Best execution",

hidden:
LINK_POOL:
- 'Market Maker'
- 'Algorithmic Trading'
- 'Order Flow'
- 'Bid-Ask Spread'
- 'Limit Order'
- 'Market Order'
- 'Financial Instrument'
- 'Broker-Dealer'
- 'Liquidity'
- 'Regulatory Compliance'
- 'Execution Venue'
- 'Transaction Costs'
- 'Fiduciary Duty'
- 'Portfolio Management'
- 'Market Conditions'

What Is Best Execution?

Best execution is a legal and ethical obligation requiring brokers to obtain the most favorable terms reasonably available for their clients' orders in the prevailing Market Conditions. This principle, central to regulatory compliance in financial markets, falls under the broader category of market regulation. It ensures that when a broker-dealer executes a trade on behalf of a client, they prioritize the client's interests above their own incentives, such as commissions or payment for order flow. Achieving best execution involves considering various factors beyond just price, including speed of execution, the likelihood of a trade being completed, and overall transaction costs.

History and Origin

The concept of best execution has evolved significantly over time, particularly with the increasing automation of financial markets. In the United States, the duty of best execution for broker-dealers originates from common law agency principles and fiduciary duty. This duty was first formalized as a rule in 1968 by the National Association of Securities Dealers, Inc. (NASD), the predecessor to the Financial Industry Regulatory Authority (FINRA)²⁴.

In Europe, the Markets in Financial Instruments Directive (MiFID) and its subsequent revision, MiFID II, significantly strengthened best execution requirements. MiFID II, which came into force in January 2018, aimed to enhance investor protection and market transparency by requiring investment firms to take "all sufficient steps" to obtain the best possible result for their clients when executing orders²², ²³. The European Securities and Markets Authority (ESMA) has since provided further guidance and clarifications, including proposals for more specific requirements for firms using a single execution venue and increased transparency regarding order execution policies²⁰, ²¹.

Key Takeaways

• Best execution is a regulatory obligation for brokers to secure the most advantageous terms for client trades.
• Factors considered include price, speed, likelihood of execution, and total costs.
• It is a core investor protection principle enforced by financial authorities like the SEC and FINRA in the U.S. and ESMA under MiFID II in Europe.
• Broker-dealers must establish, maintain, and review policies and procedures designed to achieve best execution.
• The duty applies to all types of client orders and various financial instruments.

Formula and Calculation

While there isn't a single universal formula for "best execution," the principle involves optimizing several factors that can be quantified and analyzed. For equities, the implicit cost of a trade can be considered, which measures the difference between the execution price and a benchmark price (e.g., the midpoint of the bid-ask spread at the time of order receipt).

One common way to assess execution quality involves analyzing:

Where:

• Execution Price is the price at which the order was filled.
• Midpoint Price is the average of the national best bid and offer (NBBO) at the time the order was received.

Lower effective spreads generally indicate better execution quality, as the trade was executed closer to the midpoint of the available prices.

Interpreting Best Execution

Interpreting best execution goes beyond simply achieving the lowest price for a buy order or the highest price for a sell order. It requires a holistic assessment of various execution factors. Brokers must consider the size and nature of the order, the liquidity of the financial instrument, and the prevailing market conditions. For instance, a large order in an illiquid security might require a different execution strategy than a small order in a highly liquid stock to achieve the best overall result, which might prioritize likelihood of execution over a marginal price improvement. Firms are expected to conduct regular and rigorous reviews of their execution quality and adjust their order handling practices accordingly¹⁹.

Hypothetical Example

Imagine a retail investor, Sarah, wants to buy 100 shares of XYZ Corp. She places a market order with her broker. At the time, the national best bid for XYZ is $50.00 and the national best offer is $50.05.

A broker fulfilling its best execution duty would strive to get Sarah's order filled at $50.05 or lower. If the broker routes the order to a market maker who fills it at $50.04, this would represent a positive price improvement, demonstrating best execution. Conversely, if the order is filled at $50.06 while $50.05 was readily available elsewhere, it might indicate a failure to achieve best execution, assuming all other factors were equal. The broker would also consider the speed of the fill and ensure minimal transaction costs.

