The regulatory requirements of best execution can pose challenges for many advisors.
Prior to the advent of FINRA's Trade Reporting and Compliance Engine and the MSRB’s Electronic Municipal Market Access systems for transaction reporting, the concept of best execution in the fixed-income markets was somewhat vague.
Recognizing that many of the attributes of the equity markets didn’t apply to fixed income, interpretations and guidance often included fuzzy qualitative excuses, such as “confidentiality,” “knowledge of the other side of the trade,” “market depth,” “overall qualitative execution” and “speed of execution” to justify a bad price.
The SEC said in 1986 that, in seeking best execution, an asset manager must “execute securities transactions for clients in such a manner that the client’s total cost or proceeds in each transaction is the most favorable under the circumstances.” The SEC has declared that, in seeking this standard, a manager “should consider the full range and quality of a broker’s services in placing brokerage including, among other things, the value of research provided as well as execution capability, commission rate, financial responsibility, and responsiveness to the … manager.”
But, as good lawmakers tend to do, they also left themselves some wiggle room in their interpretations, requiring that firms periodically and systematically assess the quality of execution services received and amend their procedures over time as changes occur in the market and give rise to improved execution. Fast forward 15 years or so, and regulators have embraced technology and sought to bring the same level of transparency in the equity market to bonds, and hence are exercising their option to re-assess the definition of best execution.
With that in mind, here are three questions that every advisor needs to ask about best execution in the fixed-income market.
1. What is new?
The fixed-income market has not historically enjoyed the centralization and transparency that the equity market has, partly due to the sheer number of issuers and CUSIPs in this market, both corporate and municipal. The “over-the-counter” or “trade-by-appointment” nature has caused concerns over the risk inefficiencies and potential for price dislocation among market participants.
Last year, FINRA and the MSRB implemented more stringent best execution standards for broker-dealers, setting forth standards for what they consider reasonable diligence in executing a trade, including the use of electronic-trading platforms. In summary, FINRA began requiring brokers to perform a regular and rigorous review of fixed-income trades to ensure that their clients are receiving the best available price on their bond trades.
Another noteworthy revelation from FINRA is the recognition of alternative trading systems that are available for the bond market, so much so that they will be expecting that brokers evaluate these platforms to determine if they will add value to their customer order flow process.
In the same breath, they caution that electronic-trading platforms are not a panacea for best execution and that a broker can’t presume best execution merely for using one. Additional due diligence is required to assemble all the different market participants before those assurances can be concluded.
2. If I am not regulated by FINRA, do those rules apply to me?
The Investment Advisers Act of 1940 is generally considered a principles-based rule regime in that it doesn’t frequently require or proscribe specific activities to carry out one's fiduciary duty.
Advisors, of course, are held to the highest standard of care. Fiduciary duty is a relatively broad obligation to do what is in clients’ best interests.
Rather, the SEC often relies on broad interpretive latitude informed by the specific facts and circumstances of potential violations, as well as other legal or regulatory precedent. The SEC has unequivocally stated that the duty of best execution, as it is applied to advisors, requires them to execute securities transactions for clients in such a manner that the client’s total costs or proceeds in each transaction are the most favorable under the circumstances.
The SEC has brought a number of enforcement cases against advisors in which an advisor failed to conduct an analysis on broker selection, whereby their clients incurred higher-than-average costs as a result. The more rules-based approach that FINRA has taken is likely to also establish more defined industry best practices and legal precedence for advisors, especially given the ever-blurring lines between the two regulatory regimes.
In one study, the SEC found that about 88% of investment advisor representatives are also registered representatives of broker-dealers, so it isn’t unreasonable to assume that best execution for fixed income is on the horizon for advisors as well.
3.What should I look for in a trading partner?
Independent advisors are also independent small-business owners, so it stands to reason that they would want to maximize every relationship. An optimal executing broker relationship should include thorough pre-trade intelligence, timely execution and customer service, and access to a trade desk that allows access to all parts of the market, not just those networked to the electronic communication networks.
Advisors should ask their broker-dealers to articulate their process for evaluating and negotiating bonds. And know that any reputable firm should be transparent about what it is charging on behalf of a client.
Equally important is post-trade documentation designed to help advisors fulfill best execution and their books and records obligations. This documentation should provide a thorough and easy-to-read summary of the prevailing market at the time of the trade, as well as the actions taken by the broker-dealer to achieve best execution.
For advisors who are not getting best execution support from their trading partners, it might be time to make a change.
Although advancements in technology have helped, they are not a panacea for helping advisors navigate the new regulatory requirements surrounding best execution. By making an effort to find their situation-specific answers to the above questions, advisors can pursue fixed-income investments on behalf of clients with greater confidence.
This story is part of a 30-30 series on evaluating fixed-income opportunities when rates are rising.