Brokerage compliance managers might have to scale back their holiday plans. The US Financial Industry Regulatory Authority (FINRA) is revisiting broker-dealer order routing, and it wants answers by the end of this month.
Last month, the self-regulatory agency for broker-dealers sent an undisclosed number of broker-dealers a request for detailed information on how they quantify the benefits to their customers when orders are sent to venues with rebates and other fee incentives. FINRA also wants to know how broker-dealers handle conflicts of interest in their order routing strategies.
Briefings with trading and algorithmic units are likely to be on the holiday schedule. Compliance managers are already likely to meet regularly with traders to discuss best-execution policies at a high level. Algo developers, however, often have free reign in designing and tweaking the order-routing strategies that must be justified to FINRA. “Inputs such as fill probability and information leakage based on the evaluation of large quantities of data will need to be incorporaed into compliance departments’ documenation for best execution purposes,” says Dave Weisberger, director of equities for ViableMkts, a New York consultancy specializing in market structure and technology.
FINRA’s action isn’t the first time regulators have taken a deep dive into best execution practices. This time, it appears to be specifically targeted on finding conflicts of interest in which traders choose venues that benefit the broker-dealer rather than the end investor. “The spirit of FINRA’s request isn’t new, yet broker-dealers are worried about whether FINRA will be satisfied that whatever documentation they provide will be sufficient,” says Jack Drogin, partner with the law firm of Schiff Hardin in Washington, DC. “Best execution is more than about the best price. Overall execution quality also counts and that is subject to interpretation.”
In 2015 FINRA issued two separate notices to member firms asking them for greater oversight of their algorithmic trading strategies and best execution practices, particularly for fixed-income instruments. Last year, the US Securities and Exchange Commission voted to require broker-dealers to disclose more information to institutional customers about how they handle orders, but that rule is still pending.
Rebates vs. Risk
Large institutional orders are typically broken down into multiple smaller — or child– orders and forwarded to multiple trading venues either simultaneously, sequentially or over an extended period of time during the day. Exchanges often give broker-dealers rebates for passive orders which add liquidity to the market because the bid was entered at below the offer price or an offer was entered above the bid price. Passive orders may end up making money for traders, but face a higher risk of not being filled so investors will be harmed when the price moves away from the investor.
Consider a simple example where a stock is bid for at US$50.10 and offered at US$50.12. If a broker enters an order to buy at US$50.10 and it does not get filled, it is likely that, by the time it cancels the order, the offer might have moved to US$50.14. In that case, the failure to buy at US$50.12 when the order was received, cost the investor 2 cents per share of opportunity cost.
Joanna Fields, principal at Aplomb Strategies, a New York-based consultancy specializing in regulatory compliance, insists that based on FINRA’s 2015 guidance firms using algorithms for order-routing should already have effective supervisory procedures and controls in place to review their trading stratgies. “A cross- disciplinary commitee of legal, compliance, product development, technology, risk and operations staffers need to assess and react to the risk associated with algorithmic strategies,” she says.
Algorithms that don’t perform correctly might lead to information leakage, affect market prices, or result in poor execution quality. When analyzing execution quality, firms need to factor multiple costs such as market data and any fee incentives. Compliance managers should handle the post-trade analysis of algorithms while operational risk and tech support teams analyze algorithms on a daily real-time basis, says Fields.
No Liability Haven
Broker-dealers that rely on third-party brokers to execute their orders using third-party algorithms and smart order routers will likely have a lot more to worry about than those that have all the technology in house. Those non-executing brokers also will have to evaluate the trading decisions made. Thus, they will need to have detailed enough data to evaluate the algorithms they use; potentially similar to what they would if they were to use their own algorithms and smart order routing systems. A handful of broker-dealers might execute client orders using their own systems, yet hundreds more rely on third-parties such as UBS, Goldman Sachs, Credit Suisse, Morgan Stanley, JP Morgan, Barclays, Deutsche Bank, Instinet, ITG, Citi, Dash Financial Technologies and Virtu Financial.
