, Lynch, Pierce, Fenner & Smith, Inc.,
135 F.3d 266, 270 (3d Cir.),
cert. denied,
525 U.S. 811 (1998).

9

See id.

10

See id.

See also
Securities Exchange Act Release No. 37619A (Sept. 6, 1996), 61 FR 48290 (Sept. 12, 1996) (“Order Execution Obligations Adopting Release”). A Report of the Special Study of Securities Markets stated that, according to an NASD District Business Conduct Committee in a 1952 proceeding, “[t]he integrity of the industry can be maintained only if the fundamental principle that a customer should at all times get the best available price which can reasonably be obtained for him is followed.”
See
SEC, Report of the Special Study of Securities Markets, H.R. Doc. No. 95, 88th Cong., 1st Sess. Pt. II, 624 (1963) (“Special Study”),
available at

https://www.sechistorical.org/collection/papers/1960/1963_SSMkt_Chapter_07_2.pdf
.

11
The Commission also oversees investment advisers, which have a similar duty. As part of its duty of care, an investment adviser has a duty to seek best execution of a client's transactions where the adviser has responsibility to select broker-dealers to execute client trades, and the Commission previously has described the contours of that duty.
See
Commission Interpretation Regarding Standard of Conduct for Investment Advisers, Advisers Act Release No. 5248 (June 5, 2019), 84 FR 33669, 33674-75 (July 12, 2019). In addition, the Commission has brought a variety of enforcement actions against registered investment advisers in connection with their alleged failure to satisfy their duty to seek best execution.
See, e.g.,

In the Matter of Aventura Capital Management, LLC,
Investment Advisers Act Release No. 6103 (Sept. 6, 2022) (settled action);
In the Matter of Madison Avenue Securities, LLC,
Investment Advisers Act Release No. 6036 (May 31, 2022) (settled action).

The Commission is proposing Regulation Best Execution pursuant to, among other provisions, sections 11A and 15 of the Exchange Act.
12

In section 11A, Congress identified key national market system objectives, including the practicability of brokers executing investors' orders in the best market.
13

The Commission has rulemaking authority to further the section 11A objectives.
14

Separately, section 15 of the Exchange Act provides authority for rules that are reasonably designed to prevent fraudulent acts or practices. Specifically, section 15(c)(2)(A) provides that no broker or dealer may make use of the mails or any means or instrumentality of interstate commerce to effect any transaction in, or to induce or attempt to induce the purchase or sale of, any security (other than an exempted security
15

or commercial paper, bankers' acceptances, or commercial bills) otherwise than on a national securities exchange of which it is a member, in connection with which such broker or dealer engages in any fraudulent, deceptive, or manipulative act or practice, or makes any fictitious quotation.
16

Section 15(c)(2)(B) prohibits brokers, dealers, and municipal securities dealers from engaging in such activity in “any municipal security.”
17

Section 15(c)(2)(C) prohibits government securities brokers and government securities dealers from engaging in such activity in any “government security.”
18

Section 15(c)(2)(D) authorizes the Commission to adopt rules that define, and prescribe means reasonably designed to prevent, such acts and practices as are fraudulent, deceptive, or manipulative and such quotations as are fictitious.
19

When a broker-dealer violates its duty of best execution, it could be in violation of section 15(c) of the Exchange Act.
20

12
15 U.S.C. 78k-1; 15 U.S.C. 78
o.

13
15 U.S.C. 78k-1(a)(1)(C).

14
15 U.S.C. 78k-1(a)(2).

15

See
15 U.S.C. 78c(a)(12) (defining the term “exempted security” to include, among other things, government securities and municipal securities, as defined in sections 3(a)(42) and 3(a)(29) of the Exchange Act, respectively).

16
15 U.S.C. 78
o
(c)(2)(A).

17

See
15 U.S.C. 78
o
(c)(2)(B).
See also
15 U.S.C. 78c(a)(29) (defining municipal securities).

18

See
15 U.S.C. 78
o
(c)(2)(C).
See also
15 U.S.C. 78c(a)(42) (defining government securities).

19
15 U.S.C. 78
o
(c)(2)(D).

20

See, e.g.,

In the Matter of Knight Securities L.P.,
Securities Exchange Act Release No. 50867 (Dec. 16, 2004) (settled action) (finding that the broker-dealer defrauded its institutional customers by failing to provide best execution in violation of section 15(c) of the Exchange Act).

B. Prior Commission Statements

The Commission has made statements concerning the duty of best execution in various contexts over the years. The following are some of the statements that the Commission has made with respect to the duty of best execution. The Commission solicits comment below, however, on whether any of these prior statements should be revised in light of the proposed rules.

The Commission has previously stated that the duty of best execution requires a broker-dealer to execute customers' trades at the most favorable terms reasonably available under the circumstances,
i.e.,
at the best reasonably available price.
21

The Commission has also recognized that price is a critical concern for investors.
22

In addition, the

Commission has described a non-exhaustive list of factors that may be relevant to broker-dealers' best execution analysis. These factors include the size of the order, speed of execution, clearing costs, 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.
23

21
Securities Exchange Act Release No. 51808 (June 9, 2005), 70 FR 37496, 37538 (June 29, 2005) (“Regulation NMS Adopting Release”).
See also

Geman
v.
SEC,
334 F.3d 1183, 1186 (10th Cir. 2003) (“[T]he duty of best execution requires that a broker-dealer seek to obtain for its customer orders the most favorable terms reasonably available under the circumstances.”) (quoting
Newton, supra
note 8, 135 F.3d at 270);
Kurz
v.
Fidelity Management & Research Co.,
556 F.3d 639, 640 (7th Cir. 2009) (describing the “duty of best execution” as “getting the optimal combination of price, speed, and liquidity for a securities trade”).

22

See
Securities Exchange Act Release No. 43590 (Nov. 17, 2000), 65 FR 75414, 75418 (Dec. 1, 2000) (“Order Execution and Routing Practice Release”) (“The Commission strongly believes, however, that most investors care a great deal about the quality of prices at which their orders are executed, and that an opportunity for more vigorous competition

among market participants to provide the best quality of execution will enhance the efficiency of the national market system.”).

23

See id.,
at 75422; Regulation NMS Adopting Release,
supra
note 21, 70 FR 37538.

Over the years, the Commission has stated the need for broker-dealers to continue to modernize their best execution practices. For example, the Commission has stated that broker-dealer practices for achieving best execution, including the data, technology, and types of markets they access, must constantly be updated as markets evolve.
24

In particular, the Commission has stated 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, including opportunities to trade at more advantageous prices.
25

As these changes occur, a broker-dealer's procedures for seeking best execution for its customer orders also must be modified to consider price opportunities that become reasonably available.
26

In doing so, broker-dealers must take into account price improvement opportunities
27

and whether different markets may be more suitable for different types of orders or particular securities.
28

24

See
Regulation NMS Adopting Release,
supra
note 21, 70 FR at 37538; Order Execution Obligations Adopting Release,
supra
note 10, 61 FR at 48322-23.

25

See
Order Execution Obligations Adopting Release,
supra
note 10, 61 FR 48323.

26

See id.;
Regulation NMS Adopting Release,
supra
note 21, 70 FR 37516 (stating that broker-dealers must examine their procedures for seeking best execution in light of market and technology changes and modify those practices if necessary to enable their customers to obtain the best reasonably available prices).

27

See
Order Execution Obligations Adopting Release,
supra
note 10, 61 FR 48323 n.357 (stating that price improvement means the difference between execution price and the best quotes prevailing in the market at the time the order arrived at the market or market maker, and that any evaluation of price improvement opportunities would have to consider not only the extent to which orders are executed at prices better than the prevailing quotes, but also the extent to which orders are executed at inferior prices).

28

See id.

In addition, the Commission has expressed concerns regarding interpositioning and the duty of best execution. Interpositioning can occur when a broker-dealer places a third party between itself and the best market for executing a customer trade in a manner that results in a customer not receiving the best available market price.
29

Interpositioning can violate the broker-dealer's duty of best execution when it results in unnecessary transaction costs at the expense of the customer.
30

29

See Edward Sinclair, et al.,
Securities Exchange Act Release No. 9115, 1971 WL 120487 (Mar. 24, 1971) (Comm'n op.),
aff'd,
444 F2d. 399 (2d Cir. 1971) (order clerk in OTC department of broker-dealer interposed a broker-dealer between his firm and best available market price in return for split of profits with the interposed broker);
H.C. Keister & Co., et al.,
Securities Exchange Act Release No. 7988, 1966 WL 84120 (Nov. 1, 1966) (Comm'n op.) (in exchange for payments, trader for a large broker-dealer interpositioned a small broker-dealer between its customers' orders and the best available market prices);
Synovus Securities, Inc.,
Securities Exchange Act Release No. 34313, 1994 WL 323096 (July 5, 1994) (settled order) (broker-dealer and its president placed customer orders with person who was able to promptly sell the bonds to or buy the bonds from other brokers at a profit and customers did not get the best market price).
See also

SEC
v.
Ridenour,
913 F.2d 515 (8th Cir. 1990) (a bond salesman violated the antifraud provisions based on his secret interpositioning of his personal trading account between his customers' securities transactions and the fair market price of the trades).

30

See Thomson & McKinnon,
Securities Exchange Act Release No. 8310, 1968 WL 87637 (May 8, 1968) (Comm'n op.) (a National Association of Securities Dealers (“NASD”) member firm interposed broker-dealers between itself and the best available market, and the added transaction cost was borne by its customers; the Commission found that, “[i]n view of the obligation of a broker to obtain the most favorable price for his customer, where he interposes another broker-dealer between himself and a third broker-dealer, he
prima facie
has not met that obligation and he has the burden of showing that the customer's total cost or proceeds of the transaction is the most favorable obtainable under the circumstances”).

The Commission has also discussed its views with respect to the application of best execution to different order types. With regard to the handling of limit orders, broker-dealers must take into account material differences in execution quality, such as the likelihood of execution among the various markets or market centers to which limit orders may be routed.
31

Broker-dealers are also subject to the duty of best execution when executing customer orders at the beginning of regular trading hours and should take into account alternative methods when considering how to execute these orders.
32

31

See
Order Execution Obligations Adopting Release,
supra
note 10, 61 FR 48323.

