Customer Order Handling: Best Execution and Order Routing Disclosures

Regulatory Obligations

FINRA Rule 5310 (Best Execution and Interpositioning) requires that, in any transaction for or with a customer or a customer of another broker-dealer, a firm and persons associated with a firm shall use reasonable diligence to ascertain the best market for the subject 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. A firm must have procedures in place to ensure it conducts “regular and rigorous” reviews of the execution quality of its customers’ orders if it doesn’t conduct an order-by-order review.1 MSRB Rule G-18 (Best Execution) sets forth similar obligations with respect to transactions in municipal securities.

Best execution obligations apply to any firm that receives customer orders for purposes of handling and execution, including firms that receive customer orders from other firms for handling and execution.2 These obligations apply whether a firm acts in a principal or in an agency capacity. A firm cannot transfer its duty of best execution to another person. Additionally, a firm that routes all its customer orders to another firm must either conduct its own regular and rigorous review of the execution quality received, or periodically review the statistical results and rationale of the other firm’s regular and rigorous review of execution quality. 

Relatedly, Rule 606 of Regulation NMS requires broker-dealers to disclose information regarding the handling of their customers’ orders in NMS stocks and listed options. These disclosures are designed to help customers better understand how their firm routes and handles their orders, assess the quality of order handling services provided by their firm, and ascertain whether the firm is effectively managing potential conflicts of interest that may impact their firm’s routing decisions.

Recently Adopted FINRA Rule 6151

  • On June 30, 2024, FINRA Rule 6151 (Disclosure of Order Routing Information for NMS Securities) took effect. 
  • Firms are now required to submit to FINRA for centralized publication the order routing reports required under SEC Rule 606(a) (Rule 606(a) Reports).3
  • For additional guidance, please see Regulatory Notice 24-05 (FINRA Adopts Amendments to Improve the Accessibility of Order Routing Disclosures for NMS Securities).

Findings and Effective Practices

Findings

Best Execution

Order Routing Disclosures

  • Inaccurate Quarterly Reports: Publishing incomplete or otherwise inaccurate information in the quarterly report on order routing, such as:
    • inaccurately classifying orders (e.g., classifying orders as “other orders” without considering whether such orders involve a customer request for special handling);4
    • incorrectly stating that the firm does not receive payment for order flow (PFOF) from execution venues;
    • not including payments, credits or rebates (whether received directly from an exchange or through a pass-through arrangement) in the “Net Payment Paid/Received” and “Material Aspects” sections of the quarterly report;
    • not including exchange pricing arrangements (e.g., tiered pricing) in the “Net Payment Paid/Received” and “Material Aspects” sections of the quarterly report;
    • not disclosing any amounts of “Net Payment Paid/Received,” when the firm receives PFOF for at least one of the four order types (i.e., Market Orders, Marketable Limit Orders, Non-Marketable Limit Orders, Other Orders);
    • reporting only held orders in listed options, instead of both held and not held orders;
    • inaccurately identifying reported execution venues as “Unknown;”
    • inaccurately identifying an entity as an execution venue when that entity does not execute trades (e.g., identifying a routing broker-dealer as an execution venue, where the broker-dealer re-routes but does not execute orders; or an options consolidator that does not provide liquidity); and
    • not posting the quarterly report on their firm’s website in both required formats (i.e., PDF and XML schema).
  • Incomplete Disclosures: Not adequately describing material aspects of the firm’s relationships with disclosed venues in the Material Aspects disclosures portion of the quarterly report, such as:
    • inadequate descriptions of specific terms of PFOF and other arrangements (e.g., “average” amounts of PFOF rather than specific disclosure noting the payment types, specific amount received for each type of payment, terms and conditions of each type of payment);
    • ambiguous descriptions of receipt of PFOF (e.g., firm “may” receive payment);
    • inadequate or incomplete descriptions of PFOF received through pass-through arrangements;
    • incomplete descriptions of exchange credits or rebates; and
    • incomplete descriptions of tiered pricing arrangements, including the specific pricing received by the firm.
  • Incomplete Disclosure When Incorporating by Reference: Incorporating by reference another firm’s Rule 606(a)(1) quarterly report with incomplete disclosure of:
    • the firm’s relationship with the referenced firm, including the clearing or execution relationship;
    • the amount and type of order flow routed to the referenced firm;
    • the material terms of PFOF received from the referenced firm;
    • payment from any profit-sharing relationship received from the referenced firm; and
    • transaction rebates received from the referenced firm.
  • Deficient Communications: Not notifying customers in writing of the availability of information specified under Rule 606(b)(1), as required by Rule 606(b)(2).5
  • Not Held Customer Reports: Failing to provide Rule 606(b)(3) Not Held reports to customers in a timely manner.
  • Insufficient WSPs: Either not establishing or not maintaining WSPs reasonably designed to achieve compliance with the requirements of Rule 606, including:
    • not updating Disclosure of Order Routing Information WSPs to include requirements detailed in Rule 606(a)(1) or Rule 606(b)(3);
    • not describing the steps taken to review whether the firm has verified the integrity of information sent to, or received from, their third-party vendor — or not stating how the review would be evidenced;
    • not articulating a supervisory method of review to verify the accuracy, format, completeness, timely processing, and details of the Rule 606 (b)(1) and (b)(3) reports, if requested, as well as documenting the performance of that review; and
    • when incorporating by reference another firm’s Rule 606(a)(1) quarterly report, not examining the report and having a reasonable basis to believe that the report does not materially misrepresent the order routing practices.