Practical Applications

Best execution is a fundamental aspect of the broker-client relationship across various financial activities. In portfolio management, investment managers must ensure that trades executed for their clients' portfolios meet best execution standards. This often involves selecting appropriate execution venues and continuously monitoring the quality of execution provided by their chosen brokers.

Regulatory bodies actively enforce best execution rules. For example, FINRA Rule 5310 requires broker-dealers to use "reasonable diligence to ascertain the best market for the subject security, and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions."¹⁸ This includes considering factors such as the character of the market, the size and type of transaction, and the accessibility of price improvement opportunities¹⁶, ¹⁷. The U.S. Securities and Exchange Commission (SEC) also proposed new Regulation Best Execution in December 2022, which aims to codify a federal best execution standard requiring broker-dealers to achieve the "most favorable price" for customers and implement robust policies and procedures¹⁴, ¹⁵.

Limitations and Criticisms

Despite its importance, best execution faces challenges and criticisms. One limitation is the subjective nature of what constitutes "best" in all circumstances, as it involves balancing multiple factors beyond just price, such as speed and likelihood of execution¹³. For complex or illiquid securities, determining the best possible outcome can be particularly difficult.

Critics also point to potential conflicts of interest, especially in models where brokers receive payment for order flow from market makers. While regulators emphasize that such arrangements should not compromise the broker's duty of best execution, concerns persist about whether these payments could incentivize brokers to route orders to venues that compensate them most, rather than those offering the absolute best outcome for the client¹². Ensuring proper regulatory compliance and continuous oversight is crucial to mitigate these potential conflicts. The European Securities and Markets Authority (ESMA) has also identified shortcomings in how firms document and demonstrate their compliance with best execution processes under MiFID II, highlighting the ongoing need for improved transparency and harmonization¹⁰, ¹¹.

Best Execution vs. Order Routing

Best execution refers to the overarching obligation for a broker-dealer to obtain the most favorable terms for a client's order. This encompasses a broad range of considerations, including price, speed, likelihood of execution, and total transaction costs.

Order routing, on the other hand, is the specific process by which a broker sends a client's order to a particular execution venue for fulfillment. While closely related, order routing is a component of achieving best execution. A broker's order routing decisions must be designed to fulfill their best execution duty. This means selecting venues and strategies that are reasonably likely to deliver the most favorable outcome for the customer, rather than simply directing orders to the fastest or cheapest venue without considering other factors. The choice of where to send a limit order versus a market order can significantly impact the final execution quality.

FAQs

What factors determine best execution?

Several factors determine best execution, including the price of the financial instrument, the speed at which the order is executed, the likelihood that the order will be fully completed, the size and nature of the order, and any direct or indirect transaction costs involved. Brokers must weigh these factors to achieve the most favorable overall outcome for their client⁹.

Who is responsible for ensuring best execution?

Broker-dealers are primarily responsible for ensuring best execution for their clients' orders. This responsibility is a core part of their fiduciary duty and is enforced by regulatory bodies such as the SEC and FINRA in the United States, and ESMA in Europe⁸.

Does best execution apply to all types of orders?

Yes, the duty of best execution generally applies to all types of customer orders, whether they are market orders, limit orders, or other order types⁷. Brokers must apply reasonable diligence to achieve the most favorable terms regardless of the specific instruction, unless the client provides a very specific instruction that limits the broker's discretion⁵, ⁶.

How do regulators monitor best execution?

Regulators monitor best execution by requiring firms to establish and maintain written policies and procedures for order handling and execution. They also mandate regular reviews of execution quality and public disclosures of execution venue performance. These measures help regulators assess whether firms are consistently fulfilling their best execution obligations and identify any potential shortcomings or conflicts of interest², ³, ⁴. Regulators also conduct targeted reviews and enforce penalties for non-compliance¹.