32

See
Order Execution and Routing Practice Release,
supra
note 22, 65 FR 75422 (recognizing that customer orders in listed securities were executed at one opening price in an auction whereas customer orders in Nasdaq securities at the time traded at the quoted bids and offers resulting in a liquidity premium for a large number of orders that effectively cross each other at a single point in time).

Moreover, the Commission has recognized practical challenges associated with the handling of a large volume of orders. In particular, the Commission acknowledged in 1994 that although it may be impractical for a broker-dealer that handles a heavy volume of orders to make an individual determination regarding where to route each order it receives, the broker-dealer must use due diligence to seek the best execution possible given all facts and circumstances.
33

At that time, the Commission reasoned that, in such circumstances, the duty of best execution requires a broker-dealer to periodically assess the quality of competing markets to ensure that order flow is directed to the markets providing the most beneficial terms for its customer orders.
34

33

See
Securities Exchange Act Release No. 34902 (Oct. 27, 1994), FR Document 94-27109 (Nov. 2, 1994) (“Payment for Order Flow Release”).

34

See id.

See also
Regulation NMS Adopting Release,
supra
note 21, 70 FR 37516.

The Commission has further identified the types of data needed by broker-dealers to fulfill their duty of best execution. For example, quotation information contained in the public quotation system must be considered in seeking best execution of customer orders.
35

In adopting Rules 605 and 606 of Regulation NMS,
36

the Commission recognized that the reports required of market centers would provide statistical disclosures regarding certain factors, such as execution price and speed of execution, relevant to a broker-dealer's order routing decision and that these public disclosures of execution quality should help broker-dealers fulfill their duty of best execution.
37

More recently, the Commission stated that broker-dealers should consider the availability of consolidated market data, including the various elements of data content and the timeliness, accuracy, and reliability of the data in developing and maintaining their best execution

policies and procedures.
38

However, recognizing that best execution analysis varies depending upon the characteristics of customers and orders handled and the large array of potential scenarios, the Commission stated that it cannot specify the data elements that may be relevant to every specific situation.
39

35

See
Order Execution Obligations Adopting Release,
supra
note 10, 61 FR 48324.

36

See
17 CFR 242.605, 242.606.

37

See
Order Execution and Routing Practice Release,
supra
note 22, 65 FR 75413. The Commission further stated that the rules were designed to generate uniform, general purpose statistics that will prompt more vigorous competition on execution quality. The information provided by these reports is not, by itself, sufficient to support conclusions regarding the provision of best execution, and any such conclusions would require a more in-depth analysis of the broker-dealer's order routing practices than will be available from the disclosures required by the rules.
See id.
at 75420.

38

See
Securities Exchange Act Release No. 90610 (Dec. 9, 2020), 86 FR 18596, 18605-06 (Apr. 9, 2021) (“MDI Adopting Release”). The Commission stated that it was not establishing minimum data elements needed to achieve best execution nor mandating consumption of the expanded data content. The Commission also acknowledged that different market participants and different trading applications have different market data needs.
See id.
(citing Securities Exchange Act Release No. 88216 (Feb. 14, 2020), 85 FR 16726, 16734, 16755 (Mar. 24, 2020) (“Market Data Infrastructure Proposing Release”)).

39

See
MDI Adopting Release,
supra
note 38, 86 FR at 18606.

The Commission has also stated the importance of price improvement opportunities in the context of listed and over-the-counter (“OTC”) equities.
40

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.
41

Rather, broker-dealers handling small orders in listed and OTC equities should look for price improvement opportunities when executing these orders.
42

And the expectation of price improvement for customer orders is particularly important when broker-dealers receive payments in return for routing their customer orders.
43

40

See
Order Execution Obligations Adopting Release,
supra
note 10, 61 FR at 48323.
See also

id.
at 48323 n.357.

41

See id.
at 48323.

42

See id.

43

See
Payment for Order Flow Release,
supra
note 33, 59 FR at 55008.
See also
17 CFR 240.10b-10(d)(8) (defining “payment for order flow” as any monetary payment, service, property, or other benefit that results in remuneration, compensation, or consideration to a broker or dealer from any broker or dealer, national securities exchange, registered securities association, or exchange member in return for the routing of customer orders by such broker or dealer to any broker or dealer, national securities exchange, registered securities association, or exchange member for execution, including but not limited to: research, clearance, custody, products or services; reciprocal agreements for the provision of order flow; adjustment of a broker or dealer's unfavorable trading errors; offers to participate as underwriter in public offerings; stock loans or shared interest accrued thereon; 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). Retail broker-dealers receiving cash payments from wholesale market makers in return for routing their customers' orders to the market maker for execution is a common example of payment for order flow.
See
Memorandum to the SEC Equity Market Structure Advisory Committee from the SEC Division of Trading and Markets, Certain Issues Affecting Customers in the Current Equity Market Structure 5-6 (Jan. 26, 2016). Staff reports, Investor Bulletins, and other staff documents (including those cited herein) represent the views of Commission staff and are not a rule, regulation, or statement of the Commission. The Commission has neither approved nor disapproved the content of these staff documents and, like all staff statements, they have no legal force or effect, do not alter or amend applicable law, and create no new or additional obligations for any person.

C. FINRA and MSRB Best Execution Rules

FINRA, an SRO,
44

has a best execution rule (Rule 5310) and has issued interpretive regulatory notices concerning its members' duty to provide best execution to customer orders.
45

FINRA Rule 5310 states that, “[i]n any transaction for or with a customer or customer of another broker-dealer, a member and persons associated with a member must use reasonable diligence to ascertain the best market for the subject 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.” Over the years, FINRA and its predecessor, the NASD, have modified the rule and issued interpretations to account for changes in market practices and market structure, and to account for new technologies and new data available to broker-dealers that handle and execute customer orders.
46

44
While the MSRB is an SRO for only certain purposes of the Exchange Act,
see
Exchange Act section 3(a)(26), 15 U.S.C. 78c(a)(26), MSRB rules are rules of an SRO,
see
Exchange Act section 3(a)(28), 15 U.S.C. 78c(a)(28). FINRA and the MSRB are both referred to herein as SROs.

45
For ease of discussion and consistency, this release refers to FINRA members as broker-dealers when discussing the FINRA rules that are applicable to FINRA members.

46

See, e.g.,
FINRA Regulatory Notices 21-23 (June 23, 2021), 21-12 (Mar. 18, 2021), 18-29 (Sept. 12, 2018), 15-46 (Nov. 2015), and 09-58 (Oct. 2009); NASD Notices to Members 01-22 (Apr. 2001), 00-42 (June 2000), and 99-12 (Feb. 1999).

Modeled on FINRA Rule 5310,
47

MSRB Rule G-18 is the best execution rule for transactions in municipal securities
48

and similarly requires broker-dealers to “use reasonable diligence to ascertain the best market for the subject security and to buy or sell in that market so that the resultant price to the customer is as favorable as possible under prevailing market conditions.”

47
In proposing Rule G-18, the MSRB stated that a best execution rule should be generally harmonized with FINRA Rule 5310 for purposes of regulatory efficiency, but appropriately tailored to the characteristics of the municipal securities markets.
See
Securities Exchange Act Release No. 73764 (Dec. 5, 2014), 79 FR 73658 (Dec. 11, 2014) (“MSRB Best Execution Approval Order”). While proposed Regulation Best Execution does not include different requirements for markets with different characteristics, proposed Regulation Best Execution is designed to enable broker-dealers to tailor their compliance based on the different characteristics of the markets.

48
MSRB Rule G-18 applies to brokers, dealers, and municipal securities dealers. For ease of discussion and consistency, when discussing the MSRB rule, the release refers to these entities collectively as broker-dealers. Furthermore, the term “municipal securities” throughout this release is referred to as either “municipal bonds” or “municipal securities.”

The Commission describes the elements in FINRA Rule 5310 and MSRB Rule G-18, as well as the differences between those rules and the proposed rules, in section IV below.

III. Existing Order Handling Practices and Overview of Proposed Regulation Best Execution

A. Existing Order Handling Practices

1. General Broker-Dealer Practices

In the past few decades, there has been a proliferation of markets and increasingly accessible prices across asset classes. For example, broker-dealers have numerous execution venues from which to choose in the NMS stock market. These include 16 registered equities exchanges, an increase from 11 registered equities exchanges approximately 12 years ago.
49

In the options markets, the number of options exchanges continues to increase, with 6 new options exchanges in the last 10 years and 16 registered options exchanges operating today. In the corporate and municipal bond markets and government securities markets, traditional OTC voice trading protocols and customer liquidity provision by principal trading desks of broker-dealers are being supplemented by other methods of execution that are both electronic and multilateral in nature. As of October 31, 2022, there are 21 corporate bond alternative trading systems (“ATSs”), 7 municipal securities ATSs, and 14 government securities ATSs, each operating pursuant to a Form ATS currently on file with the Commission.

49

See
Securities Exchange Act Release No. 61358 (Jan. 14, 2010), 75 FR 3594 (Jan. 21, 2010) (“Concept Release on Equity Market Structure”).

The Commission believes that customers would benefit from broker-dealers' robust considerations of liquidity sources and price improvement opportunities, which may provide customers with the most favorable prices. In the NMS stock market, for example, broker-dealers that primarily service the accounts of individual investors (“retail broker-dealers”) route more than 90% of their customers' marketable orders to a small group of off-exchange dealers, known as wholesalers,
50

and the Commission

believes 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.

50

See
Table 8,
infra
section V.B.3.(a).i.d..

For NMS stock orders that receive price improvement from wholesalers, approximately 18.6% of those shares receive an amount of price improvement of less than 0.1 cent per share when executed by the wholesaler.
51

Moreover, for stocks priced higher than $30, between approximately 46-63% of shares executed by wholesalers received price improvement that was less favorable than the midpoint of the prevailing national best bid and offer (“NBBO”) at the time the wholesaler received the order.
52

For stocks priced higher than $30, it appears that for between 60-93% of the shares executed by the wholesaler in a principal capacity at a price less favorable than the NBBO midpoint there was midpoint liquidity that was available on exchanges and ATSs at the time the wholesaler executed the order.
53

Retail broker-dealers often do not route customer orders to execute against midpoint liquidity that may be present on other markets prior to routing for execution by wholesalers.
54

While a retail broker-dealer's decision to route orders to a wholesaler that provides price improvement may indeed be consistent with its duty of best execution in many cases,
55

the Commission believes 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.

