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January 3, 2006

Best-Execution Questions Discussed

By Peter Chapman

The Securities and Exchange Commission's new trade-through rule could make it difficult for brokers to comply with their best execution obligations.

In certain circumstances, a top brokerage official told a recent gathering of traders, complying with the new trade-through rule might prevent them from getting the best fills for their clients.

Mark Madoff, a senior executive with Bernard L. Madoff Investment Securities and a governor with the Security Traders Association, broached the issue with a top SEC official at this year's STA confab.

Madoff told Bob Colby, the SEC's acting head of market regulation, that his firm could face a problem in the event it sent an "intermarket sweep order" to the New York Stock Exchange. A problem would arise if, under the New York's new hybrid, or semi-automated, model its fast' quotes became slow.'

"How do we ensure," an obviously vexed Madoff asked Colby, "that when we send out an [intermarket sweep] order we can satisfy both our trade-through and best execution obligations?"

The new intermarket sweep order designation is meant to be used by broker-dealers to trade against all of the available quotes in the marketplace without incurring a delay due to trade-through compliance.

The sweep order allows broker-dealers to send a single order to multiple market centers simultaneously. Receipt of the order informs the market center that it can permit a trade to occur without delay even if its quote is not the best in the overall marketplace.

That eliminates any delay that might occur as the market center checks to see if it has the best quote or not. Under the SEC's new Regulation NMS order protection rule, automated market centers are obligated to prevent trades from occurring in their systems if better prices are available elsewhere.

The problem, Madoff pointed out, would arise in the case when part of a sweep order is sent to the New York Stock Exchange.

The New York assuming its conversion to hybrid status is successful may be displaying an automated, or fast, quote. But, Madoff explained, the order suddenly triggers a circuit breaker that sends the quote into manual, or slow, mode.

The order is now trapped in manual limbo (the specialist's hands) contrary to the original intent of the order sender.

Yet, even though that order has fallen into the hands of the specialist, the Big Board may still offer the best execution at that point, Madoff said. So, what to do?

In sum, the broker, by working within the guideposts of the new trade-through rule, has put the quality of his fill in jeopardy.

"We have been asked," Colby said, "but we cannot tell people to disregard manual quotes for best execution purposes. The manual quote, even if it is not automatically accessible, may by far be the best quote. And it is relatively accessible."

Colby pointed out that the problem is not new. Traders must contend with execution delays at the Big Board today. Reg NMS only exacerbates the problem.

"You don't exactly know what you are going to get [on the New York] so you have to decide what is best for your customer," Colby said.