Order Routing and Best Execution


Yesterday, the House Financial Services Committee held a hearing titled “Oversight of the Financial Industry Regulatory Authority” where the only witness was FINRA’s President/CEO Robert Cook.  In his written testimony, Mr. Cook covered numerous FINRA programs including FINRA360 (their self-imposed review of their own operations), cross-market surveillance initiatives (which have been working as effective deterrents against market manipulators) and an update on their enforcement cases.  While Mr. Cook’s written testimony was very impressive, there was surprisingly no mention of best execution investigations.  However, during the hearings question/answer session, Rep. Stephen Lynch (D-MA) did ask Mr. Cook a direct question about best execution (1:26 mark):

“Given the recent attention placed on best execution and conflicts surrounding the payment of rebates to brokers, will FINRA dive in and investigate best execution and specifically whether the conflict within the maker-taker rule leads to sub-optimal order routing by brokers?”

Mr. Cook responded by acknowledging that best execution is a vital part of ensuring that customers are getting the best prices and that brokers are not biased in how they execute orders.  Rep. Lynch then interjected and said “That is how it is supposed to work, but that’s not how it is working right now.”  Rep. Lynch is one of the few members of Congress that understands market structure.  He is well-aware of the maker/taker model and how it distorts order routing.  He has spoken out numerous times about this and even authored a bill titled “Maker-Taker Conflict of Interest Reform Act of 2015” where he sought to have a pilot program to prohibit rebates.

Mr. Cook then went on to explain what FINRA has done in the best execution space saying that FINRA has:

 1 – Issued further guidance to brokers on best execution.  Mr. Cook appears to be referring to this November 2015 Regulatory Notice on Best Execution . Specifically, on payment for order flow and rebates, FINRA’s best execution guidance states:

“The SEC has stated that an order routing inducement, such as receipt of payment for order flow, cannot be allowed to interfere with a broker-dealer’s duty of best execution. Similarly, firms should not allow access fees charged by particular venues to inappropriately affect their routing decisions, and, in general, a firm’s routing decisions should not be unduly influenced by a particular venue’s fee or rebate structure. Rule 5310 also addresses the practice of payment for order flow as it relates to best execution. Specifically, Supplementary Material .09 states that a firm should consider the existence of internalization or payment for order flow arrangements when conducting its regular and rigorous review of execution quality.”

2- Conducted a sweep in reviewing firms best execution practices.  We think Mr. Cook is referring to this July 2014 letter that was sent to some firms.  The letter asked a number of questions about a firm’s routing decisions for both limit and market orders. Unfortunately, we don’t recall anything meaningful resulting from this sweep.

 3- Is anticipating doing more examination and surveillance work which has been a high priority. We’re glad Mr. Cook said FINRA was going to step up the examination work when it comes to order routing.  With their 2015 guidance on Best Execution, FINRA is armed with a rule that can be enforced.  If brokers are routing to venues where they receive the highest rebate and not necessarily the best fill, then it’s time that FINRA cracks down on this.

Rep. Lynch also followed up with a question about the recent SEC and FINRA cases against ATS’s. He said while FINRA has taken action against them, he wanted to know why they haven’t called them out best execution violations.  Mr. Cook responded that the cases involved the disclosures of how orders were being handled as opposed to best execution.  However, he said how brokers handle best execution, including in the context of ATS’s that they run, is a focus of FINRA’s examination program. Mr. Cook said FINRA expects to bring more guidance and action in this area.

We hope FINRA follows through with their comments and begins to enforce their own best execution rules when it comes to order routing.  As for broker-owned ATS’s, it looks like they are going to have a whole new set of best execution guidelines to abide by soon.