51

See
Table 8,
infra
section V.B.3.(a).i.d.

52
The percentage ranges are based on stock prices, the liquidity of the stock, whether or not the stock was in the S&P 500 Index, and whether or not the stock is an exchange-traded fund (“ETF”).
See
Table 8,
infra
section V.B.3.(a).i.d (analysis showing that depending on the type of NMS stock, its price, and liquidity, between 46% and 73% of retail marketable order shares are internalized by a wholesaler at a price worse than the NBBO midpoint).

53

See
Table 8,
infra
section V.B.3.(a).i.d (analysis showing that, depending on the type of NMS stock, its price, and its liquidity, between 40% and 93% of the shares in marketable retail orders that wholesalers internalize at prices less favorable than the NBBO midpoint had midpoint liquidity available at a better price on an exchange or ATS).

54

See
Table 3,
infra
section V.B.3.(a).i.d (according to Table 3, retail brokers appear to outsource handling of over 87% of customer orders and over 90% of customer marketable orders to wholesalers).

55
For example, wholesalers appear to provide customers with executions in NMS stocks at the midpoint or better (based on the NBBO at the time the wholesaler received the order) for almost 46% of the customer orders executed by the wholesaler in a principal capacity.
See
Table 7,
infra
section V.B.3.(a).i.d .
But see

supra
note 53 and accompanying text (describing that for stocks priced higher than $30, it appears that between 60-93% of the shares executed by the wholesaler in a principal capacity at a price less favorable than the NBBO midpoint had liquidity available at the NBBO midpoint on an exchange or ATS).

Similar considerations are present with the order handling and routing practices of wholesalers in the NMS stock market.
56

While the prices that wholesalers provide to a customer may often justify the determination by the wholesaler that it is the best market for the customer order, the specific amount of price improvement for orders that are executed internally is largely within the discretion of the wholesaler. The wholesaler typically first determines whether or not it desires to transact with a particular customer order in a principal capacity. Should it choose to do so, the wholesaler determines what amount of price improvement it will provide for the order, and the data described above shows that wholesalers often do not execute customer orders at the NBBO midpoint. When the wholesaler has determined that it does not want to transact with a customer order in a principal capacity, the wholesaler may attempt to route such order to other markets.

56
Wholesalers owe a duty of best execution to the customers of retail broker-dealers under FINRA Rule 5310.
See
FINRA Rule 5310(a) (applying its best execution requirements to any transaction for or with a customer or a customer of another broker-dealer).

As discussed in section III.A.2, the Commission believes that customers would benefit from robust considerations by broker-dealers of liquidity sources and price improvement opportunities in the options market, particularly with respect to transactions that involve order handling conflicts of interest.

The corporate and municipal bond markets and the government securities markets are different from the NMS stock market in substantial ways that can impact how a broker-dealer fulfills its duty of best execution. For example, market participants do not have the same level of price transparency in these markets as they do in the NMS stock market. While the corporate and municipal bond markets disseminate post-trade price information, this information often is not available immediately upon execution of a bond transaction as FINRA and MSRB rules permit a trade to be reported within 15 minutes of the transaction.
57

In the government securities market, there is no real-time public dissemination of post-trade price information. Despite the increase in electronic trading and the use of ATSs, these markets are decentralized with most trading occurring through broker-dealers that make markets in securities they have underwritten or hold in inventory.
58

There is virtually no exchange trading of these bonds.
59

Generally, trades occur both by voice and through the use of electronic systems that provide trading facilities and communication protocols with varying degrees of execution functionality and access to pre-trade pricing information.
60

However, market participants in the corporate and municipal bond markets and the government securities markets are increasingly utilizing technology to trade these securities, and electronic trading is growing.
61

The lower level of price transparency in, and the decentralized nature of, the corporate and municipal bond and government securities markets make it more difficult for customers to evaluate their transactions and highlights the importance of robust best execution considerations by broker-dealers in these markets.

57
However, both FINRA and the MSRB recently solicited comment about shortening the applicable transaction reporting window to one minute.
See
FINRA Regulatory Notice 22-17 (Aug. 2, 2022); MSRB Notice 2022-07 (Aug. 2, 2022).

58

See, e.g.,
Maureen O'Hara & Xing (Alex) Zhou,
Anatomy of a Liquidity Crisis: Corporate Bonds in the COVID-19 Crisis,
142 J. Fin. Econ. 46 (2021).

59
A small percentage of corporate bonds are exchange-traded on trading systems such as NYSE Bonds and the Nasdaq Bond Exchange.
See generally,

https://www.nyse.com/markets/bonds
and
https://www.nasdaq.com/solutions/nasdaq-bond-exchange
. Trading volume in exchange-traded bonds was reported to be around $19 billion as of January 2020.
See
Securities Exchange Act Release No. 94062 (Jan. 26, 2022), 87 FR 15496 (Mar. 18, 2022) (“Government Securities ATS Proposing Release”), at 15604 n.863 (citing Eric Uhlfelder, A Forgotten Investment Worth Considering: Exchange-Traded Bonds, Wall St. J. (Jan. 5, 2020),
https://www.wsj.com/articles/a-forgotten-investment-worth-considering-exchange-traded-bonds-11578279781
).

60

See
Government Securities ATS Proposing Release,
supra
note 59, 87 FR 15606.

61
For example, according to one industry group, approximately 32% of investment-grade and 23% of high-yield corporate bond daily dollar volumes are executed electronically.
See id.,
at 15606 n.890.

Commission analysis shows significant differences in the variability of execution prices among interdealer trades
62

compared to the variability of execution prices among customer trades in the same bonds on the same trading day. For example, in the corporate bond market, the dispersion, or standard deviation, of customer execution prices for transactions under $100,000 was almost 3 times more than that of interdealer execution prices.

63

Similarly, in the municipal bond market, the dispersion of customer execution prices for transactions under $100,000 was more than 4 times greater than that of interdealer trades.
64

And in the government securities market, the dispersion of customer execution prices for transactions under $100,000 was almost 40 percent greater than that of interdealer trades.
65

The variability of prices for customer transactions suggests that some customers may be paying or receiving worse prices than other customers in the same security on the same day because their broker-dealers may not be evaluating as many markets for those transactions as other broker-dealers. While it is possible that some of the variability of prices paid by customers may be attributable to variations in broker-dealer compensation as reflected in the markups or markdowns charged by broker-dealers when they transact with customers in a principal capacity, the Commission does not believe that this is the only reason for customer price dispersion in the same bonds on the same day.
66

For example, Commission analysis shows that in the corporate bond market, for trades that were reported by the broker-dealer as not involving any collection of commissions, markups or markdowns, the dispersion of customer execution prices was still 65% greater than that of interdealer trades.
67

Because the variability in the customer execution prices suggests that some broker-dealers may not be exercising as much diligence in identifying the best market for customer orders, the Commission believes that customers would benefit from consistently robust best execution considerations by broker-dealers, including considerations of the various markets that may provide their customers with the most favorable prices.

62
It is well-established that interdealer prices can reflect the prevailing market value for a bond.
See, e.g.,
FINRA Rule 2121.

63

See
Table 17,
infra
section V.B.3.b.i.

64

See
Table 17,
infra
section V.B.3.b.i and V.B.3.b.ii.

65

See
Table 17,
infra
section V.B.31.b.i and V.B.3.b.iii .

66

See, e.g.,
John M. Griffin, Nicholas Hirschey, and Samuel Kruger,
Do Municipal Bond Dealers Give their Customers `Fair and Reasonable' Pricing?
J. Fin., Forthcoming (Aug. 4, 2022) (“Instead of delivering uniform pricing, dealer transactions with customers take place at highly variable markups relative to both reoffering prices and dealer costs. On the same day, customers frequently buy the same bond at different prices from different dealers, and prices even vary across different customers purchasing the same bond from the same dealer on the same day. These price differences are not explained by trade characteristics or by dealer costs. Some dealers provide customers with low and consistent markups, but this does not appear to be the industry norm. Pricing at quarter or eighth price or yield increments is common and is seemingly a method to deliver higher markups.”).

67

See infra
note 478.

2. Order Handling Conflicts of Interest

The Commission also believes that execution of retail customer orders by broker-dealers that have order handling conflicts of interest warrants heightened attention by those broker-dealers. These order handling conflicts of interest include payment for order flow, principal trading, and routing customer orders to affiliates.

Payment for order flow
68

creates a conflict of interest because it creates an incentive for a broker-dealer to send customer orders to a market, such as a wholesaler or an exchange, which agrees to pay the broker-dealer for sending its customer orders.
69

Payment for order flow may harm customers because the broker-dealer may be making order handling decisions to benefit itself at the expense of its customer.
70

Because payment for order flow is a form of economic inducement that has the potential to influence the way a broker-dealer handles customer orders, the Commission has stated that such arrangements must be considered as part of a broker-dealer's best execution assessment.
71

68
When discussing payment for order flow in the context of the proposed rules, the Commission uses the term as defined in Exchange Act Rule 10b-10(d)(8). This definition includes payment for order flow from wholesalers to retail broker-dealers, as well as exchange rebates that are paid to broker-dealers in return for sending orders to the exchange.
See
17 CFR 240.10b-10 (defining payment for order flow and requiring a broker-dealer to disclose to the customer whether payment for order flow is received by the broker-dealer for the customer transaction and the fact that the source and nature of the compensation received in connection with the particular transaction will be furnished upon written request of the customer).

