Is This The Best Execution We Can Get?
Dec. 14, 2022
Thank you, Mr. Chair. A broker’s best execution obligation is one of its fundamental duties to its customers. The customer relies on the broker to exercise its judgment to figure out how best to execute a trade to achieve the customer’s objectives. The broker, as agent, must follow its principal’s—meaning its customer’s—orders and, as articulated in judicial precedents going back at least to the nineteenth century, must do so in good faith.
Today, we are proposing to supplant brokers’ judgment with our own step-by-step guide to achieving best execution. In the process, we are drawing sweeping conclusions about execution quality in equity markets, options markets, corporate bond markets, municipal markets, and crypto markets. Although I could have supported a principles-based Commission best-execution rule proposal, I cannot support this proposal, which is unduly prescriptive and seems less concerned about whether customers actually get best execution than if brokers implement a checklist that the Commission itself is not confident will help brokers achieve even better—much less best—execution.
The principal-agent problem is a perennial one. Brokers’ interests do not always align with those of their customers. Some conflicts are as old as our markets, but others are new or particularly hard to detect, a reflection of the complexity of today’s markets. With commissions falling and technology and compliance costs rising, running a profitable brokerage business is challenging, and meeting this challenge can intensify conflicts. Yet, tools for achieving and measuring execution quality are improving—indeed, we have proposed at least two that purport to do so already today—and these tools make it easier for customers to hold their brokers’ feet to the fire.
An appropriately-crafted SEC best execution rule also could play a role in holding brokers accountable for providing best execution. Although the Commission already has given its views on this obligation and both FINRA and the Municipal Securities Rulemaking Board (“MSRB”) have best execution rules, today’s proposal would codify this obligation at the Commission level for the first time. Under the proposed rule, a broker or dealer, or a natural person who is an associated person of a broker or dealer, would be required to use reasonable diligence to ascertain the best market for the security, and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions. That core obligation appropriately draws on the principles outlined in the time-tested FINRA and MSRB rules. But the proposed rule does not stop there. It applies to all institutional and retail customers; it imposes detailed policies and procedures requirements; it requires a “regular review of execution quality”; and it mandates creation and presentation to the broker-dealer’s board of directors of an annual report that discusses the effectiveness of the firm’s best execution policies and procedures.
The proposed rule provides a handy checklist for SEC examiners and enforcement attorneys, but it does not foster brokers’ exercise of judgment to achieve what is best for customers. Best execution cannot be reduced to a checklist. Indeed, a checklist mandated by the Commission invites a culture of check-the-box compliance that does little to improve execution quality. Instead, it may promote broker and regulatory complacency about working creatively to get the best execution possible for customers.
Institutional customers arguably do not need the protection of a best-execution rule, particularly one as prescriptive as this proposal. The proposed rule makes price the primary objective of the broker. Institutional investors may have other important objectives, such as speed and minimizing the effect on price. The rule makes it hard for institutional brokers to tailor best execution to a customer’s objectives.
Retail customers also may find that the proposed rule does not serve their best interests. Many retail brokers are going to be subject to the proposed rule’s heightened standard for conflicted transactions because they likely receive “payment for order flow,” either in the form of payments from wholesalers or rebates from exchanges. A retail broker can eliminate the conflict if it stops receiving payments or rebates or develops systems to pass those payments and rebates on to customers. These changes, however, may require it to alter its business model in other ways, such as by relying more heavily on other revenue sources, including commissions, paid by the customer. The release does not take serious account of the potential for increased commissions when it assesses likely changes in execution quality, even though it seems that any estimate of execution quality, particularly in a rulemaking like this, should take the per-share cost of commissions into account. At some points in the release, the discussion hints that a broker-dealer, to meet its requirements under the rule, should convert PFOF into price improvement. Why is withholding price improvement from the customer worse than charging the customer a (likely higher) commission?
Perhaps such metaphysical questions are irrelevant since retail firms may not have a real choice between continuing to accept payment for order flow or changing their business model. It is not clear how a retail broker-dealer would go about complying with the heightened policies and procedures requirements that apply when there is a conflict. These requirements as interpreted in the release are so detailed and complex that the Commission’s discussion of its expectations for how retail brokers will comply with them spans over thirty pages and includes separate discussions of its expectations for firms handling customer orders in NMS stocks, options, and fixed income securities.
A particularly troubling example of the daunting task these broker-dealers will face is the requirement that they evaluate a broader range of markets beyond those identified as “material potential liquidity sources.” Under the proposed rule, every broker would have to look at “material potential liquidity sources,” but conflicted retail brokers would have to “evaluate a broader range of markets, beyond those identified as material potential liquidity sources, that might provide the most favorable price for customer orders, including a broader range of order exposure opportunities and markets that may be smaller or less accessible than those identified as material potential liquidity sources” (emphasis added). Requiring firms to look for immaterial liquidity sources is neither sensible nor protective of retail customers. Why not simply require conflicted brokers to exercise greater diligence in light of the conflict?
A footnote that attempts to reassure conflicted broker-dealers that they need not connect to every venue or buy all the data will offer little comfort to the cautious compliance officer trying to figure out when she has fulfilled the obligations imposed by rule. Rather than spending her time crafting a reasonable approach to managing her firm’s unique conflicts, she will worry about proving to examiners that she has met the Commission’s impossible standard. The winners of course will be the tiny trading venues that play on this earnest compliance officer’s anxieties and convince her to connect to their data feeds just in case her firm might find a great price there one day.
In the course of attempting to justify the rule’s prescriptions, the proposing release covers a lot of territory. The release finds itself musing about customer execution quality across different asset classes and how the proposed rule would improve it. An asset-class specific discussion would not be necessary if the rule were principles-based and thus inherently flexible enough to apply to any asset class. The release even stops for a moment to remind crypto firms to come in and register. The baseline in the economic analysis occupies many pages and offers many data-laden tables. The release is thinner when it comes to assessing how the rule alone, or in combination with the other rules on today’s dockets, will change markets and affect investors. I hope that commenters will help us discern the shape of the future as we have proposed it.
It has been a long day and a long year for our rulemaking staff. Thank you to all of the staff in the Divisions of Trading and Markets and Economic and Risk Analysis, the Office of General Counsel, and elsewhere in the Commission for your commitment to this project. My disagreement with some of the policy choices does not diminish my appreciation for the difficulty of the task and your diligence in carrying it out.
 Francis J. Facciolo, “A Broker’s Duty of Best Execution in the Nineteenth and Early Twentieth Centuries,” 26 Pace L. R. 155, 162 (2005).