Speech by SEC Chairman:
Best Execution: Promise of Integrity,
Guardian of Competition
Chairman Arthur Levitt
U.S. Securities & Exchange Commission
Securities Industry Association
Boca Raton, Florida
November 4, 1999
A few months ago, I discussed many of the developments unfolding as our markets respond to the forces of competition, technology and globalization. I emphasized the Commission's commitment to a framework that has guided our markets since 1975. This framework has four interdependent elements: competition among markets; transparency of pricing; better linkages between market centers; and best execution of customer orders. It is this framework which will move us closer to achieving a true National Market System.
Today, I would like to focus more closely on the fourth element in this framework: best execution. With more market centers than ever before, the duty of best execution must be woven more fully into the fabric of our markets. It must be at the very core of our promise of integrity to investors a promise that brokers will act in their customers' best interest when they route and execute orders. It must reinforce competition, rewarding those markets that improve their execution quality, and punishing those that don't.
As markets around the world continually evolve, the commitment to integrity, and the innovation spurred by competition among market centers, will be our two-fold competitive edge. The stakes have never been greater for America's markets. We simply cannot afford to let our competitive edge be dulled.
In today's dynamic environment, the duty of best execution presents brokers with new and difficult challenges. I recognize that many of you in this room have risen to meet these challenges, that you strive daily to ensure that your customers receive the execution they deserve. I commend you for your individual and collective efforts.
I worry, however, that the duty of best execution is being neglected by those who fail to review carefully their order routing arrangements. I worry that best execution may be compromised by payment for order flow, internalization and certain other practices that can present conflicts between the interests of brokers and their customers.
Are conflicts in the order routing and execution process diluting the natural forces of competition in our markets reducing price competition and isolating pools of liquidity? The investor interest, the integrity of our markets, and the future of our global preeminence demand that we face these questions, and that we resist any erosion in the duty of best execution.
This is a critical time to ask: What does the fundamental obligation of best execution mean in today's markets and in the markets of tomorrow regardless of what form they take? The impending changeover to decimals will create even more profound challenges for all market participants. And decimalization's impact on best execution could prove to be no less of a challenge.
The Roots of Best Execution
Best execution encompasses a number of factors starting with the price of the execution and the opportunity for price improvement. Other factors include speed and likelihood of execution. For institutional investors, anonymity and liquidity might be overriding concerns. In any case, the quality of execution must always be viewed from the customer's perspective, not the firm's.
At the same time, increased competition among market centers has provided new execution alternatives. Some market centers guarantee immediate automated execution of trades. Others promise the possibility of price improvement. And some use a transparent book which is visible to any customer via the Internet. Where one trading platform might provide anonymity for large orders, another will promise "optimal" executions by searching many market centers for very specific opportunities.
Recently, I called on the SEC's examiners to review how firms are complying with their obligation to seek best execution for retail customers. We have a number of preliminary findings many of them troubling. Some firms appear to be allowing payments for order flow or other inducements to affect which markets they send their orders to at the expense of quality executions. Now, payment for order flow is acceptable if and I underscore if the quality of execution is not sacrificed. But it's becoming increasingly clear that's not always the case.
Some firms, for example, have told us that execution speed is the most important factor in their routing decisions. But some of these firms have not conducted a regular and rigorous review of execution alternatives reviews to determine whether there are other places that offer faster executions, or executions that are just as fast but with a greater likelihood for price improvement. These firms also offer no support for their belief that their customers prefer speedy execution above all else. Sometimes, the invocation of speed rings as a hollow rationalization for selling order flow or capturing the spread on internally executed orders.
Now, I'm sure that some in the industry think that the Commission has a myopic, picayune focus on price improvement. "What's the big deal?" they ask, "if the difference is only 1/16th?" Well, consider these numbers. Assume a broker-dealer receives payment for order flow from a market maker at the rate of a penny a share on a 1,000 share order. By routing the order to that market maker, the broker gives up the possibility of getting 1/16th in price improvement somewhere else. Even if the broker passes along the entire rebate which is unheard of the customer has overpaid by $52.50. To an investor, that's real money.
To discharge its best execution obligation in a meaningfully way, a firm must consider and analyze execution alternatives without regard to the firm's economic self-interest. Some firms are currently asking the different market centers for execution quality statistics, including speed of execution and percentage of price improvement. Others route "test trades" to gather the same data. These are encouraging steps on the road toward better markets.
Externalities: Conflicts and Inefficiencies
When a broker-dealer sells customer order flow to a designated market maker or exchange, the question of whose interest is being served the broker's or the customer's is squarely raised. The same question arises when a broker-dealer executes buy and sell orders in its own book, or routes them to an affiliate, rather than routing orders to a market center that offers consistently superior prices.