“All we receive is an execution report with the details of filled orders,” says the compliance manager at an East Coast brokerage. “We also conduct a transaction cost analysis of those trades, but don’t have data or analysis on all the orders that weren’t filled.”
Will FINRA penalize the non-executing broker for no-fault of its own? When asked, a spokesman for the regulatory agency referred FinOps Report to FINRA’s November 2015 guidance. “FINRA notes that the existence of such a contract in no way alters a firm’s best execution obligation to analyze and review the execution quality of orders routed to that firm,” says FINRA on page 15 of that memo to member firms. “Firms should note that such contracts do not inappropriately influence or constrain the firm in making its routing decisions based on the results of its regular and rigorous analysis for best execution.”
When justifying financial perks related to order routing, says Weisberger, broker-dealers will need to explain how and where they posted orders regardless of whether they did so manually, through a smart-order routing system, or a third-party. That explanation will have to rely on more than just explicit costs, such as commission rates.
Weisberger breaks the analysis into two parts: order analysis and market or execution quality analysis. Order analysis refers to how the orders executed at each trading venue compare with each other based on fill rates and opportunity costs for unfulfilled orders. Market quality analysis refers to the conditions on each market and overall when each decision is made and includes the bid offer spread, the displayed size by each market, and volume traded up to that point at each market.
Completing order analysis will require the broker-dealer to compare the fill rates — or percentage of orders executed– to the subsequent trades in the market to determine if the order could have been filled. Opportunity costs for unfulfilled orders would measure the stock price movement after order placement until the time the order is cancelled, where the cost is equal to that movement of unfilled quantity, explains Weisberger.
The analysis requires two types of data, often located in a multitude of front-office order management and trade execution platforms. The first is data obtained by analyzing public market data of which trading venues are more likely to be at the NBBO, set the NBBO, and what size they display at the NBBO the previous quarter. The second is the data about filled and unfilled orders to measure for opportunity costs and potential price improvement compared to the NBBO. Short for National Best Bid and Offer Price, the NBBO is considered the benchmark for best execution. The SEC regulation requires US brokers to execute customer trades at the best available ask price when buying securities and best available bid price when selling securities.
Weisberger predicts that broker-dealers will likely need to spend the most time justifying any trading strategies where they received either a large number of rebates or lower explicit commissions. Broker-dealers will need to document instances where their clients specifically requested to pay commission rates that are below the average fees charged by execution venues. The reason: broker-dealers need to show FINRA it would be unreasonable to blame a third-party broker for not fulfilling best execution if the broker were forced to choose cheaper venues due to a client choice.
“The key to justifying best execution is to prove that the process used and the choices made were reasonable in every situation,” says Weisberger. “The more detail a broker can provide to either justify why the choice was appropriate or how the trading performance achieved best execution, the better.”
Weisberger recommends that the best way to handle rebates is to pass them on to clients via “cost plus” pricing. Broker-dealers using “cost-plus” pricing, he says, could no longer face a potential for a conflict of interest because they would have no reason to make decisions based upon the difference in costs or rebates.
Under the standard “all-in” commission model, where broker-dealers charge an agreed upon per share price inclusive of all costs, broker-dealers have an incentive to minimize their fees. Therefore, exchanges that offer rebates become attractive execution venues. With “cost-plus” pricing, investors pay a brokerage commission and associated execution costs. If these costs are negative due to an exchange rebate that rebate is forwarded back to the investor.
Dash Financial Technologies, a New York-based firm providing multi-asset trading technology and agency execution, says that has adopted “cost-basis” pricing as its standard business model. “Not only does cost-plus pricing remove a broker’s conflict of interest, but it also allows investors of all types to be rewarded for price formation,” explains Peter Maragos, chief executive officer. “That price formation is extremely important in today’s fragmented marketplace where investors have difficulty finding liquidity.”