Regulation best execution — ignore it at your own peril

Wall Street has worked itself into a lather debating the merits of regulators’ proposal to impose retail auctions as part of a broader U.S. stock-trading overhaul.

But the Securities and Exchange Commission’s best-execution proposal, largely dismissed as duplicating an existing Financial Industry Regulatory Authority edict, could have wide-ranging implications for trading firms in options, bonds, and crypto securities as well as equities — especially since it’s one of the proposals most likely to be implemented.

Overlooked rule
Over the past couple of months, I’ve devoured every article, podcast, and webinar I can find about the quadruple whammy of regulation the SEC dropped on Dec. 14. As expected, the auction rule has received the most scrutiny, with dissent coming from most corners of the industry, followed by the tick size rule, with some interesting debate on both sides.

There has been a lot of analysis of Rule 605, although relatively little dissent; the industry has been pushing for Rule 605 improvements since at least 2014. But Regulation Best Execution (Rule 1101) has been largely ignored.

“It’s basically what FINRA already has,” I hear people say. “Most firms are already being more rigorous than the requirements. They require quarterly meetings, but most firms conduct them monthly,” I hear.

Certainly there has been some discourse. The joint New York Stock Exchange-Citadel-Schwab comment letter requested this rule be withdrawn. The aligned opposition of a triumvirate of powerful market players with diverse interests suggests the proposal has broader implications than many realize.

I was glued to my computer screen on Dec. 14 listening to each of the commissioners opine on these proposals, and I was curious to see how each would vote.

Two things surprised me.

First, they voted unanimously to support the tick-size rule. This suggests there’s broad support for some kind of tick-size update, but it’s clear the commissioners want feedback from the industry on how to proceed (and I’m sure they will receive plenty).

The second surprise was that Regulation Best Execution did not receive unanimous support. SEC Chair Gary Gensler’s comments about this regulation were that, while similar rules already exist at the self-regulatory level (FINRA and the Municipal Securities Rulemaking Board), such a fundamental requirement should come from the top-level regulator.

This seems like it would have been an easy unanimous decision for the commissioners.

As CEO of a firm that provides best-ex services to much of the industry, I had a vested interest in understanding why it wasn’t.

New obligations
During the holidays, I spent hours sitting in front of the fireplace poring over the proposed regulations, especially focusing on Regulation Best Execution and Rule 605. The commissioners had good reasons to question Regulation Best Execution. The rule has some very substantial requirements over and above the current FINRA and MSRB regulations, especially around “conflicted transactions.”

At this point, you may be thinking, “We don’t have any conflicted transactions,” or, “We’re not a retail broker,” or, “We don’t accept payment for order flow.” But the SEC’s rule reaches beyond what you probably think of as retail payment for order flow (PFOF).

Yes, the conflicted transactions part of Regulation Best Execution applies only to orders for “retail” customers. And yes, taking PFOF makes an order conflicted. But imagine you are an agency broker-dealer who only trades corporate bonds from other broker-dealers and, rather than simply routing orders somewhere else, you choose to use riskless principal orders to fill your order.

You may think, “Surely this doesn’t apply to me.”

If your broker-dealer clients take orders from retail traders, though, you will likely be subject to the new regulations for conflicted transactions. (See section IV.C.5 of the Regulation Best Execution proposing release of information on conflicted transactions for corporate bonds.)

SEC Regulation 1101, like FINRA 5310, applies to any transaction “for or with” a natural person. Whether you’re the direct broker or down the chain, since the order is for the retail trader, you’re involved in the transaction.

Second, because you trade against these orders as principal, even riskless principal, this is now a conflicted transaction. The SEC has included principal trading, in addition to payment for order flow, as a defining characteristic of conflicted transactions.

Compliance challenge
This example is just that — an example. I’m not sure if this particular scenario was the SEC’s intent or an unintended consequence.

Conflicted transactions include those in equities, options, corporate and municipal bonds, and crypto securities. They include payments to retail brokers as seen from the perspective of the retail broker as well as from the wholesaler’s perspective. They include rebates from exchanges. They include orders filled as principal, including riskless principal.

The SEC estimates this rule will cost the industry $165 million in one-time costs, plus $129 million annually.

It is in everyone’s best interest for the new rule to be well vetted by the entire capital markets industry. If not, there will be myriad unexpected outcomes.