69

See, e.g.,
Payment for Order Flow Release,
supra
note 33, FR Doc No: 94-27109; FINRA Regulatory Notice 21-23;
Robinhood Financial, LLC,
Letter of Acceptance, Waiver and Consent (FINRA Case No. 2017056224001) (Dec. 2019) (“Robinhood FINRA”) (describing violations of FINRA's best execution rule where the firm routed its customers' orders to four broker-dealers that all paid for order flow and “did not exercise reasonable diligence to ascertain whether these four broker-dealers provided the best market for the subject securities to ensure its customers received the best execution quality from these as compared to other execution venues”);
In the Matter of Robinhood Financial, LLC,
Securities Exchange Act Release No. 90694 (Dec. 17, 2020) (settled action) (“Robinhood SEC”). Broker-dealers that accept payment for order flow must disclose certain information concerning the payments publicly.
See
17 CFR 242.606(a)(1)(iv) (requiring a description of any arrangement for payment for order flow and any profit-sharing relationship and a description of any terms of such arrangements, written or oral, that may influence a broker-dealer's order routing decision).

70

See, e.g.,
Robinhood FINRA,
supra
note 69; Robinhood SEC,
supra
note 69 (finding that the retail broker-dealer explicitly offered to accept less price improvement for its customers than what the wholesalers were offering, in exchange for receiving a higher rate of payment for order flow for itself).

71

See
Payment for Order Flow Release,
supra
note 33, FR Doc No: 94-27109.

While the Commission has stated that a broker-dealer's receipt of payment for order flow is not a violation of its duty of best execution as long as it periodically assesses the quality of the markets to which it routes order flow, a broker-dealer must not allow payment for order flow to interfere with its efforts to obtain best execution.
72

Likewise, FINRA has stated that broker-dealers may not negotiate the terms of order routing arrangements for customer orders in a manner that reduces the price improvement opportunities that, absent payment for order flow, otherwise would be available to those customer orders.
73

FINRA has also stated that obtaining price improvement is a heightened consideration when a broker-dealer receives payment for order flow and it is especially important to determine that customers are receiving the best price and execution quality opportunities notwithstanding the payment for order flow.
74

Accordingly, the Commission believes that the receipt of payment for customer order flow continues to warrant heightened attention by broker-dealers.
75

72

See id.

73

See
FINRA Regulatory Notice 21-23 (June 23, 2021).

74

See id.,
at 3-4. FINRA has also stated that “inducements such as payment for order flow and internalization may not be taken into account in analyzing market quality.”
See id.
at 4.

75
Commission staff, in a recent report, stated that wholesaler payment for order flow to retail broker-dealers is “individually negotiated prior to trading between the retail broker-dealer and the [wholesaler], and the rates and amounts can vary substantially depending on the broker-dealer and its customer order flow. [Wholesalers] may give the retail broker the choice of how to allocate those funds—either by applying some or all of that payment to improve the prices of its customers' orders or by allowing the retail broker-dealer to keep part of the payment for itself.” Commission staff stated that these payments can create a conflict of interest for the retail broker-dealer.
See
Staff Report on Equity and Options Market Structure Conditions in Early 2021 (Oct. 14, 2021),
available at

https://www.sec.gov/files/staff-report-equity-options-market-struction-conditions-early-2021.pdf
. Additionally, Rule 606(a) of Regulation NMS requires broker-dealers to make publicly available on a quarterly basis certain aggregated order routing disclosures for held orders that provide, among other things, detailed disclosure of payments received from or paid to certain trading centers, as well as a discussion of the material aspects of broker-dealers' relationships with those trading centers, including a description of any arrangements for payment for order flow and any profit-sharing relationships and a description of any terms of such arrangements, written or oral, that may influence broker-dealers' order routing decisions.
See
17 CFR 242.606(a).

A significant portion of retail orders in the NMS stock and listed options market is routed in return for payment

for order flow. In the first quarter of 2022, wholesalers paid more than $796 million dollars to retail broker-dealers for order flow in NMS stocks and listed options.
76

Listed options represented approximately 70% of the total payment for order flow with more than $561 million paid to retail broker-dealers by wholesalers.
77

Payment for order flow creates an incentive for the retail broker-dealer to adopt order handling and execution practices that may not result in best execution for their customers.
78

For example, as discussed more fully in section V, analysis in the NMS stock market appears to show that payment for order flow can harm customer execution quality. More specifically, the orders of broker-dealers that receive more payment for order flow from wholesalers are internalized by wholesalers with (1) higher effective spreads, (2) higher execution quality ratios, and (3) slightly smaller price improvement when compared with the orders of broker-dealers that do not receive payment for order flow and that are internalized by wholesalers.
79

In the context of exchange rebates in the options market, one study finds that some brokers seemingly route non-marketable orders to exchanges that offer large liquidity rebates to maximize the value of order flow and suggests that broker-dealers can enhance non-marketable limit order execution quality by routing those orders to exchanges that do not offer liquidity rebates to non-marketable limit orders.
80

76

See
Table 12,
infra
section V.B.3.(a).iii.a.

77

See id.

See also
Thomas Ernst & Chester S. Spatt,
Payment for Order Flow and Asset Choice,
40 (NBER Working Paper No. w29883, May 2022),
https://ssrn.com/abstract=4068065
(retrieved from Elsevier database) (finding that approximately 65% of all payment for order flow is attributable to the options market). In addition to payment for order flow paid by wholesalers to retail broker-dealers, some exchanges administer “marketing fee” programs pursuant to rules filed with the Commission, that result in payment for order flow directed by exchange market makers to order flow providers, which can include retail broker-dealers.
See, e.g.,
Nasdaq Phlx LLC Options 7, Section 4; Miami International Securities Exchange LLC Fee Schedule Section (1)(a)(xi); NYSE American LLC Options Fee Schedule Section I.A. Under these programs, the exchanges assess fees on market makers who then typically direct the disbursement of some or all of the marketing fees to selected market participants in return for retail order flow directed to the market makers from the broker-dealer recipients of the marketing fees. If the directed market maker is quoting at the NBBO when the order is received, exchange rules typically guarantee the market maker a certain allocation of the incoming directed order, typically determined by the number of other market makers quoting at the NBBO at the time the order is received.
See, e.g.,
PHLX Options 3, Section 10(a)(1)(C) (describing the directed market maker priority).

78
The Commission and FINRA settled claims against a retail broker-dealer for, among other things, failing to provide best execution to customer orders for which it received payment for order flow.
See supra
note 69. The inherent trade-off between payment for order flow for a retail broker-dealer and price improvement for their customers was discussed in the Commission's settled enforcement action against the retail broker.
See
Robinhood SEC,
supra
note 69. The Commission found that the retail broker-dealer had negotiated with a number of wholesalers about potentially routing customer orders to those firms and that, in the course of those negotiations, certain of the wholesalers told the retail broker-dealer that there was a trade-off between payment for order flow on the one hand and price improvement on the other.
See id.
The Commission also found that the retail broker-dealer explicitly offered to accept less price improvement for its customers than what the wholesalers were offering, in exchange for receiving a higher rate of payment for order flow for itself.
See id.
Subsequently, the retail broker-dealer conducted a more extensive internal analysis, which showed that its execution quality and price improvement metrics were substantially worse than other retail broker-dealers in many respects, including the percentage of orders that received price improvement and the amount of price improvement, measured on a per order, per share, and per dollar traded basis.
See id.

79

See
Table 16,
infra
section V.B.3.b..iii.b.

80

See
Robert Battalio et al.,
Do (Should) Brokers Route Limit Orders to Options Exchanges That Purchase Order Flow?,
56 J. Fin. & Quantitative Analysis 183 (2020).

The Commission has also acknowledged that the opportunity for a broker-dealer to trade with a customer order as principal is an order routing inducement that could interfere with the broker-dealer's duty of best execution.
81

Internalizing customer orders may create a conflict of interest because broker-dealers do so for the opportunity to capture the spread,
82

and may thereby provide broker-dealers an incentive to trade with orders as principal. In the NMS stock market and listed options market, principal trading with retail customers is a common practice. As stated above in section III.A.1, a significant portion of retail customer orders are routed to wholesalers for handling and execution. Once the wholesaler receives retail customer orders for handling and execution, it often trades with those customer orders as principal. Wholesalers internalize over 90% of the dollar value of the marketable order flow retail broker-dealers send them.
83

The Commission believes that the incentive to trade in a principal capacity at a price most advantageous for the wholesaler itself rather than the customer warrants heightened attention by the wholesaler.

81

See
Order Execution Obligations Adopting Release,
supra
note 10, 61 FR 48323.

82

See
Internalized/Affiliate Practices, Payment for Order Flow and Order Routing Practices, Securities Exchange Act Release No. 34903 (Oct. 27, 1994), 59 FR 55014, 55014 (Nov. 2, 1994) (recognizing several commenters who described this conflict of interest).

83

See
Table 7,
infra
Section V.B.3.a.i.d.

Principal trading in the listed options market is also common. Options exchange trading and priority rules, which must be filed with the Commission under section 19(b) of the Exchange Act
84

and Rule 19b-4 thereunder,
85

provide wholesalers with a number of methods to internalize customer orders. For example, the wholesaler or an affiliate is often either a specialist or directed market maker on one or more of the options exchanges. Exchange rules typically provide the specialist or directed market maker with the right to trade with a certain portion of incoming order flow regardless of whether other market participants may also be quoting at the same price as the specialist or directed market maker.
86

These “allocation guarantees” effectively allow the wholesaler to internalize a minimum amount of the customer orders by routing the customer orders to exchanges where the wholesaler or its affiliate is designated as a specialist or directed market maker. Similarly, many options exchanges provide small order guarantees that permit the specialist (which potentially can be an affiliate of the wholesaler) to trade with 100% of all orders sent to the exchange for five contracts or less.
87

Moreover, options exchanges' two-sided auctions (“price improvement auctions”) allow a wholesaler to internalize a customer order by submitting a proposed transaction between the wholesaler and a customer at a specified price.
88

Other market participants are permitted to compete with the wholesaler for the opportunity to trade with the customer order. These price improvement auctions, however, generally afford the wholesaler with certain advantages over other market participants that may be interested in competing for the right to trade with a customer order.
89

The Commission estimates that wholesalers in the listed options market generally internalize approximately 31% of the executed

orders routed to option exchanges, with approximately 73% of orders routed to price improvement auctions being internalized and approximately 17% of orders routed to the limit order book being internalized.
90

The Commission believes that the incentive to trade in a principal capacity at a price most advantageous for the wholesaler itself rather than the customer warrants heightened attention by the wholesaler.

