If you trade securities in the stock market, the best execution rule from FINRA (Financial Industry Regulatory Authority) impacts you. Or, more accurately stated, the best execution rule protects you and your clients from conflicts of interest that can arise from the trade execution process.
What is best execution?
Best execution is a broker’s legal obligation to choose the trade execution routing method that provides the most favorable terms possible for the customer. Both the Securities and Exchange Commission (SEC) and FINRA mandate and enforce best execution, as detailed in FINRA Rule 5310.
At its core, the best execution rule protects consumers from conflicts of interest. As a broker, you choose where to route trade orders. As you know, the various exchanges and market makers that execute trades may offer different terms. Transaction price, execution speed, ability to fulfill sizable transactions, transaction confidentiality, and settlement capabilities can all vary by trading venue. But here’s where the conflict of interest comes in: Some trading firms may be offering you incentives, rebates, or free research services in exchange for deal flow.
Best execution prohibits you from choosing trading routes based on compensation you may receive, or any factor other than the best interests of your customer. More specifically, you must use “reasonable diligence” to select the trading route that’s most advantageous. That reasonable diligence should consider pricing along with the order size, execution speed, the security’s trading volume and volatility, the firm’s settlement processes, and whether you have access to other markets.
In other words, it’s not enough to lock in on the lowest price. The SEC views “most favorable terms” more comprehensively, meaning what’s best overall for the customer in that situation.
How does best execution work?
A broker’s obligations under FINRA Rule 5310 are extensive. They go well beyond the trade execution process. For example, a broker must:
- Regularly evaluate partner trading firms on execution quality
- Publish and enforce internal policies to ensure best execution
- Regularly review execution quality of preferred trading firms
- Disclose payments and other incentive arrangements with trading firms to customers
Internal best execution policies provide the framework for individual brokers to achieve best execution consistently. They define how trading partners are selected and reviewed, for example. The process typically evaluates trading partners on:
- Ability to handle large trades
- Speed of execution
- Transaction costs
- Transaction confidentiality
- Settlement capabilities
- Potential for conflicts of interest including revenue-sharing deals, rebates, and delivery of services that don’t benefit the client
A rigorous approval process for trading firms is only part of the puzzle, however. A broker has multiple approved trading partners, so best execution policies will also establish how to choose one for an individual customer transaction. And, to ensure that brokers are effectively achieving best execution, internal policies should define how customer orders are audited for execution quality.
Where brokers are falling short
A risk alert published by the SEC in 2018 found some commonly recurring violations of the best execution obligation, such as:
- Failing to conduct best execution reviews
- Not considering relevant factors in the reviews that were conducted
- Not comparing partners’ execution quality to competitors’
- Not disclosing best execution practices or incentive arrangements to customers
- Not following internal best execution policies
- Not establishing sufficient best execution policies
Why is best execution important?
Best execution is important because many individual investors are in the dark about the complexities of trade execution. They may not know brokers can choose how to execute a trade or that brokers may be receiving payments for using certain trading venues. Worse, individual investors may not realize there are financial implications to choosing one trading firm over another. For example:
- One trading venue might offer a better price
- Slower execution can lead to missed opportunities
- Information leaks can inhibit your ability to complete the customer’s transaction successfully
- Less reliable settlement processes can delay receipt of proceeds after a sale
Unfortunately, individual investors cannot monitor execution quality on their own. Without the best execution rule, customers wouldn’t know if a subpar trading venue is paying their broker for customer orders. They also wouldn’t know that they may be paying higher transaction prices because there’s a revenue arrangement between the broker and the subpar trading firm.
Robinhood’s best execution failure
In December of 2020, the SEC charged trading app Robinhood with failure to satisfy its best execution obligation. Robinhood offers free stock trades to its customers, but earns revenue payments from the firms it uses to execute trades. The SEC complaint revealed that those firms were not providing competitive transaction prices to Robinhood’s customers. Specifically, between 2015 and 2018, Robinhood’s inferior execution process cost its customers $34.1 million in aggregate. And that is after considering the savings customers realized from not paying commissions on their trades.
Additionally, the SEC says Robinhood repeatedly made misleading statements or omitted information from customer communications regarding its execution processes. For example, the company did not disclose that it received payments for routing trades to specific firms. Robinhood also claimed that its execution practices were as good as or better than the competition’s.
Robinhood did not admit to the SEC’s findings, but the company did pay a $65 million civil penalty. The brokerage also agreed to hire an independent consultant to review and enforce its best execution practices.
Citadel’s best execution case
In 2017, Citadel paid the SEC $22.6 million to settle best execution charges. The SEC says Citadel knowingly executed customer trades at less favorable pricing when a better price was available. Behind the scenes, Citadel used two algorithms to execute trades. One would identify when a stock order had better pricing on a faster private data feed. The other would execute the customer order at a less favorable price on a slower data feed. The company did not disclose the use of these algorithms to its customers.
12b-1 fees and best execution
The SEC has also filed best execution charges against brokers for recommending mutual funds with 12b-1 fees and revenue sharing arrangements with the clearing broker. A 2020 case against SCF Investment Advisors is an example. The SEC argued that the funds SCF recommended had less favorable terms for the customer vs. funds without 12b-1 fees. SCF did not disclose the fees to the SEC as required by the Share Class Selection Disclosure Initiative.
Put your clients’ interest first in every regard
The SEC takes your best execution obligations very seriously. It’s likely that regulatory oversight and efforts to ensure customers’ interests are protected will only increase going forward. Putting your customers’ needs first in all aspects of what you do is good for your customer relationships, but also a good defensive strategy for you.
One step in this direction is to ensure you’re aware of all financial strategies available to your customers. Life settlements, for example, are a frequently overlooked investment approach that fits nicely within the portfolios of high-net-worth clients. Check out our Life Settlement Investment Guide to learn more about this option, or contact us today to get started with life settlements.