Effective Practices

Best Execution

  • Supervision of Order Flow: Ensuring supervisory procedures, systems and controls address the execution of the entirety of the firm’s marketable order flow, including order types such as activated stop orders, all or none orders, and odd lot orders.
  • Monitoring Orders: 
    • Monitoring the handling of marketable orders of all types fully and promptly, including market orders, marketable limit orders, activated stop orders, all or none orders, odd lot orders, marketable orders in illiquid securities, and marketable orders in preferred securities.
    • If your firm relies on the regular and rigorous review of execution quality conducted by an executing firm, consolidator or other recipient handling customer orders, reviewing to ensure that the statistical results and rationale of the executing firm’s, consolidator’s or other route recipient’s review are fully disclosed to you, and periodically reviewing both the methodology and the results of the review.
  • Exception Reports: Using exception reports and surveillance reports to support the firm’s efforts to meet their best execution obligations. 
  • Full and Prompt Execution of Marketable Customer Orders: Regularly evaluating the firm’s thresholds used to generate exceptions as part of the firm’s supervisory systems designed to achieve compliance with the firm’s “full and prompt” obligations; and modifying such thresholds to reflect current promptness standards for marketable order execution, including statistics available from FINRA, other relevant indicators of industry standards, and the firm’s internal data. 
  • PFOF Order Handling Impact Review: Reviewing how PFOF affects the firm’s order-handling process, including the following factors: 
    • any explicit or implicit contractual arrangement to send order flow to a third-party broker-dealer; 
    • the terms of these agreements; 
    • whether it is on a per-share basis or per-order basis; and 
    • whether it is based upon the type of order, size of order, type of customer or the market class of the security.
  • Risk-Based “Regular and Rigorous Reviews”: Conducting “regular and rigorous” reviews on a quarterly or more frequent basis (such as monthly), depending on the firm’s business model, that consider the potential execution quality available at various trading centers, including those to which a firm does not send order flow.
  • Support of Analysis: Being prepared to explain and evidence the firm’s best execution analysis, including internalized orders, on a “regular and rigorous” or order-by-order basis, as applicable.
  • Continuous Updates: 
    • Updating WSPs and best execution analysis to address market and technology changes. 
    • Maintaining and regularly reviewing firm policies and procedures to comply with FINRA Rule 5310 and updating or revising such policies and procedures, as necessary.
  • Best Execution Committees: Establishing committees that meet quarterly or more frequently to conduct “regular and rigorous” reviews and determine, if necessary, to modify the firm's order routing and execution arrangements.