84
15 U.S.C. 78s(b).

85
17 CFR 240.19b-4.

86

See, e.g.,
BOX Exchange LLC Rule 7135(c); Miami International Securities Exchange LLC Rule 514(g)-(i); Nasdaq Phlx LLC Options 3, Section 10(a)(1); Nasdaq ISE, LLC Options 3, Section 10(c)(1); NYSE American LLC Rule 964NY(b)(2).

87

See, e.g.,
Nasdaq ISE, LLC Options 3, Section 10(c)(1)(D); Nasdaq Phlx LLC Options 3, Section 10(a)(1)(D); BOX Exchange LLC Rule 7135(c)(2)(iii); NYSE American LLC Rule 964NY(b)(2)(C)(iv).

88
Customer orders that are submitted into price improvement auctions are guaranteed complete execution at a minimum execution price and are electronically auctioned for price improvement.
See, e.g.,
Nasdaq ISE, LLC Options 3, Section 13; Nasdaq Phlx LLC Options 3, Section 13; Miami International Securities Exchange LLC Rule 515A; BOX Exchange LLC Rule 7150; NYSE American LLC Rule 971.1NY; Cboe Exchange, Inc. Rule 5.37.

89

See infra
notes 137-140 and accompanying text.

90

See infra
Section V.B.3.a.ii.

Finally, the practice of routing customer orders to affiliates raises a conflict of interest for the broker-dealer. When a broker-dealer chooses to route customer orders to an affiliate, it may do so because of financial incentives, and these incentives can vary depending on the business model or business lines of the broker-dealer. For example, broker-dealers may have conflicts of interest to the extent that they operate or are affiliated with an entity that operates a trading venue, such as an ATS, because the broker-dealer or its affiliate receives financial benefits when the broker-dealer operator chooses to route customer orders to its ATS for execution (
e.g.,
by routing an order to its ATS, a broker-dealer operator that does not pass through trading fees to its customers may be able to avoid paying fees that it otherwise would have to pay when routing and executing orders on unaffiliated trading venues).
91

A broker-dealer operator also benefits by routing to its ATS because it creates higher volume on the ATS, which can attract additional order flow to the ATS, ultimately increasing the ATS' market share and associated revenue.
92

Another example of affiliate routing conflicts of interest relates to a financial services firm that may have an organizational structure that separates its retail facing business from its order handling and execution business. The retail broker-dealer that receives a customer order may have a financial incentive to send the customer order to its affiliated executing broker-dealer because the affiliated executing broker-dealer may wish to trade as principal with the customer order. While an affiliated executing broker-dealer could provide best execution for customer orders, the incentive to send customer orders to an affiliate may influence the broker-dealer to route the customer order in a manner that maximizes the broker-dealer's interest, rather than route the customer order to another market consistent with its duty of best execution.
93

Accordingly, the Commission believes that the impact of this practice on customer orders continues to warrant heightened attention by broker-dealers.

91

See
Amber Anand et al.,
Institutional Order Handling and Broker-Affiliated Trading Venues,
34 Rev. Fin. Stud. 3364, 3366 (July 2021) (“Anand”) (recognizing the conflict between obtaining the best outcome for the customer and maximizing the broker-dealer's revenue due to avoiding a fee that is typically borne by the broker-dealer). This study found that “institutional brokers who route more orders to affiliated [ATSs] are associated with lower execution quality (
i.e.,
lower fill rates and higher implementation shortfall costs).”
Id. See

also
Regulation of NMS Stock Alternative Trading Systems, Securities Exchange Act Release No. 83663 (July 18, 2018), 83 FR 38768, 38775, 38834 (Aug. 7, 2018).

92

See
Anand, supra note 91, at 3366.

93
Recently, FINRA has entered into settlements with broker-dealers for best execution violations of FINRA rules involving affiliated routing practices. In one case, FINRA found that the broker-dealer “failed to consider whether alternate routing arrangements could have provided price improvement opportunities and better speed of execution” for customer orders despite its consideration of certain execution quality factors for orders routed to an affiliated ATS. FINRA also stated that “although [the firm] reviewed fill rates in [its affiliated ATS] during the relevant period, the firm failed to consider alternate routing arrangements when the firm showed that fill rates in [its affiliated ATS] were inferior to fill rates at some competing execution venues.” FINRA found that this practice violated FINRA's best execution rule.
See
Barclays Capital Inc., Letter of Acceptance, Waiver, and Consent No. 2014041808601 (Oct. 4, 2022),
available at

https://www.finra.org/sites/default/files/2022-10/Barclays-Capital-AWC-100522.pdf
. In another case, FINRA found that the broker-dealer routinely routed institutional customer orders to its affiliated ATS prior to routing such orders to exchanges or to other ATSs. According to FINRA's findings, the broker-dealer routed to its affiliated ATS despite having evidence that (1) orders that were sent to the affiliated ATS had lower fill rates as compared to orders sent directly to exchanges, and (2) other ATSs consistently ranked higher in the firm's rankings for execution quality than the affiliated ATS. FINRA found that this affiliated routing practice violated FINRA's best execution rule 5310.
See
Deutsche Bank Securities Inc., Letter of Acceptance, Waiver, and Consent No. 2014041813501 (Mar. 7, 2022),
available at

https://www.finra.org/sites/default/files/2022-03/deutsche-bank-awc-030722.pdf
.

3. Crypto Asset Securities

As discussed in section II.A above, a broker-dealer has a legal duty to seek best execution of customer orders in securities. Proposed Regulation Best Execution would apply to all securities, including any digital asset that is a security or a government security under the Federal securities laws. The term “digital asset” refers to 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.”
94

94

See
Custody of Digital Asset Securities by Special Purpose Broker-Dealers, Securities Exchange Act Release No. 90788 (Dec. 23, 2020), 86 FR 11627, 11627 n.1 (Feb. 26, 2021) (“Crypto Asset Securities Custody Release”). A digital asset may or may not meet the definition of a “security” under the Federal securities laws.
See, e.g.,
Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Securities Exchange Act Release No. 81207 (July 25, 2017) (“DAO 21(a) Report”),
available at

https://www.sec.gov/litigation/investreport/34-81207.pdf
.
See also

SEC
v.
W.J. Howey Co.,
328 U.S. 293 (1946). To the extent digital assets rely on cryptographic protocols, these types of assets also are commonly referred to as “crypto assets” and “digital asset securities” can be referred to as “crypto asset securities.” For purposes of this release, the Commission does not distinguish between the terms “digital asset securities” and “crypto asset securities.”

Unlike securities that are not issued or transferred using distributed ledger technology, the Commission has limited information about the order handling and best execution practices of broker-dealers that engage in transactions for or with customers in crypto asset securities.
95

This information limitation is, in part, due to the fact that only a small portion of crypto asset security trading activity is occurring within entities that are registered with the Commission and any of the SROs. For example, there are currently no special purpose broker-dealers authorized to maintain custody of crypto asset securities.
96

Similarly, only a limited

amount of crypto asset security volume is executed on trading venues under the Commission's ATS framework.
97

This information limitation is also, in part, due to the significant trading activity in crypto asset securities that may be occurring in non-compliance with the Federal securities laws.
98

95

See, e.g.,
Fin. Stability Oversight Council, Report on Digital Asset Financial Stability Risks and Regulation 119 (2022) (“FSOC Report”),
available at

https://home.treasury.gov/system/files/261/FSOC-Digital-Assets-Report-2022.pdf
(“The crypto-asset ecosystem is characterized by opacity that creates challenges for the assessment of financial stability risks.”); U.S. Dep't of the Treasury, Crypto-Assets: Implications for Consumers, Investors, and Businesses 12 (Sept. 2022) (“Crypto-Assets Treasury Report”),
available at

https://home.treasury.gov/system/files/136/CryptoAsset_EO5.pdf
(finding that data pertaining to “off-chain activity” is limited and subject to voluntary disclosure by trading platforms and protocols, with protocols either not complying with or not subject to obligations “to report accurate trade information periodically to regulators or to ensure the quality, consistency, and reliability of their public trade data”); Fin. Stability Bd., Assessment of Risks to Financial Stability from Crypto-assets 18-19 (Feb. 16, 2022) (“FSB Report”),
available at

https://www.fsb.org/wp-content/uploads/P160222.pdf
(finding that the difficulty in aggregating and analyzing available data in the digital asset space “limits the amount of insight that can be gained with regard to the [digital asset] market structure and functioning,” including who the market participants are and where the market's holdings are concentrated, which, among other things, limits regulators' ability to inform policy and supervision); Raphael Auer et al.,
Banking in the Shadow of Bitcoin? The Institutional Adoption of Cryptocurrencies
4, 9 (Bank for Int'l Settlements, Working Paper No. 1013, May 2022),
available at

https://www.bis.org/publ/work1013.pdf
(stating that data gaps, which can be caused by limited disclosure requirements, risk undermining the ability for holistic oversight and regulation of cryptocurrencies); Int'l Monetary Fund, The Crypto Ecosystem and Financial Stability Challenges, in Global Financial Stability Report 41, 47 (Oct. 2021),
available at

https://www.imf.org/-/media/Files/Publications/GFSR/2021/October/English/ch2.ashx
(finding that digital asset service providers provide limited, fragmented, and, in some cases, unreliable data, as the information is provided voluntarily without standardization and, in some cases, with an incentive to manipulate the data provided).

96
For background on Rule 15c3-3, 17 CFR 240.15c3-3, as it relates to digital asset securities,

see
U.S. Sec. & Exch. Comm'n, Joint Staff Statement on Broker-Dealer Custody of Digital Asset Securities (July 8, 2019),
https://www.sec.gov/news/public-statement/joint-staff-statement-broker-dealer-custody-digital-asset-securities
; Fin. Indus. Regul. Auth., SEC Staff No-Action Letter, ATS Role in the Settlement of Digital Asset Security Trades (Sept. 25, 2020),
available at

https://www.sec.gov/divisions/marketreg/mr-noaction/2020/finra-ats-role-in-settlement-of-digital-asset-security-trades-09252020.pdf
. To date, five offerings of crypto asset securities have been registered or qualified under the Securities Act of 1933, and five classes of crypto asset securities have been registered under the Exchange Act. The Commission issued a statement describing its position that, for a period of five years, special purpose broker-dealers operating under the circumstances set forth in the statement will not be subject to a Commission enforcement action on the basis that the broker-dealer deems itself to have obtained and maintained physical possession or control of customer fully paid and excess margin digital asset securities for purposes of Rule 15c3-3(b)(1) under the Exchange Act.
See
Crypto Asset Securities Custody Release,
supra
note 94. To date, no such special purpose broker-dealer registration applications have been granted by FINRA.

