Regulation Best Ex: Investors’ ‘new bestie’ or just extra hassle?

In an explainer video posted recently on the Securities and Exchange Commission’s (SEC’s) YouTube channel, chair Gary Gensler introduces viewers to a new rule proposed by the Commission: Regulation Best Execution. Armed with an inoffensive soundtrack, quirky animations, and some dubious puns, Gensler sets out what the rule proposes to do and why investors should care. “Best ex might just turn out to be investors’ new bestie,” he quips.

Not all market participants are as upbeat as Gensler. The thousands of public comments that have been submitted to the SEC on the reform package put forward in December 2022 paint a mixed picture of the proposed rule.

The principle of brokers putting a client’s interests first is widely applauded in the letters, and some commentators—particularly members of the public—also endorsed the way in which the SEC plans to go about putting it into practice. But others raised concerns about the potential administrative burden for broker-dealers, the exact definition of best execution, and whether there is any need for the SEC to take a position on the matter.

Comment letters submitted by the broker-dealer community have described the Commission’s proposals as “onerous,” “superfluous,” “unreasonable,” and “the definition of arbitrary, capricious action.”

In short, best execution is a broker-dealer’s obligation to seek the most favorable way to execute a client’s order. The SEC’s rule seems to be particularly aimed at retail brokers who send order flow on to wholesalers. It would require these retail brokers to compare the prices that wholesalers currently offer their clients with other prices available elsewhere on the market.

Broker-dealers would also be obliged to publish their policy on best execution, which may be aimed at cracking down on payment for order flow (Pfof), when brokers send their orders to a certain market maker to execute in return for money.

The notion of best execution is not controversial in and of itself. Indeed, it became an industry-wide obligation as early as 1968, when the National Association of Securities Dealers (the predecessor of Finra) brought in the first best execution rule. Finra still has a best ex requirement, as does the Municipal Securities Rulemaking Board (MSRB) in the municipal bonds market.

“Think of it as the Hippocratic Oath for the financial services industry. By definition, if you’re a trader on the buy side or on the sell side, you should be striving to get the best possible outcome every time you trade,” says Andrew Morgan, president and chief revenue officer of TS Imagine.

So what exactly will this rule change, and why has it created such a stir?

Electric boogaloo

In the draft text for the proposed rule, the SEC cites the electronification of securities markets, arguing that broker-dealers are now better placed to consider a range of “liquidity sources and price improvement opportunities which may provide customers with the most favorable price.”

“As markets become increasingly digitized, sophisticated and high-frequency, it becomes all the more important to have a digital audit trail of everything that’s happened. Electronic trading lends itself to satisfying a lot of these criteria,” Morgan says.

The idea is to create a verifiable record of transactions, cataloging prices received, transaction outcomes, and audit trails to increase the accountability of broker-dealers and phase out verbal price quotes as a basis for execution choices.

This implies some significant technical changes to the way the market operates. According to data cited by the SEC, retail broker-dealers currently route more than 90% of their customers’ marketable orders to wholesalers. Any rule obliging retail broker-dealers to show their workings on every one of those orders and potentially send them to alternative venues will entail some degree of upheaval.

Precisely how much would change under the proposed rule depends on some key details on which the SEC has not yet decided. For example, how prescriptive will the rule be in stipulating what retail brokers must do to demonstrate best ex? How many different market-makers will retail brokers have to query, and what process can they use to determine which is the best option for customers? The answers to these questions could also determine how much executing brokers will have to change their business models if the rule comes into force.

“Will it be a very strict rule which is set in stone? Or will it be more of a guideline, where the executing broker must adapt to be competitive? If it’s the latter, there would need to be a lot of intelligence in the technology that retail brokers use, akin to what we see in smart order routers,” says Sylvain Thieullent, CEO of Horizon Software. “This technology costs a lot, but it’s also a broker’s secret sauce, allowing each broker to have their own unique approach to order handling.”

In Europe, under the Mifid II framework that updated Europe’s best execution requirement, firms had to publish periodic data on the quality of their execution and detail how they arrived at their decisions. As a result, the number of fields needed to execute a client order went from around a dozen to more than 50. A similarly burdensome process could await broker-dealers operating in the US if the Regulation Best Execution is adopted.

“You need to store that data and then you need to report it to a designated entity (the Approved Publication Arrangement [APA] in the case of Mifid). So the technological implications could be quite significant. The cost of making an order/execution management system (O/EMS) Mifid II-compliant triggered a price increase of between 5% and 10% per year. … And that’s just for reporting,” Thieullent says.

The concern is that the actual overarching objective of this proposal is to just cut wholesalers out of the workflow for the execution of retail orders

Head of policy at a firm that handles a large portion of retail trading

The proposed best execution standard could also be expensive for the regulator. The estimated budget for the rule currently stands at around $700 million.

It’s not yet clear how the SEC plans to enforce the best execution obligation. One obvious but resource-intensive approach would be for the Commission to store all of the market’s execution conditions, audit them, and then trigger an inquiry whenever best execution does not appear to have been met. But processing this amount of data would be very costly.

An alternative would be for the SEC to tell retail brokers to store data on their own execution conditions as part of the audit trail, reserving the right to check the records kept by brokers to see how well they are implementing the best ex rule.

“There’s very little technical challenge in this route, except for tracing different kinds of systems for each inquiry. But regulators are used to that,” Thieullent says.

If it ain’t broke …

One argument in favor of the current system, which sees most retail orders routed to wholesale brokers, is that this often results in price improvements for the end customer. As it stands, retail investors can make unlimited size orders in around 10,000 listed stocks and ETFs, often with no commission. With the proposed Regulation Best Execution appearing to disincentivize routing to wholesalers, brokers warn that retail trades could get more expensive.

