Trading Supervision

Best Execution

FINRA Rule 5310 requires member firms to use reasonable diligence to ascertain the best market for a security and to buy or sell in that market so that the resultant price to the customer is as favorable as possible under prevailing market conditions. This is known as the best execution obligation, and it applies to all customer transactions. As a principal, you must ensure that the firm has systems and procedures in place to evaluate and achieve best execution across all markets and venues where the firm routes customer orders.

Best execution is not simply about obtaining the lowest price for a buy order or the highest price for a sell order. It encompasses a range of factors including:

• Price: The most important factor, but not the only one
• Speed of execution: How quickly the order is filled
• Size of execution: Whether the full order is filled or only partially
• Likelihood of execution: The probability of getting the order filled at the quoted price
• Market depth and liquidity: The availability of shares at or near the quoted price
• Transaction costs: Commissions, fees, and other costs associated with execution

Regular and Rigorous Review

FINRA expects firms to conduct regular and rigorous reviews of their order routing and execution practices. This includes at least quarterly review of execution quality data from the markets and venues where the firm routes orders, comparison of execution quality across different venues, evaluation of payment for order flow arrangements and their impact on execution quality, and analysis of the firm's order routing decisions. The firm must document these reviews and take corrective action when deficiencies are identified.

Regulation NMS

Regulation National Market System (Reg NMS), adopted by the SEC in 2005, is a comprehensive set of rules designed to modernize and strengthen the regulatory structure of the U.S. equity markets. Reg NMS addresses the interconnection of markets, the execution of customer orders, and the dissemination of market data. As a principal supervising trading activities, you must understand the core components of Reg NMS.

Key Components

• Order Protection Rule (Rule 611): Also known as the "trade-through" rule, it requires trading centers to establish policies and procedures reasonably designed to prevent trade-throughs (executing an order at a price inferior to the best displayed price available in the national market system). Protected quotations must be automated and immediately accessible.
• Access Rule (Rule 610): Establishes standards for access to quotations displayed by trading centers. Limits access fees to $0.003 per share for equity securities, and prohibits locked and crossed markets (where the bid equals or exceeds the ask across markets).
• Sub-Penny Rule (Rule 612): Prohibits market participants from displaying, ranking, or accepting quotations in NMS stocks in price increments smaller than one cent (for stocks priced at or above $1.00) or $0.0001 (for stocks priced below $1.00).
• Market Data Rules (Rules 601 and 603): Govern the collection, consolidation, and distribution of market data, including trade and quotation information.

Regulation SHO

Regulation SHO is the SEC's comprehensive regulation governing short selling of equity securities. Short selling involves selling securities that the seller does not own (or has borrowed), with the intent of purchasing them later at a lower price. While short selling provides market benefits (liquidity, price discovery), it can also be abused to manipulate stock prices. Reg SHO establishes rules to prevent abusive short selling practices.

Key Reg SHO Requirements

• Locate requirement (Rule 203(b)(1)): Before effecting a short sale, a broker-dealer must borrow the security, enter into a bona fide arrangement to borrow the security, or have reasonable grounds to believe the security can be borrowed and delivered on the delivery date. This is known as the "locate" requirement.
• Close-out requirement (Rule 204): If a security fails to deliver on settlement date, the firm must close out the fail-to-deliver position by purchasing or borrowing the security. For short sales, the close-out must be completed by the beginning of regular trading hours on the settlement day following the settlement date (T+2 for most securities).
• Short sale price test (Rule 201): Known as the "alternative uptick rule" or "circuit breaker," this rule applies when a stock has declined 10% or more from the prior day's closing price. Once triggered, short sales can only be executed at a price above the current national best bid (the "short sale price restriction" or SSPR). The restriction remains in effect for the remainder of the trading day and the following trading day.

Market Making and Order Handling

Market makers play a critical role in maintaining orderly markets by providing continuous two-sided quotations (bid and ask) for the securities in which they make markets. As a principal, you must supervise market-making activities to ensure compliance with applicable rules, including FINRA rules on quotation requirements, the SEC's order handling rules, and Reg NMS.

Market Maker Obligations

• Two-sided quotation requirement: Market makers must publish continuous, firm two-sided quotations during regular market hours for each security in which they are registered as a market maker
• Firm quote obligation: Market makers must be willing to execute orders at their displayed prices for at least the size they display (minimum of one round lot)
• Limit order display rule: When a market maker receives a customer limit order that improves the market maker's quote, the market maker must display the order (make it publicly available) unless the customer requests otherwise or the order is of block size (10,000+ shares or $200,000+)