Bill Yancey thought he was doing everything right.
As the head of Nasdaq trading at Southwest Securities he is responsible for an agency desk that handles orders for the firm's roughly 200 correspondent brokers. He always figured the trades were routed to the appropriate dealers and market centers.
Then came an SEC inspection.
"The SEC was so critical [of the desk]," said a wounded Yancey, referring to the Securities and Exchange Commission's correspondence that followed the agency's inspection of Southwest Securities' best-execution practices. "The [agency] didn't like our price improvement numbers so it questioned our routing decisions."
The inspection of Southwest Securities is part of a broader SEC oversight of best execution practices at retail brokerages that route trades for their customers. And price improvement, one of several major components of best execution obligations, is foremost on the SEC agenda.
Between 50 and 60 firms – many of them online and discount brokers – were contacted or visited earlier this year by the SEC. The agency says it plans to contact more firms.
Some brokerages are describing the SEC inspection efforts as a sweep. The SEC says they are inspections. "A sweep implies a discreet event," a spokesman for the SEC said. "This is an ongoing process. It will continue into next year."
Whatever the name, the SEC activity on best execution prompted many retail brokers to look more closely at their order flow relationships and arrangements.
"The SEC action was a wake-up call for order-entry firms," said Tom Gira, vice president of market regulation at NASD Regulation, the regulatory arm of the National Association of Securities Dealers. "Those who may be routing orders on blind faith will have to be able to document how they make their decisions."
Robert W. Baird & Co., which was not a part of the recent SEC activity, has just begun a study of its routing procedures. "We are reacting to the stories we read in the newspaper," said Susan Labant, a compliance officer at the Milwaukee-based firm. "We are analyzing where our orders are sent and we will make some modifications."
Southwest Securities received a so-called deficiency letter' from the SEC that led it to make changes on its order routing and preferencing arrangements with other broker dealers. (A deficiency letter is a term used to describe SEC correspondence that points out deficiencies in a firm's compliance practices.) "We did move some of our business around," Yancey said.
Apparently, other firms are doing the same or are considering their options. Phil Rapp, senior vice president for marketing and sales at Knight Securities, the largest Nasdaq wholesaler as measured by trade volume, said some of his customers are considering alternative routing arrangements. "There is definitely a little more focus on this issue," he said.
Unprecedented
The SEC actions on best execution may be unprecedented.
Best execution compliance is being scrutinized more closely that ever before, according to Ted Karn, president of Market Systems, a Buchanan, Mich.-based firm that analyses stock transactions. What was considered a "regular and rigorous" best execution compliance effort by firms just a few years ago is no longer acceptable, he says.
"Now regulators want to see documentation and a best execution committee [in place at firms]," Karn said.
The exact volume of trades that fail to comply with the regulator's best execution objectives is not available from the SEC. But according to statistics compiled by Karn, the number of affected trades is low – less than one per cent of all equity trades. "Given that volume," he said, "we don't have a bad system."
Though many experts consider it elusive, price improvement is one of three elements generally considered part of the best-execution objective. The other two are immediacy and liquidity enhancement. The former refers to how quickly an order is filled, while the latter occurs when a dealer fills an order for a size greater than that associated with the national best bid and offer, or NBBO.
As defined by regulatory experts, the price improvement ratio is the percentage of overall trades in a stock executed at prices superior to the NBBO.
Brokers say most customer complaints on best execution are about immediacy, or speed of execution, and not about price improvement. Some brokers contend that the SEC focus on price improvement is badly timed.
Spreads on many securities have narrowed in recent years, making price improvement on those stocks extremely difficult, they say. They also say it is more difficult to improve the price of an actively-traded stock with a narrow spread than on a thinly-traded stock with a wider spread.
Decimalization could make the attainment of price improvement on these issues more problematic, they add.
At the same time, the depth of the dealer market – the quantity of shares that dealers are showing on their advertised markets – has declined as a result of the same changes forcing narrower spreads. (The biggest change was the SEC-mandated order handling rules with its emphasis on limit order protection for individual investors.) As a result, liquidity enhancement is considered by many experts to be more important than ever before.
The SEC has bolstered its case for price improvement with stock transaction statistics electronically collected by Northport, N.Y.-based Transaction Auditing Group. But brokers complain that the SEC unfairly compares one broker's rate to another's without taking into account the make-up of the order flow.
The SEC does have its supporters on Wall Street. They counter that the regulator is not overly focused on price improvement and is, in fact, aware that a routing decision is multi-faceted. "The SEC has never been categorical," said Lee Pickard, senior partner at Pickard and Djinis, a securities law firm in Washington.
Lawsuit
Whatever the case, it is clear that trade execution at the NBBO is no longer sufficient in many instances. Last year a class-action lawsuit, Newton vs. Merrill Lynch, proved to be a landmark. In it, the judges sided with the plaintiffs, who claimed that the filling of their retail orders at the NBBO did not constitute the best execution for their trades. The case bounced from the U.S. District Court of New Jersey to the Supreme Court, and then back to the District Court in New Jersey where the case is pending.
Some of the troublesome trades fingered for best-execution inspection are those executed during volatile markets. At times, trades that stack up on a dealers network before the market opens unleash problems in volatile early morning trading. Knight/Trimark Group and Bernard L. Madoff Investment Securities in New York recently instituted remedial action by offering price improvement on all pre-open orders received before 9:25 a.m. Now customers are said to be guaranteed the mid-point price between the first uncrossed, unlocked NBBO of the day.
Sources say a more comprehensive solution has been hinted at by the SEC. "SEC-speak is subtle," said one source close to the agency, "but they seem to be suggesting that, given today's computing power, firms should consider investing in more sophisticated order-routing software." Detractors call the idea impractical.
Fiduciary Responsibility
It has always been a stockbroker's fiduciary responsibility to execute a customer order on the best possible terms. Now the SEC and the NASD are attempting to police the process more effectively.
The investigations by the SEC and the U.S. Justice Department into allegations of price fixing on Nasdaq in the mid-90s, pushed best execution obligations to the forefront. The investigations spawned the order handling rules.
"The order handling rules were a catalyst," said Sam Scott Miller, a partner at New York-based securities law firm Orrick, Herrington and Sutcliffe. "They marked a renewed effort by the SEC on this issue [of best execution]."
Meanwhile, the NASD has stepped up its own efforts to detect bad fills. As of last month, the Order Audit Trail System (OATS) is mandatory for all large brokerages. OATS provides NASD Regulation with a new stream of data to more effectively monitor best execution practices at brokerage firms.
That data will be combined with dealer quotes and trade data from the Automated Confirmation Transaction system (ACT), to provide a better overview of a trade than before, from order entry to execution. The data is processed through the Advanced Detection System, operated by the NASD.
NASD is fining those firms that fail to "use reasonable diligence to ascertain the best inter-dealer market." These firms have been fined: Detroit-based Olde Discount, Baltimore's Legg Mason Wood Walker, San Francisco's Banc of America Securities and Chicago-based GVR Co.
The Bounds
Some broker dealers don't believe the regulators are overstepping their bounds. "We support and endorse what the SEC is doing," said Simon Spencer, chief strategy and technology officer at Knight/Trimark, the parent of Knight Securities.
What grates on broker dealers is the importance the regulators seem to attach to price improvement as the key measure for judging the quality of a fill.
"The focus on price improvement is short-sighted," said Labant of Robert W. Baird. "It's just an easy thing to monitor. It would be better to look at the intangibles like immediacy and liquidity enhancement."