In July, the Trading Examinations Unit within the Trading and Financial Compliance Examinations group at the Financial Industry Regulatory Authority (FINRA), the principal US securities industry self-regulatory organization, published a targeted examination letter being sent to some FINRA member firms as part of a review of processes and procedures in connection with order routing and execution quality of customer orders in exchange listed securities. Review the letter.

FINRA is asking the firms receiving this letter for explanations of differences in treatment of retail customers, institutional customers and proprietary trading by the firm.

The examination letter contains 12 requests:

  • Firms are directed to provide copies of the firm’s written supervisory procedures for compliance with FINRA Rule 5310. This rule generally requires:

In any transaction for or with a customer or a customer of another broker-dealer, a member and persons associated with a member shall 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.

  • Explain how the firm uses reasonable diligence to ascertain that it complies with Rule 5310 for orders routed for execution to an exchange or broker-dealer. The response must include an explanation of reviews that are conducted concerning customer order execution quality.

Alternative trading systems are registered as broker-dealers, so this request could be directed to them directly as FINRA members, and other FINRA members receiving this       letter would need to address decisions to route to firms operating alternative trading systems.

  • Explain how exchange order-routing decisions are made for customer non-marketable limit orders? The emphasis in this question is on the influence of maker/taker fees. Maker/taker fees offered by exchanges generally provide a form of rebate to firms for orders that add liquidity by providing non-marketable limit orders and by charging firms that take that liquidity. The issues here is whether some firms are using customer limit orders to earn rebates at the expense of best execution, and does this pricing model nonetheless have advantages in promoting liquidity.
  • Explain how exchange order-routing decisions are made for customer market and marketable limit orders? Here one of the issues is the effect of ‘taker’ fees in executing these orders.
  • State whether the firm passes maker/taker fees to its customers, the rationale for the practice, and the extent of customer disclosure.
  • Explain how the firm reviews execution quality for non-marketable limit orders routed to exchanges and how maker/taker fees are considered.
  • Explain how the firm review execution quality of market and marketable limit orders routed to exchanges and how maker/taker fees are considered.
  • Does the firm use a smart order router (SOR) to route customer orders to exchanges that provide make/taker fees? Explain how these fees operate in the SOR.
  • Does the firm receive payments or other remuneration for routing orders to other broker-dealers? Identify and describe these arrangements?
  • For orders routed to other broker-dealers, explain how these decisions are made and how payments for order flow influenced these decisions.
  • Explain how SORs work in relation to orders routed to other broker-dealers that make payments for order flow.
  • Explain whether the firm has a committee that specifically reviews execution quality of customer orders and how such committee operates.

The responses to these inquiries could support policy analysis, as well as possible enforcement referrals for failures involving best execution or conflicts of interest. These potential uses are consistent with the measures outlined by SEC Chair Mary Jo White in her June 5th speech outlining new SEC initiatives involving equity market structure, including an analysis of the policy implications of maker/taker fees and continuing enforcement efforts involving broker-dealer conflicts of interest.

Read the speech on the SEC website