In 1995, the Commission decided to require disclosure of payment for order flow rather than prohibit it. While the conflicts it presented were clear, we recognized that the practice may have benefited customers by reducing commission rates. We also felt that payment for order flow was not necessarily inconsistent with the duty of best execution. Indeed, no one can dispute the fact that some of the markets that paid for order flow were at the cutting edge in developing systems that maximized opportunities for price improvement.
The rationale for the disclosure-based approach was clear: greater disclosure produces more informed investors. And more informed investors apply competitive pressure to order flow arrangements, aligning the investor's interest with the broker-dealer's. I believe the decision to push for disclosure was the right one.
Unfortunately, much of today's payment for order flow disclosure, while factually accurate, is just not clear to investors. The typical disclosure does nothing more than list the variety of compensation arrangements that may result when a broker is paid for customer orders. It does an investor little good to learn that his broker may be compensated according to a dozen different criteria, all, some, or none of which may apply. It's like turning to a weatherman and having him tell you it may rain today, but then again, it may not.
The source and the nature of a broker's compensation is more than relevant; it's fair game. And, upon request, an investor has a right to know how his broker is typically paid for executing a trade; to know whether his broker receives a payment for sending orders to a certain exchange; to know if his broker has a profit sharing arrangement with a market center.
The potential harm of conflicts between the interests of brokers and customers extends beyond the broker-customer relationship. Whether it's payment for order flow, internalization, reciprocal arrangements of any kind, rebates, or discounts, all of us must insist on the best possible execution of a customer's trade. Anything less undermines the power of competition the backbone of vibrant markets.
Rewarding a market center that has inferior execution quality may compromise the incentive of other markets to innovate and compete on price. Those market centers that pay for order flow or are affiliated with order routing firms through ownership, contract, or otherwise must measure up when held to the bright light of competition. The orders a firm handles must not be held in suspended animation. Aggressive quote competition must always prevail.
Nowhere is this more true than in our options markets. A new, fully electronic market is being developed in the options trading arena spurring greater competition and innovation. Options contracts once listed on a single exchange are now the subject of increasingly robust intermarket competition. Spreads narrowed immediately after multiple listing occurred, and remain thinner to this day. We examined trading in 81 options that recently became multiply listed and found that 76 percent have experienced a narrowing of 15 percent or more since August.
As in our equity markets, competing market centers have made the duty of best execution even more critical. Linkages, designed and implemented to facilitate best execution, must be these exchanges' foremost priority. Swift and certain progress towards the establishment of trade rules preventing inferior executions, and the prompt display of limit orders, are immediate necessities.
These are tall orders, but progress is long in coming. I am confident that the most vibrant competition is within our grasp. A commitment to best execution dictates that we refuse to tolerate further delay in any of these vital areas.
And I want to sound a note of caution about troubling signals coming from our options markets today. Some seem intent on introducing externalities payment for order flow and internalization into the options markets. I see the reports of joint ventures between options order flow providers and options specialists where profits on order flow are to be shared. Rest assured, we will guard the promise of a competitive, free and fair options marketplace.
Execution Quality at the Market Level
Quality of execution, however, does not rest solely with broker-dealers. Market centers including ECNs also have a responsibility to monitor their price setting functions. The efficiency and integrity of our markets today is due, in no small part, to the efforts of our major markets to honor execution quality. The NYSE, in many respects, has been and remains a standard setter in the area of price improvement. And currently Nasdaq is exploring promising ways to promote greater interaction among customer orders.
But there is room for improvement. One example comes to mind: Nasdaq's opening period. Today, widely disparate prices sometimes prevail during this period, compromising the quality of executions that some investors receive. This is unacceptable.
A unified opening on Nasdaq is both possible and long overdue. I am happy to report to you today that the NASD has committed to address this problem recently. The Quality of Markets Committee has made this a top priority. We will hold them to this pledge. All markets must continue to guard the integrity, and continually enhance the technology, of their pricing mechanisms.
Equally important, markets must join forces with other market participants to confront the widely scattered prices of varying quality that investors now encounter in the after hours market. This uncharted territory presents perhaps today's most formidable challenge to fulfilling the duty of best execution. The admirable restraint and responsibility that the major markets have shown, coupled with transparency and linkages, continue to offer the best approach to this challenge.
As I mentioned earlier, with the changeover to decimals slated for the middle of next year, the way we think about and execute customer trades may result in nothing less than a watershed for our markets.
Quote competition will no doubt be transformed as smaller pricing increments become a market reality. Competition unleashed with an efficiency and an expanse witnessed only once before by the unfixing of commissions may drive spreads in some securities to razor-thin proportions.