97
ATSs that do not trade NMS stocks file with the Commission a Form ATS notice, which the Commission does not approve. Form ATS requires, among other things, that ATSs provide information about: classes of subscribers and differences in access to the services offered by the ATS to different groups or classes of subscribers; securities the ATS expects to trade; any entity other than the ATS involved in its operations; the manner in which the system operates; how subscribers access the trading system; procedures governing entry of trading interest and execution; and trade reporting, clearance, and settlement of trades on the ATS. In addition, all ATSs must file quarterly reports on Form ATS-R with the Commission. Form ATS-R requires, among other things, volume information for specified categories of securities, a list of all securities traded in the ATS during the quarter, and a list of all subscribers that were participants. To the extent that an ATS trades crypto asset securities, the ATS must disclose information regarding its crypto asset securities activities as required by Form ATS and Form ATS-R. Form ATS and Form ATS-R are deemed confidential when filed with the Commission. Based on information provided on these forms, a limited number of ATSs have noticed on Form ATS their intention to trade certain crypto asset securities and a subset of those ATSs have reported transactions in crypto asset securities on their Form ATS-R.

98

See also
FSOC Report,
supra
note 95, at 5, 87, 94, 97 (emphasizing the importance of the existing financial regulatory structure while stating that certain digital asset platforms may be listing securities while not in compliance with exchange, broker-dealer, or other registration requirements, which may impose additional risk on banks and investors and result in “serious consumer and investor protection issues”); Crypto-Assets Treasury Report,
supra
note 95, at 26, 29, 39, 40 (stating that issuers and platforms in the digital asset ecosystem may be acting in non-compliance with statutes and regulations governing traditional capital markets, with market participants that actively dispute the application of existing laws and regulations, creating risks to investors from non-compliance with, in particular, extensive disclosure requirements and market conduct standards); FSB Report,
supra
note 95, at 4, 8, 18 (stating that some trading activity in crypto assets may be failing to comply with applicable laws and regulations, while failing to provide basic investor protections due to their operation outside of or in non-compliance with regulatory frameworks, thereby failing to provide the “market integrity, investor protection or transparency seen in appropriately regulated and supervised financial markets”).

The Commission believes that it is appropriate for a broker-dealer that engages in transactions for or with customers or customers of another broker-dealer in crypto asset securities to be subject to proposed Regulation Best Execution. As discussed in section I above, the duty of best execution is of fundamental importance to investors and the markets, including investors in, and the market for, crypto asset securities. For example, a customer transacting in crypto asset securities should receive the protections afforded by the requirement that broker-dealers exercise reasonable diligence to ascertain the best market for the crypto asset securities and buy and sell in such market so that the price to the customer is as favorable as possible under prevailing market conditions. In doing so, broker-dealers should be taking steps to ensure that they are evaluating the range of markets that trade crypto asset securities and appropriately identifying those markets that may be likely to provide customers with the most favorable prices.

B. Overview of Proposed Regulation Best Execution

The Commission believes that proposed Regulation Best Execution would further the Congressional goal set forth in Exchange Act Section 11A(a)(1)(C)(iv) regarding executing investors' orders in the best market and reinforce broker-dealer obligations concerning the duty of best execution. In particular, proposed Regulation Best Execution would identify specific factors that must be addressed by a broker-dealer's policies and procedures on best execution, impose additional requirements for conflicted transactions, and impose best execution-specific review and documentation requirements, all of which should better protect investors by promoting consistently robust order handling and execution practices.
99

99

See
section IV for discussions of the differences between the proposed rules and the existing FINRA and MSRB rules on best execution. As discussed in detail in section IV, proposed Regulation Best Execution is consistent with the FINRA and MSRB best execution rules in some respects and, in some other respects, goes beyond those rules imposing additional and/or more specific requirements.

Proposed Rule 1100 would set forth the standard of best execution, requiring a broker-dealer to use reasonable diligence to ascertain the best market for a 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. Proposed Rule 1101 would require a broker-dealer to establish, maintain, and enforce written policies and procedures that address specific elements that are designed to promote the best execution of customer orders, and comply with certain execution quality review and documentation requirements.

More specifically, proposed Rule 1101(a)(1) would require that a broker-dealer's policies and procedures address how it will comply with the best execution standard in proposed Rule 1100. In particular, a broker-dealer's policies and procedures would be required to address how it will: (1) obtain and assess reasonably accessible information concerning the markets trading the relevant securities; (2) identify markets that may be reasonably likely to provide the most favorable prices for customer orders (“material potential liquidity sources”); and (3) incorporate the material potential liquidity sources into its order handling practices and ensure efficient access to each such material potential liquidity source. The Commission believes this aspect of the proposal would promote consistently robust order handling practices by requiring each broker-dealer to establish a detailed framework to achieve best execution, which involves an analysis of relevant information, an evaluation of the range of liquidity sources, and the identification of and ability to efficiently access liquidity sources.

Proposed Rule 1101(a)(2) would require a broker-dealer's policies and procedures to address how it will determine the best market and make routing and execution decisions for the customer orders that it receives. In particular, a broker-dealer's policies and procedures would be required to address how it will: (1) assess reasonably accessible and timely information, including information with respect to the best displayed prices, opportunities for price improvement, and order exposure opportunities that may result in the most favorable price; (2) assess the attributes of customer orders and consider the trading characteristics of the security, the size of the orders, the likelihood of execution, and the accessibility of the market, and any customer instructions in selecting the market most likely to provide the most favorable price; and (3) reasonably

balance the likelihood of obtaining a better price with the risk that delay could result in a worse price when determining the number and sequencing of markets to be assessed. These considerations have been recognized as relevant for a broker-dealer's duty of best execution.
100

100

See, e.g.,

supra
notes 21-23 and accompanying text; FINRA Rules 5310(a)(1) and 5310.09(b)(1).

As discussed in section IV.B below, the factors that must be included in a broker-dealer's policies and procedures under proposed Rule 1101(a) are generally consistent with the factors that FINRA and the MSRB have identified as relevant to a broker-dealer's best execution determinations. The Commission understands that, currently, some broker-dealers incorporate various best execution factors from the FINRA and MSRB best execution rules in their policies and procedures. However, by requiring broker-dealers' best execution policies and procedures to explicitly address these factors, proposed Rule 1101(a) would help ensure that broker-dealers have established processes in place for considering these factors and that broker-dealers follow these processes when transacting for or with customers, which should promote consistently robust order handling practices among broker-dealers.
101

101
Moreover, requiring broker-dealers' best execution policies and procedures to address factors similar to those that FINRA and the MSRB have already identified as relevant to best execution determinations would mitigate compliance costs associated with the proposed rules.

Proposed Rule 1101(b) would require broker-dealers that have certain conflicts of interest to establish additional policies and procedures to better position them to meet the best execution standard in these circumstances. In particular, a broker-dealer's policies and procedures for conflicted transactions would be required to address how it will: (1) obtain and assess information beyond that required by proposed Rule 1101(a)(1)(i) in identifying a broader range of markets beyond the material potential liquidity sources; and (2) evaluate a broader range of markets beyond the material potential liquidity sources. Proposed Rule 1101(b) would also require broker-dealers to document their compliance with the best execution standard for conflicted transactions, including all efforts taken to enforce their policies and procedures, and their basis and information relied on for determining that their conflicted transactions would comply with the proposed best execution standard. Such documentation would be required to be done in accordance with written procedures. Proposed Rule 1101(b) would also require broker-dealers to document any arrangements concerning payment for order flow.
102

These requirements for conflicted transactions would be in addition to the current FINRA and MSRB best execution rules, although the Commission understands that some broker-dealers currently preserve information that allows them to support their best execution determinations (
e.g.,
information to recreate the pricing information that was available at the time an order was received). The Commission believes that these requirements would encourage broker-dealers to exercise additional diligence with respect to conflicted transactions in light of the incentives to handle conflicted transactions in a manner that prioritizes their own interests over their customers' interests, and are part of the Commission's ongoing efforts to protect investors when conflicts of interest exist.

102

See infra
section IV.C.2 (discussing the proposed requirement to document payment for order flow arrangements).

Proposed Rule 1101(c) would require broker-dealers to review the execution quality of customer orders at least quarterly, and how such execution quality compares with the execution quality that might have been obtained from other markets, and revise their best execution policies and procedures, including order handling practices, accordingly. The Commission understands that, currently, broker-dealers' reviews of execution quality vary in rigor,
103

and the Commission preliminarily believes that the proposed review requirement would further ensure that broker-dealers evaluate the effectiveness of their current order handling practices and enable broker-dealers to make informed judgments regarding whether their policies and procedures or practices need to be modified. This review requirement would also apply to a broader range of broker-dealers than FINRA's rule that governs the review of execution quality,
104

and would be in addition to the current MSRB best execution rule.

103

See infra
note 210 (discussing FINRA exam findings relating to execution quality reviews).

104

See infra
section IV.D (discussing the proposed execution quality review requirement, including the scope of the proposed requirement).

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), so long as the introducing broker establishes, maintains, and enforces policies and procedures that require the introducing broker to regularly review the execution quality obtained from its executing broker, compare it with the execution quality it might have obtained from other executing brokers, and revise its routing practices accordingly. This provision would provide a tailored exemption from certain provisions of proposed Regulation Best Execution for broker-dealers that do not make decisions or exercise discretion regarding the manner in which their customer orders are handled and executed, beyond their determinations to engage the services of executing brokers. This exemption would be provided to a narrower group of broker-dealers than 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.
105

105

See infra
section IV.E (describing the applicability of the proposed exemption under proposed Rule 1101(d)).

