The only thing certain about the duty of best execution is what the regulatory arm of the National Association of Securities Dealers will ask broker dealers: How do they plan to supervise the compliance effort?
Despite the continued regulatory chorus of vague principles and promises of future guidance, NASD Regulation expects firms to have a supervisory system in place to assure that customer orders are receiving quality executions.
Given that reality, head traders, compliance officers and information-technology personnel need to work together to ensure that the examiner, when he strikes, will be presented with evidence that your firm is addressing best-execution issues.
While there is no one "right" way to surveill for best execution, the cornerstone of any firm's supervisory system should be a set of written procedures documenting the chosen approach. Such procedures should have four basic elements: who is responsible for each part of your firm's best-execution review; what they do to fulfill their responsibilities; how often their review is conducted; and a record that the review was performed.
In this vein, daily exception reports can be particularly useful. They can be generated on a regular basis, reviewed by a supervisor quickly and efficiently, and initialed and filed away as evidence for regulatory authorities.
Reports that should be considered include lists detailing market orders executed outside the national best bid and offer, or NBBO; limit orders not executed despite an obligation under Manning Rules; and instances of potential front-running.
Drafting procedures, however, is only the start of the process. Thoughtful implementation is essential to avoid a compliance disaster. Worse than having no procedures is having procedures that are not followed. Successful implementation requires a coordinated effort of front-line and backoffice personnel.
Given that so many best-execution issues arise in the trenches, on an ongoing basis, desk heads and supervisors play a vital role. Compliance and other support personnel must provide professionals with the information and education to carry out their best-execution duties in an efficient and effective manner. Manageable exception reports, technology-enhanced follow-ups and assistance with trader education allows managers to properly supervise best execution without jeopardizing other responsibilities.
The labor-intensive nature of monitoring best execution makes technology-based solutions not only an attractive alternative, but the only alternative for high-volume firms. However, if an order-management system operates in a way that raises a best-execution issue for one customer order, it is likely to do so for thousands of others. Accordingly, all aspects of the manner in which a firm's systems process orders should be evaluated to ensure that orders are not auto-disadvantaged.
Once a firm's system has been programmed to fulfill certain best-execution responsibilities, an answer that "the system takes care of it" will not appease an examiner. Murphy's Law dictates that systems don't always work. Procedures must be devised to ensure that systems will be periodically tested to verify continued operation. When a malfunction does occur, back-up plans should be in place to ensure that customers do not suffer as a result. Once again, these procedures should be documented in writing.
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.