Best execution may also be reshaped by this new market imperative. Fundamental questions await us. As spreads narrow, some are asking whether searching for a penny of price improvement serves the average retail investor's interest? Will the significance of price improvement depend increasingly on the size of the trade or the spread involved? Should the notion of materiality serve as the touchstone for brokers as they evaluate customer preferences? Should brokers be able to step ahead of a customer's order with a penny's price improvement and, if so, will this reduce the incentive to enter limit orders?
Now is the time for all market participants to contemplate, to consider, to prepare as best we can for the impact that decimalization will have on our markets. Whatever changes we face, the core of our approach must remain constant: no market restructuring, no matter how far-reaching or profound, can pull the roots of best execution from the ground of the investor interest.
Toward Greater Transparency of
Amidst today's current of change and tomorrow's promise of no less, now is not the time for rulemaking regarding order execution. We must not enter the millennium handcuffed by potentially cumbersome, and perhaps even soon outdated, restrictions. But future uncertainties should not put the duty of best execution on hold. Rather we should use this time of change to think creatively about ways to realize more fully the promise of best execution.
In the past, customers have generally trusted their brokers to make decisions about how and where to execute trades. A new breed of investor, however more informed, more inquisitive, and more in touch with our markets than ever before is being spawned by the information age. New technologies and faster, cheaper computing power make it even more possible to include customers in the order execution process.
If the SEC's investor education phone lines are any indication, investors would benefit greatly from more information about execution quality. It is the subject of a steady stream of questions received by our Office of Investor Education and Assistance. So I say to firms: Begin a more meaningful dialogue with your customers about the execution of their orders. Think about distributing voluntary, plain English reports to customers illustrating your track records for execution in a quantifiable and meaningful way. Make your execution protocols your standards for handling customer orders available to the public. Let them know whether you emphasize speed certainty, the opportunity for price improvement, or something else.
It goes without saying that, at some point, a customer will sacrifice some chance of a better price for speed and visa versa. You won't find many investors willing to wait a week to get an opportunity in price improvement of 1/8th when the market for the security may have declined by significantly more than 1/8th. On the other hand, I suspect most retail investors would willingly sacrifice 5 or 10 seconds in order to get a chance for price improvement. But in order to make an informed choice about that trade-off, a customer must know what its consequences are.
In that vein, I also appeal to the financial press: Add execution quality to a reporter's beat. Just this month, I read a magazine's survey of brokers that included execution quality in its rankings. To my knowledge, this is the first story of its kind, and an important step towards more informed investors. I see no reason why execution quality should not be included in every future review of retail brokerage services. It is every bit as important as commission rates. Most firms already track their average speed of execution and average percentage of price improvement. A simple, comparative analysis of these factors, along with a description of competing firms' execution protocols, is an easy and important first step.
Finally, I want to say a word about the power of informed investors. Some say execution quality is too complicated, too technical to be of much use to the average investor. I'm just not sure I believe it. Understanding speed of execution and price improvement does not require a Ph.D. or experience on a trading floor. The appetite of retail investors for financial information has far surpassed what any of us in this room would have predicted just a few years ago. Let's not squelch that appetite for information let's help feed it.
Towards this end, the Commission has published on its web-site today guidance that explains the basics of order routing, payment for order flow, and internalization. I say to investors: Learn these basics. Ask your broker for the details of any payment for order flow arrangements. Look beyond just commission costs. Ultimately, you can play a vital role in shaping fairer, more efficient order flow patterns.
Best Execution: Guardian of
Our Global Competitive Edge
I've been coming to this conference for over two decades first as a broker, then as head of a small firm, then a larger firm, an exchange, and now as a regulator. I have been blessed to see so many perspectives of an industry for which I care deeply. And through it all, an ethic has permeated so much of what we do whether it's through a heart that conceives, an understanding that directs, or a hand that executes.
Year after year and challenge after challenge, we have stood together to be counted. We have stood together to seize the mantle of leadership in capital markets around the world. We have stood together to instill a competitive spirit that drives down costs and fuels innovation. And we have stood together to make the promise of integrity much more than a slogan, but a professional way of life.
It is our shared experience which proves something Somerset Maugham
once said: "It is a funny thing about life if you refuse to accept anything but the best you very often get it."
As we embark upon what I hope and expect will be a century replete with opportunity, innovation and drive, let us continue to embrace the principle of best execution, not only for the sake of investors, but for the promise of America's markets in tomorrow's global marketplace. As markets around the world compete for customers and capital, one overriding principle will serve as our competitive advantage: the quality of our markets. And nothing honors this dedication to quality more than a commitment to achieving the best possible execution of any order, by any investor, from anywhere in the world.
Thank you very much.