Proposed Rule 1102 would require each broker-dealer to review and assess the design and overall effectiveness of their best execution policies and procedures, including their order handling practices, on at least an annual basis, and document such review and assessment in an annual report that would be provided to the broker-dealer's governing body. The Commission understands that, currently, broker-dealers periodically review their policies and procedures (including those related to best execution), although the frequency of review may vary.
106

However, proposed Rule 1102 would require the broker-dealer to review and assess the policies and procedures it established under proposed Regulation Best Execution, and the Commission believes that these requirements would help ensure the effectiveness of broker-dealers' best execution policies and procedures that are adopted pursuant to the proposed rules.

106

See infra
notes 222, 223, and 224 and accompanying text (describing the minimum frequency standards for review of execution quality under the FINRA and MSRB rules and how broker-dealers may need to review execution quality more frequently than the minimum requirements depending on the circumstances).

Finally, the Commission is proposing to amend Rule 17a-4 under the Exchange Act
107

to include record preservation requirements for records made under proposed Regulation Best Execution.

107
17 CFR 240.17a-4.

The Commission believes that proposed Regulation Best Execution would also enhance its oversight of

broker-dealers through the broker-dealers' best execution policies and procedures required by the proposal, as well as broker-dealers' documentation of their compliance with proposed Regulation Best Execution.
108

108
The Commission believes that Proposed Regulation Best Execution will also provide certain investor protection benefits. As discussed in Section V below, by having its own rule, the Commission will be able to seek certain remedies and other sanctions for violations of the Commission rule best execution violations that are not necessarily available under the current regulatory framework. In general, a best execution rule promulgated pursuant to the Exchange Act will expand and enhance the Commission's flexibility when pursuing best execution violations and produce efficiencies resulting from that greater flexibility.

Request for Comment

The Commission requests comment on its understanding of broker-dealers' current best execution practices, and in particular:

1. Do commenters agree with the Commission's understanding that some broker-dealers currently incorporate various best execution factors from the FINRA and MSRB best execution rules in their policies and procedures? Please explain whether, and the extent to which, broker-dealers currently incorporate those factors in their policies and procedures. For example, do broker-dealers currently incorporate all of the best execution factors from the FINRA and MSRB rules in their policies and procedures?

2. Do commenters agree with the Commission's understanding that some broker-dealers currently preserve information that allows them to support their best execution determinations, such as information to recreate the pricing information that was available at the time of an execution? Please explain whether broker-dealers currently preserve information that allows them to support their best execution determinations, and if so, the type of information that they preserve.

3. Do commenters agree with the Commission's understanding that, currently, broker-dealers' reviews of execution quality vary in rigor? Please explain how broker-dealers currently conduct execution quality reviews of customer orders.

4. Do commenters agree with the Commission's understanding that, currently, broker-dealers periodically review their best execution policies and procedures, but with varying frequency? Please describe how frequently broker-dealers currently review their best execution policies and procedures.

IV. Discussion of Proposed Regulation Best Execution

As discussed in this section IV below, the Commission is proposing Regulation Best Execution, which is consistent with the FINRA and MSRB best execution rules in many respects and is different from those rules in some respects. Proposed Regulation Best Execution would not affect a broker-dealer's obligation to comply with the FINRA or MSRB best execution rule. Accordingly, a broker-dealer would be required to comply with proposed Regulation Best Execution, in addition to their existing obligations to comply with the FINRA and MSRB best execution rules, as applicable.
109

109
For example, where proposed Regulation Best Execution would impose additional or more specific requirements as compared to the FINRA or MSRB rules, a broker-dealer would be required to comply with the additional or more specific requirements under the proposed rules.
See, e.g.,

infra
section IV.A (discussing the application of proposed Rule 1100 to transactions with sophisticated municipal market professionals, which are exempted from the MSRB's best execution rule). Similarly, where FINRA or the MSRB impose more specific requirement than proposed Regulation Best Execution, a broker-dealer would be required to continue to comply with those requirements of FINRA and the MSRB.
See, e.g.,

infra
note 223 and accompanying text (discussing the requirement under FINRA Rule 5310 for broker-dealers to conduct at least a quarterly review of execution quality).

A. Proposed Rule 1100—The Best Execution Standard

Proposed Rule 1100 would set forth the best execution standard for broker-dealers.
110

Specifically, proposed Rule 1100 states that, in any transaction for or with a customer, or a customer of another broker-dealer, a broker-dealer, or a natural person who is an associated person of a broker-dealer,
111

must 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.
112

110
For purposes of this release and proposed Regulation Best Execution, “broker-dealer” refers to a broker, dealer, government securities broker, government securities dealer, and municipal securities dealer, unless specifically indicated otherwise.

111
Section 3(a)(18) of the Exchange Act defines “person associated with a broker or dealer” to mean any partner, officer, director, or branch manager of the broker or dealer (or any person occupying a similar status or performing similar functions), any person directly or indirectly controlling, controlled by, or under common control with the broker or dealer, or any employee of the broker or dealer. 15 U.S.C. 78c(a)(18). Any person associated with a broker or dealer whose functions are solely clerical or ministerial is not included in the meaning this term for purposes of section 15(b) the Exchange Act (other than paragraph 6 thereof).
See id.
Proposed Rule 1100 would apply to a natural person who is an associated person of a broker-dealer, and would avoid the application of proposed Rule 1100 to all associated persons of a broker-dealer, as all associated persons would capture affiliated entities of the broker-dealer and could extend the application of proposed Rule 1100 to entities that are not themselves broker-dealers.

112
FINRA Rule 5310.09(a) states that “[n]o member can transfer to another person its obligation to provide best execution to its customers' orders.” The standard proposed by the Commission in Rule 1100 is consistent with the FINRA rule, and would not establish any exception to allow a broker-dealer to transfer its obligation to provide best execution to another person.

The proposed best execution standard would apply to securities transactions for or with a broker-dealer's own customers, as well as securities transactions for or with customers of another broker-dealer. A broker-dealer that initially receives customer orders may not necessarily be the broker-dealer that engages in transactions for or with those orders. Instead, the broker-dealer receiving the customer orders may utilize the services of another broker-dealer to engage in transactions for or with those orders (
e.g.,
a wholesaler, executing broker-dealer, or clearing firm that handles or executes those orders). Even though the other broker-dealer does not have a direct relationship with the customers of the receiving broker-dealer, the other broker-dealer (or natural persons who are associated persons of that broker-dealer) would be required to comply with the proposed best execution standard because it would be engaged in transactions for or with a customer.

In addition, the proposed best execution standard would apply to transactions for or with a customer, regardless of whether the broker-dealer is transacting for or with the customer on an agency basis or in a principal capacity.
113

For example, the proposed best execution standard would apply to broker-dealers that internalize their customers' orders, as well as to wholesalers or clearing firms that trade

as principal with the customer orders routed to them from other broker-dealers.

113
The proposed application of the standard to both agency and principal trades is consistent with FINRA and MSRB rules.
See
FINRA Rule 5310(e) (stating that the best execution obligations in FINRA Rule 5310(a)-(d) exist not only where the broker-dealer acts as agent for the account of its customer but also where transactions are executed as principal); MSRB Rule G-18(c) (stating that the best execution obligations in MSRB Rule G-18(a)-(b) apply to transactions in which the broker-dealer is acting as agent and transactions in which the broker-dealer is acting as principal). In addition, the application of the existing duty of best execution in both agency and principal transactions is well-established in common law.
See, e.g.,

Newton,
135 F.3d 266, 270 (3d Cir.),
cert. denied,
525 U.S. 811 (1998);
E.F. Hutton & Co.,
Exchange Act Rel. No. 25887, 49 SEC. 829, 832 (1988) (“A broker-dealer's determination to execute an order as principal or agent cannot be `a means by which the broker may elect whether or not the law will impose fiduciary standards upon him in the actual circumstances of any given relationship or transaction.' ”) (citations omitted).

Proposed Rule 1100 would provide exemptions from the best execution standard for a broker-dealer, or a natural person who is an associated person of a broker-dealer, when the broker-dealer is (i) quoting a price for a security where another broker-dealer routes a customer order for execution against that quote or (ii) an institutional customer, exercising independent judgment, executes its order against the broker-dealer's quotation.
114

These exemptions distinguish between a broker-dealer that is acting solely as the buyer or seller of securities (it would be exempt) from a broker-dealer that is accepting order flow from another broker-dealer or institutional customer for the purpose of facilitating the handling and execution of those orders (it would not be exempt).

114
The first proposed exemption is consistent with FINRA Rule 5310.04, which states that a broker-dealer's duty to provide best execution does not apply in circumstances when another broker-dealer is simply executing a customer order against the broker-dealer's quote, and MSRB Rule G-18.05, which states that a broker-dealer's duty to provide best execution does not apply in circumstances when the other broker-dealer is simply executing a customer transaction against the broker-dealer's quote. The second proposed exemption is new. Like the first proposed exemption, the second would exempt a broker-dealer that is acting solely as a buyer or seller of a securities. However, under the second exemption, the broker-dealer would be acting solely as a buyer or seller of securities in transactions directly with an institutional customer. In the corporate and municipal bond and government securities markets, for example, institutional customers often handle and execute their own orders. Institutional customers in these markets commonly request prices from broker-dealers for particular securities (prices for any given security are often not quoted and made widely available) and exercise their own discretion concerning the execution of a particular transaction. In these instances, a broker-dealer is simply responding to the institutional customer's request (
e.g.,
through widely known request for quote (“RFQ”) mechanisms) and the institutional customer is exercising independent discretion over the handling and execution of its orders. Accordingly, the Commission believes that the broker-dealer in these circumstances should be exempted from the best execution standard under proposed Rule 1100. However, in these circumstances, the broker-dealer would still be subject, if applicable, to FINRA Rule 2121 and MSRB Rule G-30 concerning fair prices and the fairness and reasonableness of commission rates and markups or markdowns.
See
FINRA Rule 2121; MSRB Rule G-30.