Order Routing Disclosures

  • Supervision: Conducting regular, periodic supervisory reviews to ensure that:
    • public quarterly reports and customer-specific order disclosure reports are:
      • accurate (e.g., assuring that per-venue disclosures of net aggregate PFOF and other payments are accurately calculated); and
      • complete (e.g., assuring that the Material Aspects section adequately describes the firm’s PFOF and other payment arrangement for each execution venue, including all material aspects that may influence the firm’s order routing decisions).
    • SEC Rule 606(a) Reports are provided to FINRA, in the manner prescribed by FINRA, within the same time and in the same formats that such report is required to be made publicly available pursuant to Rule 606(a), and that:
      • erroneous or rejected submissions to FINRA are corrected and resubmitted;
      • hyperlinks in reports submitted to FINRA are operational; 
      • reports made publicly available by firms are consistent with the reports submitted to FINRA; and
      • complete and current clearing firm information is submitted to FINRA (for introducing firms that incorporate by reference their clearing firm(s)’ Rule 606(a) Reports).
  • Due Diligence:
    • Identifying Execution Venues: Routing-only firm (i.e., a broker-dealer that re-routes but does not execute orders) confirming it is not inaccurately reported as an execution venue.
    • Third-Party Vendors: Assess the accuracy of public quarterly reports and customer-specific order disclosure reports provided by third-party vendors by, for example:
      • reviewing the content of reports; 
      • comparing order samples against third-party vendor-provided information; and confirming with the third-party vendor that all appropriate order information is being received (particularly when the firm has complex routing arrangements with execution venues).

Additional Resources

SEC Amends Standards for Covered Clearing Agencies for U.S. Treasury Securities

  • In December 2023, the SEC adopted rule amendments that impose requirements on clearing agencies that provide central counterparty services for U.S. Treasury securities (“covered clearing agencies”).6
  • Among other things, the amendments require covered clearing agencies to have policies and procedures that:
    • require their direct participants7 to submit for clearing certain eligible secondary market transactions in U.S. Treasury securities; 
    • calculate, collect and hold margin for their direct participants’ proprietary transactions in U.S. Treasury securities separately from transactions submitted on behalf of indirect participants8; and
    • ensure that the covered clearing agencies have appropriate means to facilitate access to clearance and settlement services of all eligible secondary market transactions in U.S. Treasury securities, including those of indirect participants.
  • The requirements also amend the broker-dealer customer protection rule to permit margin required and on deposit at a covered clearing agency for U.S. Treasury securities to be included as a debit in the customer and PAB reserve formulas, subject to certain conditions.
  • The amendments regarding changes to improve covered clearing agencies’ risk management practices, protection of customer assets, and access to clearing and settlement services have a compliance date of March 31, 2025. 
  • After that time, compliance by the direct participants of a U.S. Treasury securities covered clearing agency with the requirement to clear eligible secondary market transactions is required by December 31, 2025, and June 30, 2026, respectively, for cash and repo transactions. 
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1 MSRB Rule G-18 (Best Execution) sets forth similar obligations with respect to transactions in municipal securities.

2 In this situation, the routing firm and receiving firm may have different best execution obligations. See Supplementary Material .09 to FINRA Rule 5310 (Best Execution and Interpositioning).

3 FINRA will separately issue a Regulatory Notice regarding Rule 6470 (Disclosure of Order Routing Information for OTC Equity Securities), which will require firms to create and submit to FINRA order routing disclosures for OTC Equity Securities. FINRA intends to provide firms with sufficient implementation time to comply with Rule 6470 and will publish technical information and guidance, as appropriate, at least eight months in advance of the effective date, which will be announced at a future time. See Regulatory Notice 24-05.

4 See SEC Division of Market Regulation, Staff Legal Bulletin No. 13A, Frequently Asked Questions About Rule 11Ac1-6, FAQ #9.

5 In addition to the order routing disclosures under Rule 606, Rule 607 of Regulation NMS requires firms to disclose their policies regarding PFOF and order routing when customers open accounts, and on an annual basis thereafter, so firms should consistently provide the same information in both types of disclosures. 

6 Under the SEC’s rules, such an agency is a “covered clearing agency,” meaning a registered clearing agency that provides the services of a central counterparty or central securities depository.

7 The term “direct participants” refers to “the entities that directly access a U.S. Treasury securities [covered clearing agency]”, which are “generally banks and broker-dealers”. See Standards for Covered Clearing Agencies for Treasuries Final Rule Release, 89 FR at 2717.

8 The term “indirect participants” refers to “those entities which rely on a direct participant to clear and settle their U.S. Treasury securities transactions with the U.S. Treasury securities [covered clearing agency]”. These entities are “generally [direct participants’] customers or clients, which typically include market participants such as money market funds, hedge funds, other asset managers, and smaller banks or broker-dealers”. Id.