“I think the market has evolved in the way that it has because it’s so good for the retail trader. Their commissions have moved to zero. Yes, it’s a profitable game for the Citadel Securities and the Virtus of this world, but keep in mind that their execution generally is better than the execution prices that institutions would even be getting,” says Jeff O’Connor, head of market structure, Americas, at Liquidnet.

In the text for the proposed rule, the SEC recognizes that marketable orders routed to wholesalers appear to have higher fill rates, lower effective spreads, and lower E/Q ratios. It also notes that orders sent to wholesalers are more likely to receive price improvement.

“The Commission acknowledges that some retail customers could pay more for their transactions when, in reducing its conflicted transactions, a broker-dealer changes order-handling practices to route to destinations that may not always provide the same price improvement,” says the proposed rule.

Data collected by the SEC shows that wholesale broker-dealers delivered more than $3 billion in price improvements for retail orders in 2022. Research by academics from the University of Notre Dame and Indiana University suggests that the real figure could be more like $15 billion if inaccuracies in best execution reporting data are taken into account.

The SEC has acknowledged these inaccuracies, and proposes to improve best execution reporting alongside Regulation Best Execution itself. But critics say the data from reporting that the SEC acknowledges to be flawed should not be used as a basis for changes to market structure that could leave the retail investor out of pocket.

“The concern is that the actual overarching objective of this proposal is to just cut wholesalers out of the workflow for the execution of retail orders. Instead, retail broker-dealers would have to route all their orders directly to an exchange or ATS themselves. I think it should be abundantly clear that this is not a good outcome for retail investors, and that’s what’s causing a lot of people to scratch their heads,” says a head of policy at a firm that handles a large portion of retail trading.

The notion that the SEC has not presented a convincing analysis of the potential costs and benefits of introducing a best execution rule also crops up regularly in comment letters. A letter submitted by the Securities Industry and Financial Markets Association (Sifma) states that “the Commission has not articulated a single quantifiable benefit that would result from the adoption of Reg Best Ex or that would justify the significant costs and burdens to broker-dealers (and, in turn, investors).”

And it was not only broker-dealers who questioned the need for the rule in its current form. Buy-side institutions and some exchanges also raised concerns.

Nasdaq’s comment letter, which focuses on the need for any reform to support a robust national best bid and offer (NBBO), calls for changes to be implemented incrementally. It asks that the new rule do more than “merely add a new layer of bureaucracy to the existing best execution regimes,” and suggests that the SEC clarify the standards which brokers will be expected to comply with, to avoid setting them up for regulation by enforcement.

“We’re very supportive of evolutionary change to markets. Technology changes, lots of other variables change, so markets and regulations need to adapt as well,” says Chuck Mack, vice president and head of US equities and strategy for North American trading services at Nasdaq.

Would the real Best Execution please stand up?

One of the big question marks hovering over this rule is how the SEC would define best execution. As it stands, brokers can decide which criteria are the most important when executing a client’s trade—it could be price, speed of execution, time for settlement, size of trade, or any combination of these things. Different clients also have different priorities, which they will often communicate to the broker-dealer before their trades are executed.

“It’s not always apples to apples. My bogey if I worked at one buy-side firm might be my arrival price. Another one might be volume-weighted average price (Vwap). Another might be the price at 10 o’clock the following day. Everyone has different bogeys, and they have to figure out what they think is best execution,” Liquidnet’s O’Connor says.

The bigger single-dealer platforms enjoy outsized market share, but if they weren’t performing, you could just turn that spigot on and off and potentially their business is hurt. So I think it just polices itself

Jeff O’Connor, Liquidnet

Broker-dealers say they already have to show their customers what execution quality they are receiving, including their spread savings and the types of markets their orders are sent to. The same is true of wholesalers and single-dealer platforms (SDPs)—broker-dealers that act as the counterparty for trades made on their platform. If they are failing to provide good execution quality, brokers say, customers will simply switch to a different market-maker.

“The bigger single-dealer platforms enjoy outsized market share, but if they weren’t performing, you could just turn that spigot on and off and potentially their business is hurt. So I think it just polices itself,” O’Connor says.

It remains to be seen what heightened requirements retail brokers would have to comply with under the proposed regulation when sending orders to wholesalers and SDPs to be executed as principal. WatersTechnology sources say that any solution involving retail broker-dealers getting price improvement guarantees from wholesalers prior to sending them an order would be very hard to implement.

“Our read right now is that it would be a difficult exercise to undertake documenting and achieving compliance with these heightened requirements for conflicted transactions in order to maintain some semblance of the current market structure. Is [routing orders to wholesalers] explicitly prohibited in the rule? No. But in practice, that seems to be the objective,” says the head of policy.

Nor is it clear how the SEC plans to define best execution, although speculation is rife. The Order Protection Rule under Regulation NMS states that exchanges and other trading venues cannot execute an order if there are better prices displayed for the same securities elsewhere. Some commentators have pointed to that rule as a precedent for best execution meaning simply best price, a prospect that will alarm brokers.

Last Tuesday, April 18, the SEC’s Gensler appeared at a hearing before the House Financial Services Committee, now under Republican management after the midterm elections. He looked considerably less comfortable surrounded by combative lawmakers than in the SEC’s jaunty explainer video for Regulation Best Execution, but he kept a resolute smile throughout the five-hour grilling. Most of the hearing was spent discussing crypto regulations—equity market reform hardly got a look-in. The uninformed observer might think that Gensler has bigger fish to fry than the humble best execution rule. But make no mistake: Regulation Best Execution could have huge ramifications for the market. The SEC has an unenviable task navigating the depth of feeling coming from the industry if it chooses to press on with this rule.