Proposed Rule 1100 would also provide a third exemption from the best execution standard for a broker-dealer or a natural person who is an associated person of a broker-dealer, when the broker-dealer receives an unsolicited instruction from a customer to route that customer's order to a particular market for execution and the broker-dealer processes that customer's order promptly and in accordance with the terms of the order. In this scenario, the customer has determined the market where it wants to execute its order and is not relying on its broker-dealer to determine the best market for that order.
115

115
This exemption is consistent with FINRA and MSRB rules.
See
FINRA Rule 5310.08 (stating that 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); MSRB Rule G-18.07 (stating that if a dealer receives an unsolicited instruction from a customer designating a particular market for the execution of the customer's transaction, the dealer is not required to make a best-execution determination beyond the customer's specific instruction).

Under proposed Rule 1100, the term “market” could include broker-dealers (
e.g.,
a broker-dealer's principal trading desk), exchange markets, markets other than exchange markets, and any other venues that emerge as markets evolve. The term “market” also could encompass the wide range of mechanisms operated by any given market that a broker-dealer may use to transact for or with customers. For example, markets may include different execution protocols, such as limit order books (some of which may provide for midpoint liquidity), floor auction facilities, or electronic auction mechanisms. This description of “market” is expansive and would require a broker-dealer to take into consideration a broad range of potential trading and market centers and venues that may provide the best market for customers' orders so that the resulting prices to the customers are as favorable as possible under prevailing market conditions.
116

116
This expansive description of “market” is consistent with how FINRA and the MSRB describe the term in their rules, and therefore should be familiar to broker-dealers. In particular, FINRA and the MSRB also broadly construe the term “market” for purposes of their best execution rules.
See
FINRA Rule 5310.02 (stating that “market” encompasses a variety of different venues, including, but not limited to, market centers that are trading a particular security); MSRB Rule G-18.04 (stating that “market” encompasses a variety of different venues, including but not limited to broker's brokers, alternative trading systems or platforms, or other counterparties, which may include the dealer itself as principal). MSRB Rule G-18.04 also states that the term market “is to be construed broadly, recognizing that municipal securities currently trade over the counter without a central exchange or platform. This expansive interpretation is meant both to inform dealers as to the breadth of the scope of venues that must be considered in the furtherance of their best-execution obligations and to promote fair competition among dealers (including broker's brokers), alternative trading systems and platforms, and any other venue that may emerge, by not mandating that certain trading venues have less relevance than others in the course of determining a dealer's best-execution obligations.” Pursuant to FINRA guidance, broker-dealers are also expected to consider new markets that become available as venues to which the broker-dealer could potentially route customer orders for execution.
See
FINRA Regulatory Notice 15-46, at 5. In doing so, broker-dealers should consider the execution quality of venues to which they are not connected and determine whether they should connect to new markets.
See id.,
at 4.

Proposed Rule 1100 would codify, in a Commission rule, a best execution standard that is consistent with how the Commission and the courts have described the duty of best execution over the years.
117

The proposed standard is also consistent with the best execution standards under FINRA Rule 5310
118

and MSRB Rule G-18.
119

However, with respect to municipal securities, while MSRB Rule G-48 exempts transactions with sophisticated municipal market participants (“SMMPs”)
120

from the MSRB best

execution rule, proposed Regulation Best Execution does not include a similar exemption for SMMPs from Rule 1100.
121

Unlike the MSRB rules, proposed Rule 1100 is designed to apply broadly to transactions in all securities and is not limited to transactions in municipal securities. The Commission also preliminary believes that customers that meet the MSRB's definition of SMMP would benefit from the protections offered by proposed Regulation Best Execution, just as customers that do not meet the definition of SMMP or customers that transact in securities other than municipal securities would.
122

At the same time, the Commission believes that proposed Regulation Best Execution contains several provisions that would mitigate the burdens on the broker-dealers that engage in transactions for or with customers that meet the MSRB's definition of SMMP, and proposed Regulation Best Execution would result in similar treatment as MSRB Rule G-18 and G-48 in many instances. For example, as discussed above in this section, a broker-dealer would be exempt from proposed Rule 1100 if an institutional customer is exercising independent judgment and executing its orders against a broker-dealer's quotation, and is not providing the broker-dealer with orders for handling and execution. Additionally, a broker-dealer would be exempt from proposed Rule 1100 if a customer gave the broker-dealer an unsolicited instruction to send its order to a particular market and the broker-dealer processes that customer's order promptly and in accordance with the terms of the order. Finally, as discussed in section IV.B.2 below, if a customer provides the broker-dealer with other instructions concerning the handling of its orders, the broker-dealer's compliance with the best execution standard would be informed by such customer instructions.

117

See, e.g.,
Regulation NMS Adopting Release,
supra
note 21, 70 FR 37538 (stating that the duty of best execution requires, among other things, a broker-dealer to execute customers' trades at the most favorable terms reasonably available under the circumstances,
i.e.,
at the best reasonably available price);
Newton, supra
note 8, 135 F.3d at 270 (noting that a broker-dealer's duty of undivided loyalty to its customer requires that it “seek to obtain for its customer orders the most favorable terms reasonably available under the circumstances”). As discussed below throughout this section IV, the Commission is also proposing requirements designed to help ensure compliance with the proposed best execution standard.

118
FINRA Rule 5310(a)(1) provides that, 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 and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions. FINRA Rule 5310 applies to transactions by any FINRA member in government securities.
See
FINRA Rule 0150(c).

119
MSRB Rule G-18(a) provides that, in any transaction in a municipal security for or with a customer or a customer of another broker, dealer, or municipal securities dealer (“dealer”), a dealer must use reasonable diligence to ascertain the best market for the subject security and buy or sell in that market so that the resultant price to the customer is as favorable as possible under prevailing market conditions.

120
MSRB Rule D-15 defines SMMP by three requirements: the nature of the customer; a determination of sophistication by the dealer; and an affirmation by the customer. Specifically, the rule states that the customer must be: (i) a bank, savings and loan association, insurance company, or registered investment company; (ii) an investment adviser registered either with the Commission under section 203 of the Investment Adviser Act of 1940 or with a state securities commission; or (iii) any other person or entity with total assets of at least $50 million. To achieve a determination of customer sophistication, the broker-dealer must have a reasonable basis to believe that the customer is capable of evaluating investment risks and market value independently, both in general and with regard to particular transactions and investment strategies in municipal securities. Finally, the customer must affirmatively indicate that it is exercising independent judgment in evaluating: (a) the recommendations of the broker-dealer; (b) the quality of execution of the customer's transactions by the broker-dealer; and (c) the transaction price for non-recommended

secondary market agency transactions as to which (i) the broker-dealer's services have been explicitly limited to providing anonymity, communication, order matching, and/or clearance function and (ii) the broker-dealer does not exercise discretion as to how or when the transactions are executed. The affirmation may be given orally or in writing, and may be given on a transaction-by-transaction basis, a type-of-municipal security basis, or an account-wide basis.

121
Additionally, MSRB Rule G-18.09 states that Rule G-18 does not apply to municipal fund securities. While proposed Regulation Best Execution does not contain a similar exemption for municipal fund securities, the Commission believes that the Commission's proposal and MSRB Rule G-18 would result in similar treatment for municipal fund securities. Transactions in municipal fund securities must be executed directly with the issuer. For this reason, there is only one market that can be accessed to fill a customer order in this type of security and, therefore, only one way to comply with Rule 1100 with respect to the handling and execution of a customer order in a municipal fund security.

122
When the Commission approved the MSRB's exemption for transactions with SMMPs from its best execution rule, the Commission stated that the exemption “will facilitate transactions in municipal securities and help perfect the mechanism of a free and open market in municipal securities by avoiding the imposition of regulatory burdens if they are not needed.”
See
MSRB Best Execution Approval Order,
supra
note 47, 79 FR 73664. For the reasons discussed in this section, the Commission believes that the proposed rules are designed to mitigate the regulatory burdens for broker-dealers that transact for or with SMMP customers, while providing the benefit of the protections offered by the proposed rules under appropriate circumstances.

Request for Comment

The Commission requests comment on all aspects of proposed Rule 1100, and in particular:

5. Is the proposed best execution standard appropriate? Why or why not? Has the Commission identified all the differences between the proposed best execution standard and the standards under FINRA Rule 5310 and MSRB Rule G-18? If not, please explain any differences that the Commission has not identified and any potential issues resulting from those differences.

6. Are the differences between the proposed best execution standard and the standards under FINRA Rule 5310 and MSRB Rule G-18 appropriate? Why or why not?

7. Do commenters agree that proposed Rule 1100 is consistent with prior Commission statements, including those described in section II.B above? Why or why not? If not, should the Commission revise any of its statements in light of the proposal? Please explain.

8. Do commenters agree that the proposed best execution standard should apply to natural persons who are associated persons of a broker-dealer? Why or why not?

9. Are there alternative definitions of “natural person who is an associated person” that the Commission should use instead? Is the application of proposed Rule 1100 appropriately limited to “a natural person who is an associated person” of a broker-dealer? Please explain.

10. Would the proposed best execution standard pose any challenges or burdens for entities that are dually-registered broker-dealers and investment advisers? As discussed above,
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an investment adviser has its own duty to seek best execution of a client's transactions where the adviser has the responsibility to select broker-dealers to execute client trades. What effect, if any, would the proposed best execution standard have on investment advisers and their duty to seek best execution?

123

See supra
note 11.

11. Are there elements of an investment adviser's duty to seek best execution that are relevant in assessing the proposed best execution standard for a broker-dealer?

12. Is it appropriate to provide an exemption from the proposed best execution standard to a broker-dealer when another broker-dealer is executing a customer order against the first broker-dealer's quote? Why or why not?

13. Is it appropriate to provide an exemption from the proposed best execution standard to a broker-dealer when an institutional customer, exercising independent judgment, executes its order against the broker-dealer's quotations? Why or why not?

14. Should the Commission define “institutional customer” for purposes of proposed Rule 1100? If so, how should “institutional customer” be defined? For example, should the Commission define “institutional customer” as any person that is a qualified institutional buyer (“QIB”) as defined in Rule 144A under the Securities Act of 1933?
124

Why or why not?

124
17 CFR 230.144A (defining “QIB” to mean a variety of entities such as insurance companies, investment companies registered under the Investment Company Act of 1940, and investment advisers

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2022-27644. Public record. Not legal advice.