Exchange jitter is measured in single-digit nanoseconds. Firms that achieve even tiny speed advantages have become incredibly difficult for other firms to match (see this). Some view the high frequency trading debate from the perspective of payment for order flow and how fill-rates may or may not be affected, and then conclude in favor of a lower marginal cost model (i.e. reluctantly accept the higher fixed cost/ barriers-to-entry that keeps smaller competitors out). Some say, “If you can’t beat them, join them”. Yet, there is Reg. NMS mandating order routing and what constitutes as “best execution” has stirred much controversy.
From a market design perspective, I’d like to see NMS fostering diversified trading venues, working in harmony as one. Specifically, retail investors shouldn’t receive inferior prices to those available to institutional traders. Also, according to this academic study, an odd lot order bettered the protected quote 37% of the time in its trading sample. More important, the market ought to function effectively to uphold market integrity standards (fairness of access, free from manipulations or any other disruptions), but this is hard! Markets are so convoluted and corresponding technologies are expensive. Everything has a cost to it – subscribing to proprietary feeds, connecting to more trading venues, demonstrating best execution compliance, use of transaction cost analyzers, etc. Many fled the markets citing high cost and losses, including proprietary trading firm Ketchum, hedge fund Tourbillion, etc.
So, let’s take it down a notch to review what’s considered as “suitable” for investors and how firms are fulfilling their fiduciary duties. Currently, FINRA and Broadridge are offering a Fund Analyzer and a Share Class Analyzer, respectively. Those are helpful tools which advisers rely on to generate the compliance decks to showcase what mutual fund fees’ structures are suitable for different investors based on empirical formulas. This particular process has been robust and easy for advisers to follow. Then, there are the ERISA 404(a)(5) and 408(b)(2) qualified retirement plan fee disclosure requirements, which get a bit complex. This is because plan admin fees may be billed separately or bundled, and there is indirect compensation and other nuances. Unless investors are provided with a comprehensive bench-marking reasonableness of the different plans, the few pages of disclosure received in the mail are often insufficient for investors to make an educated decision. That being said, policy makers should learn from the implementation experience of these rules.
According to the SEC, most frequent best execution issues cited in adviser exams are:
(a) Not performing best execution review;
(b) Not considering relevant factors during best execution review;
(c) Not seeking comparisons from other brokers;
(d) Not fully disclosing best execution practices;
(e) Not disclosing soft dollar arrangements; and
(f) Inadequate and/or not following best execution policies and procedures.
Per FINRA’s 2018 Examination finding reports,
“Some firms did not comply with FINRA Rule 5310 (Best Execution and Inter-positioning) because they relied upon a deficient regular and rigorous review of customer order execution quality… Firms should not allow conflicts of interest … Examples of some deficiencies [include:] … No Execution Quality Assessment of Competing Markets … [failure to] compare the quality of the execution obtained via their existing order routing and execution arrangements (including order-by-order review for the internalization of order flow) against the quality of execution they could have obtained from competing markets… No Review of Certain Order Types … No Evaluation of Required Factors when conducting a regular and rigorous review, including, among other things, speed of execution, price improvement and the likelihood of execution of limit orders.”
Brokers must examine key characteristics (nature of the market – volatility, communication availability, price, and relative liquidity; the number of markets examined; transaction type and size; and how easily a quote can be obtained), and prove that they utilized “reasonable diligence” in choosing how to route the order for execution (note: MiFID II calls for “sufficient steps” to ensure favorable execution of client orders as opposed to “reasonable steps”).
Mercy to the brokerage community for their regulatory burdens! In view of cases where orders were routed to HFTs without knowledge of clients, I think the industry should do a better job demonstrating that conflicts of interest do not exist and have appropriate controls to prevent it. Sharing with regulators on a quarterly basis data on “where” customers’ orders are routed is relatively easy for broker-dealers. The hard part is “when” routing should happen in order to qualify for the “best market-timing” for order execution. Per Steven and Steven’s empirical research, “Market makers are willing to reduce or eliminate execution advantage to exploit the information advantage”. Hence, raising additional concerns for “selective timing” to get in-and-out of market, or if firms may classify a trade as dealing with “counterparties” when they want to escape the fiduciary responsibilities, and classify a trade as dealing with “clients” for the ease of Volcker Rule compliance.
It is not how a broker-dealer “claims” the trades were dealing with a customer or counterparty. Rather, as the trade data would reveal, with consistency, whether the firm was “in effect” acting in the best interest of the customer rather than treating the party as a counterparty (i.e. without fiduciary responsibility). Therefore, an automated system is needed to conduct the “regular and rigorous review” for “best execution” compliance if regulators want to discourage the “flipping-a-switch” between clients versus non-clients behavior. Also, the automated checking would need to access if a market-maker’s risk profile may suddenly change and under what market conditions. Ultimately, any “out-of-proportion” or “unreasonable” trade activities should be curbed because the result of many small incremental exploitations or hedges and/or commitments can accumulate into outsized bets or bubbles to become the biggest threats to financial markets.
Note: This is a different automated system compared to typical transaction cost analyzers. Asking individual broker-dealer to come up with their own compliance system satisfying the rigorous requirements may be a heavy burden. However, if this is implemented as a utility service, meaning costs are shared among the industry or FINRA covers the development cost (such as their offering of Fund Analyzer as a FREE tool to help investors), then I see the possibilities to resolve this “BestEx” challenge. This project can be adopted as part of the “CAT data submission and fraud detection” package, making it a “3 for 1” deal which fits well with the SEC strategic plan – point (1.3), address misconduct that impacts investors; point (2.1), expand oversight capabilities to analyze and respond effectively to market developments and risks; and point (3.2), expand the use of risk and data analytics. It will be our honor if we can have the opportunity to contribute and participate.
Finally, a concluding remark for my series of articles: Rights should be appropriately delineated – in a simple, practical, and indisputable way or price. Then, market integrity will be rekindled, not merely by disclosures, but by diversified investors and free enterprises putting asides their differences, entrusting the market for prompt, reliable, and fair channeling of financial resources to support worthy economic activities. Ultimately, the capital markets would bear fruit from superior corporate performance and productivity gain to reward all constituents (investors, labors, suppliers, customers, and intermediates) accordingly.
