The Securities and Exchange Commission’s (SEC) proposed “Regulation Best Execution” has the potential to pose serious compliance challenges for broker-dealers — particularly for firms that assume there will be limited impact (for example, because of existing best execution frameworks).
Past experience has highlighted challenges with adopting best execution standards. In 2022, best execution reached the “Top Enforcement Issues” list for FINRA, and multiple large firms were assessed with multi-million-dollar fines. Additionally, a thematic review by the UK’s Financial Conduct Authority (FCA) has previously found that “many firms do not understand key elements of […] requirements” related to best execution, and “are not embedding them into their business practices.”
We believe the difficulty and complexity of best execution, and the many ways these standards and guidelines can be interpreted during implementation, are reflected in challenges and thematic execution mistakes seen in other best execution regimes:
Scope: some firms have previously improperly limited or “carved-out” activities from their best execution obligations.
Monitoring: many firms lack comprehensive monitoring capabilities to identify best execution failures, poor client outcomes, or other deficiencies to be addressed.
Internalization: firms often fail to evidence best execution when executing orders with potential conflicts of interest; and
Accountability: firms struggle to demonstrate clear responsibility and accountability for meeting best execution standards.
While best execution is not a new concept, the proposed regulation is the first time the SEC is expected to establish a single best execution regulatory framework for broker-dealers across security types
Below is an excerpt from our report, Preparing For The Sec’s Proposed Regulation Best Execution.
Lessons learned from other best execution implementation experiences
We recommend that firms review and understand the impact of the proposed Regulation Best Execution on their business and operations, including an assessment of changes to any existing policies and procedures related to best execution. Broker-dealers would also benefit from considering the following principles as lessons learned from other best execution implementation experiences:
Exceptions should be limited: outside of exceptions that are explicitly named in the applicable best execution standard, firms should err on the side of caution and limit carve- outs and exceptions — and clearly delineate and rationalize those exceptions where they do exist. This also means that “best execution” should be considered across a broad set of potential factors. For example, timing, likelihood of execution, conflicts of interest, and not just price.
Product-specific considerations must be taken into account: the SEC’s proposed Regulation Best Execution includes a much broader spectrum of security and product types than many other best execution regimes. In many cases, this results in product-specific complexities — for example:
• Liquidity for some asset classes (for example, certain fixed income markets) is highly fragmented — making adherence to best execution standards difficult to evidence
• Routing of certain derivative trades (such as listed options) that are largely internalized or rely on payment for order flow today will need to be reviewed
• Long-term implications for emerging asset classes (for example, crypto) where best execution should be considered as new capabilities and businesses are developed
Evidence is paramount: given the wide spectrum of transactions that fall under the scope of best execution (and the inherent need for expert judgment in the application of best execution in many cases), firms should invest in capturing management information and related data to evidence adherence to best execution standards. Pre- and post-trade monitoring helps evaluate the performance of best execution processes, as well as enabling the demonstration of success in achieving best execution.
New capabilities may be needed: the landscape of execution options is complex, and best execution will require consideration of a broader set of partners and venues. While some firms have already invested in technology related to smart order routing (and related algorithms), others will benefit from building that foundation now. And even where those smart order routing capabilities exist today, updates are likely required to include an overlay for (expanded) best execution considerations.
Processes should evolve: management information and data should also be used to identify best execution failures and poor client outcomes. This information should further provide a feedback loop for corrective action and/or clarification of processes, improving best execution for future transactions.
The SEC’s proposed Regulation Best Execution impacts the foundational business practices and processes of broker-dealers. Proposed Regulation Best Execution has, in many cases, an expanded scope and more detailed guidance than existing standards. Where multiple standards of best execution apply, the expectation is that the most stringent requirement must be met. Even for firms with existing best execution policies, these requirements will require an incremental level of effort for implementation.
