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January 1, 2003

Order Handling and Best Execution Practices

By Bill Tanem

SEC Rule 11Ac1-5 and SEC Rule 11Ac1-6 were introduced to promote competition and disclosure in market making, order routing and order execution practices. The idea is to provide disclosure of trading practices to investors, to promote fairness and confidence in the securities markets.

SEC Rule 11Ac1-5, or Rule 5 requires market centers to report their order execution quality on a monthly basis. These market centers are defined as OTC market makers that trade in National Market System securities. Reports must include:

* Security

* Types of orders

* Effective spread

* Rate of price improvement

* Price disimprovement

* Fill rates and speed of execution

SEC Rule 11Ac1-6, or Rule 6, requires market centers, as well as other broker dealers that route equity and option securities orders for execution, to report how their orders are routed on a quarterly basis. They must include any information on material relationships with firms in which orders are routed. Securities covered include:

* Nasdaq NMS

* Nasdaq SmallCap

* Listed equity securities

* Options listed on a national securities exchange

In addition, if customers request information on where their orders have been routed, the broker dealer must provide it to the customer. When combined with the order-handling rules, the disclosure rules provide insight into how orders are executed by broker dealers:

* Broker dealers are required to display certain limit orders.

* Broker dealers are obligated to execute customer's orders at the best price available (price improvement).

* Broker dealers have the duty to execute customer orders with the most favorable terms reasonably available.

These recently effective rules, combined with the information access that the Internet provides, allow investors to seek the best firm to execute their equity transactions, according to industry observers. Firms must modify systems, procedures and train personnel to comply with the myriad of order-handling and disclosure rules. A vague concept a few years ago, the term "best execution" is still a serious topic of debate.

The Costs of Compliance:

* Technology upgrades for trading systems, order routing, and reporting of executions.

* Development of trading systems to route orders for best execution

* Synchronization of time recording devices with a national standard time

* Implementation of auditing systems to track execution terms

* Self-monitoring of trade execution

* Reconsideration of longstanding arrangements for order routing

* Loss of revenue associated with reduced payment for order flow

Technology will continue to enhance the visibility of the entire market. Already, firms have had to integrate order execution systems into transaction reporting systems and transaction analysis reporting systems. This integration allows the firm to track where orders are routed. With the adoption of SuperMontage and modifications to SuperDot to monitor price improvement, broker dealers will be expected to evaluate constantly whether they are executing customer orders under the most favorable conditions available. If firms do not offer best execution services to their customers, this business will go elsewhere.

Reductions in payment for order flow, and the elimination of other potential conflicts of interest in market making and order execution services, have continued to promote fair trade executions for all investors.

Most broker dealers are looking elsewhere to replace the loss of revenue from market making. The reduction in price spread, loss of payment for order flow, and lowered commissions have hurt many broker dealers. Now many are looking at fees based on assets under management as the logical replacement for this lost revenue. Managing accounts for fees has its own challenges and an entirely new set of rules. However, the one requirement that will not disappear is the best execution obligation for broker dealers and investment advisers for customer's orders.

Because order execution is such a high profile industry topic, firms must be very aware of how the public will perceive disclosure reports pursuant to SEC Rules 11Ac1-5 and 1-6. These reports must be made publicly available through a Website and allow customers unrestricted access.