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April 30, 2001

Redefining Best Execution

By Harold S. Bradley

Also in this article

  • Redefining Best Execution

Traders rationalize a variety of behaviors under the guise of best execution.

Many contend, with a wink and a nod, that "I know it when I see it." That said, recent SEC guidance suggests that an emerging definition for best execution may place those with such cavalier attitudes in regulatory jeopardy.

Most institutions pre-commit trading commissions to a variety of bill-paying functions that include soft dollars, commission recapture and client direction. As a result, they compromise any objective notion of best execution.

Greenwich Associates in 1999 reported that portfolio managers, analysts and clients devoured more than 60 percent of a typical trader's discretion in placing orders. Some studies indicate that portfolio managers tell traders which broker to use on up to 14 percent of orders.

Levitt's Warning

Former SEC Chairman Arthur Levitt sounded a warning for the buyside in speeches before the Fordham Law School and the Securities Industry Association late last year. He reminded us that "people tend to act differently when the money on the table isn't their own, to treat lightly expenses they do not feel." He warned that "sticky" brokerage commissions of six cents per share should no longer be viewed as "safe" and that managers should face more director scrutiny about best execution processes.

Recent SEC staff comments illustrate an emerging standard tied to metrics and accountability. Traders report that SEC auditors now ask for documents outlining trade processes during routine examinations. Regulators remain on high alert for an "enforcement" action to better illustrate that "best execution" is more than a trite industry cliche.

Gene Gohlke, associate director of the SEC's Office of Compliance Inspections and Examinations, provided a framework for best execution at a December 2000 Securities Law Development Conference.

Gohlke said, "In placing a trade, the trading desk will seek to find a broker dealer or alternative trading system that will execute a trade in a way that the trader believes will realize the maximum value of the investment decision."

Additionally, he said the value of services received from broker dealers should be periodically reviewed and documented - with the active involvement of traders, portfolio managers, research analysts, the backoffice, and the compliance and legal departments. The SEC warned that:

* Hiring of a consultant to measure execution quality is not sufficient proof that a manager is in compliance.

* Adequacy of order handling systems, trade error experience and timeliness of execution reports would be reviewed; and allotment of IPO shares would be assessed against requested allocations.

* The use of ECNs as venues with anonymity, liquidity, price improvement and lower commission rates would be evaluated.

Consideration of best execution practices in this context has significant economic implications for investment managers who have neglected trading and order management infrastructure. Data requirements may necessitate integration of order management and back office accounting systems as well as better database access to analyze trading data.