The Securities and Exchange Commission should reassess broker-dealers’ best execution obligations and the Order Protection Rule it created as part of the Regulation National Market System (NMS) rules created in 2005, according to SEC Commissioner Elad Roisman.
The SEC takes BDs’ obligation to obtain best execution for their clients and their orders “very seriously,” he said Thursday at the Securities Industry and Financial Markets Association Equity Market Structure Conference in New York, referring to those obligations as “one of the cornerstones of market integrity.”
Although best execution was meant to be principles-based and considered on an “order-by-order basis,” he said, “I think the commission should consider setting forth a non-prescriptive interpretation or guidance of the regulatory requirement to achieve best execution.”
While the “premise of best execution is to seek the most favorable terms for a customer’s transaction under the circumstances,” Roisman explained, the reality is that in “many circumstances, price and speed ultimately may be determined at inputs after a broker analyzes its regulatory best interest requirements.”
Plus, there are issues beyond price and speed that determine best execution for a client’s orders, he said, like size, availability of information, trading characteristics for the security, transaction costs and ease of getting it filled.
Meanwhile, the Financial Industry Regulatory Authority cites factors such as price improvement opportunities, the likelihood of executing limit orders and client needs and expectations, Roisman noted.
“Price is relatively cut and dry, but price is just one factor in a best execution analysis, not only when firms make routing decisions, but also when regulators review those decisions after the fact,” he said.
The SEC commissioner also questioned whether regulators should focus more on outcomes and if there should be a combination of approaches, including some with a safe harbor for certain outcomes.
“I think investors, our markets and the industry as a whole would benefit from this commission saying more on broker best execution, especially if the current lack of guidance may hinder the ability of firms to satisfy best execution in a flexible, practical and principle-based manner,” he said, adding that further guidance is needed.
Roisman also was interested to hear from BDs about whether or not the Order Protection Rule had inhibited certain trading behavior that may have otherwise achieved best execution or, even worse, if OPR had required other behavior that may have even impeded best execution.
“I’d like the commission to take a closer look at the rule and its effects on our markets and to consider whether minor adjustments or more significant changes are appropriate” for OPR, he said.
When the SEC approved Reg NMS in 2005, it “could not have envisioned that 14 years later there would be 13 active equity exchanges with a 14th recently approved and two more rumored in the works as well as more than 30 alternative trading systems,” the commissioner explained.
It’s just not clear if OPR today is really best for investors, brokers and the exchanges themselves — or if it’s even still needed, he added.
In addition, Roisman highlighted a few ways the SEC could update OPR, such as by creating an exemption for block-size orders or having it apply only to exchanges that reach a specific minimum average daily volume level during a set period.
But he added: “These are just a few ideas to spur conversation. Let me be clear, I’m not committed to any [one] of them.”
Striking a cautious note, the regulator said it was important to consider how any changes in one area of the market could affect other areas of the market. “It’s fitting that ‘Equity Market Structure Season’ begins in the autumn, when we all pull sweaters out of our closets,” he said. “I often think of the laws and regulations that govern our industry like the woven threads in a sweater.
“Pulling to tighten one, typically loosens another elsewhere. Sometimes those effects are intended and other times, however, they’re not. And the unintended effects may even be more significant than those we had aimed to produce in the first place,” Roisman explained.
This challenge factors into his decision-making when considering new or amended rules and guidance for the markets and their participants, he pointed out.
Later at the conference, Brett Redfearn, director of the SEC’s Division of Trading and Markets, echoed some of Roisman’s concerns: “We’re very focused on best execution” at his division, he said. But when people talk about defining it, that’s “really hard,”
For the retail side of the BD market, best execution is “probably a lot easier” than for the institutional side, where it’s “very conditional and much more challenging,” Redfearn said.
When dealing with institutional trading, for instance, “There [are] so many different variables that come into play that I think that we would be remiss for an institutional order to try to define best execution,” he told attendees.
As for the definition of best execution in Rule 605 tied to a retail order, “that rule is a little old and can be updated and probably could use help in some areas,” Redfearn explained; for example, the rule’s “time stamp conventions are pretty dated.”
At the same time, the SEC is also “extremely focused” on the no-action relief under the Broker-Dealer Customer Identification Program rule that is set to expire next summer, he said.
The SEC issued a no-action letter in 2018 that allows BDs to rely on investment advisors to perform some or all of their Customer Identification Program (CIP) obligations under federal anti-money laundering legislation. The letter extended existing relief (granted in 2016 and set to expire last year); and the no-action letter is now set to expire at the end of 2020.
The SEC has held “a lot of meetings with a lot of the folks in this room and others about the concerns around the no-action relief expiring,” Redfearn told attendees.
He added that the commission was “significantly engaged in trying to find a solution to this [and,] hopefully, we’ll be able to deliver some more concrete information on this soon.”
Pointing out that the SEC was aware of BD’s desire for clarity, Redfearn concluded: “We continue to look at the question of extending the no-action relief for a longer period of time.” Regulators, though, haven’t determined yet exactly how long that extension will be.
— Check out Clayton: SEC Plans to Update Equity Market Rules This Year on ThinkAdvisor.