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August 31, 1998

Best-Execution Mission

By William O'Brien

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The agency desk can easily become the forgotten stepchild of a market-making firm's best-execution supervisory program, with potentially damaging results. Agency order flow can be seen as a means to generate reciprocal business from fellow market makers, an idea that regulators could view as being in direct conflict with best-execution principles. The hackneyed mantra of "we know who gives us good executions" is insufficient in this era of documentation. Firms must be in a position to prove how best execution, rather than business considerations, is the primary factor in the order-routing decision.

This is not to say that firms have no discretion in deciding where to route agency order flow. A literal interpretation of best execution, which would require broker dealers to route all their order flow to the one firm that wins the battle of best-execution statistics, is recognized as impractical and counterproductive.

What is required, however, by an order-routing firm, is an ongoing effort to ensure that agency-desk customers are not materially disadvantaged by order-routing decisions. This requires a periodic (read quarterly) evaluation of the best-execution performance of your executing firm(s) versus competing markets.

As the amount of publicly-available data increases, this task becomes easier as the awkward process of requesting specific order-execution information directly from competitors becomes unnecessary. So long as this data suggests the executing firm is competitive on a best-execution basis, your order-routing determinations are likely to go unchallenged by regulators.

At best, the lack of clarity surrounding the duty of best execution gives firms some much-needed flexibility in developing supervisory solutions. Regardless of particular methods, evidence of an honest, consistent monitoring effort can go a long way towards satisfying an examiner. Absent a supervisory void or a complete lack of regard for best execution, regulatory authorities will be hard-pressed to assert a firm violated a regulatory obligation that has not yet been completely defined.

William O'Brien is an associate in the New York office of Orrick, Herrington & Sutcliffe LLP. He specializes in broker-dealer and securities-market regulation.