OPINION
2023 Jun/27
Best Execution Obligations for Retail Investors in Major Countries and Implications
Jun. 27, 2023
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- Summary
- The best execution obligation provision under the Financial Investment Services and Capital Markets Act prescribes that a financial investment business entity should establish the best execution criteria and execute a client’s order on the best terms. In the current single trading market structure, the process of finding the most favorable conditions for clients hardly makes any meaningful difference, and the best execution compliance policies for each financial investment business entity has not yet been put in place. After the transition to a multi-market structure, however, best execution will serve as an important factor in affecting the level of investor protection and determining the quality of the entire market. For this reason, it is necessary to prepare for a multi-market environment by clearly understanding the duty of best execution and devising a specific compliance plan. In particular, considering a high share of retail investors and their active investment in the Korean securities market, the major challenge is to establish the best execution criteria that can protect retail investors and, at the same time, reduce the burden on financial investment business entities. In this regard, it is worth referring to the regulation of major countries that distinguishes retail clients from professional clients and establishes the best execution policy for retail clients with a focus on price and direct costs.
Korea’s Financial Investment Services and Capital Markets Act (FSCMA) prescribes that each broker-dealer should establish the best execution criteria and execute a client’s offer or order on the best terms (Article 68 Paragraphs 1 and 2 of the FSCMA). This is a principle that requires a financial investment business entity to make reasonable efforts to execute a client order on the most favorable terms in a given environment.
The best execution regulation was introduced in May 2015, more than a decade, but it hardly had practical binding power until this year. Given that the key to the best execution regulation is the process of finding the most favorable terms for clients among several options, such a process rarely makes a significant difference under the single trading market structure where comparable markets do not exist.1) This year, however, Nextrade announced its plan to commence full-scale operation in the second half of 2024 at the earliest after gaining preliminary and primary approvals and thus, it has become urgently necessary for each financial investment business entity to set up the regulation and implementation system for best execution.
A clear understanding of the duty of best execution and the establishment of reasonable and efficient compliance plans are crucial for investors as well as financial investment business entities that are obliged to comply with the duty of best execution. Against this backdrop, this article intends to enhance market participants’ understanding of the best execution duty in response to changes in the market environment and discuss desirable plans to introduce the duty. In particular, policy measures for best execution will be explored to protect retail investors in the increasingly complex market structure.
The best execution duty for a broker-dealer
The duty of best execution applies to the entire process ranging from a broker-dealer’s receipt of a client's order to order execution. The procedures for compliance with the best execution duty can be subdivided into pre-execution, execution and post-execution as follows.
A broker-dealer should establish appropriate policies and procedures for best execution before order execution and publicize relevant matters in advance. It needs to provide a clear and detailed explanation of how and in which market an order from a client is executed to help the client better understand order execution procedures.
Based on the best execution policy, a broker-dealer executes an order to ensure that the order contract is signed on the best terms. However, executing an order for the best results does not necessarily mean that the execution of all orders must produce the best results. What a broker-dealer needs to do is to demonstrate that it has set up appropriate criteria to consistently select the conditions that will bring about the best results and has taken measures sufficient to draw the best possible results.
After an order is executed, the outcome of order execution should be assessed. Whether the best execution is carried out should be examined on a regular basis, and if there is a need for improving the best execution criteria, the criteria should be amended accordingly. Additionally, upon the request of a client, a broker-dealer should evaluate the compliance with the best execution regulation and provide the evaluation result for the client.
Major countries’ criteria for judging best execution for retail investors
A broker-dealer should establish a specific best execution policy to comply with the best execution obligation. But it is impossible to give a single answer that applies to all orders, as to what the best terms are. This is because the best trading terms may vary, depending on the characteristics of each order, the trading market conditions, the type of clients, and separate instructions demanded by clients.
For this reason, a broker-dealer should establish quantitative and qualitative criteria for best execution. It needs to present a list of trading markets for order routing and determine the selection criteria and relative importance of trading markets. It is also necessary to examine determinants of best execution, such as price, cost, speed, the possibility of execution, order size, etc., by subdividing orders by financial instrument and type of investors. Furthermore, the process for determining the relative importance of each determinant should be prepared and disclosed.
Each country specifies various factors to be factored in to establish the best execution criteria in its best execution regulation. Even within a single country, the specific form of best execution varies by the judgment of broker-dealers. Notably, one common feature is that most countries stipulate that differentiated best execution criteria should be prepared by classifying investor groups. It is possible to categorize investors into different groups, such as dividing them into retail clients and wholesale clients or retail clients and professional clients. But such categorization methods are hardly differentiated, considering that they aim to distinguish retail clients who have a low understanding of the financial market or products from professional clients with experience and knowledge in risk assessment.
The following are the best execution regulations for retail investors by country. The European Commission specifies that the introduction of the MiFID II (Markets in Financial Instruments Directive II) mainly aims at protecting investors and that investor protection measures should be adjusted to suit each investor. As for order execution of retail investors, the MiFID II explicitly simplifies the criteria for determining the best outcome based on the total consideration, including the price of financial instruments and execution-related expenses (MiFID II Article 27(1) of the MiFID II). In this case, the total consideration is defined as the combination of the price of financial instruments and execution-related expenses. Expenses for order execution are borne by clients and include items directly related to order execution such as fees generated from the trading market, commissions imposed by a broker-dealer and liquidation and settlement fees. A professional investor makes a decision after considering relevant factors such as price, costs, speed, and feasibility. Like Europe, Australia prescribes that a retail client order should be executed based on the total consideration (MIR 3.8.1(1)).
Japan has recently revised its best execution principle to apply the price-first principle to retail investors and has enforced the revised principle starting from January 2023. As is the case with best execution regulations adopted by other countries, Japan’s Financial Instruments and Exchange Act (FIEA) requires financial instrument traders to specify how to execute client orders on the best trading terms and the reason for selecting an execution method (Article 40-2(1) of the FIEA, Article 16-6(2) of the Enforcement Decree of the FIEA). If an order from a retail client is executed under terms other than the most favorable terms, the FIEA requires the trader to provide the reason for selecting such terms (Article 124 of the Cabinet Office Ordinance on Financial Instruments Business, etc.). In other words, Japan rarely forces financial instrument traders to uniformly adopt the best execution policy that puts a priority on price, but it encourages them to change to the price-first principle by requiring traders to state the reason for not prioritizing price when executing retail client orders.
Meanwhile, the duty of best execution in the US is not stipulated under the current law. The Financial Industry Regulatory Authority (FINRA) and the Municipal Securities Rulemaking Board (MSRB), which are self-regulatory bodies, establish regulations and guidelines for best execution, and the Securities and Exchange Commission (SEC) makes a statement regarding them.2) However, the US has put in place the National Market System (NMS) and a regime prioritizing price in order to improve transparency and implement effective regulatory integration. According to the Order Protection Rule of Regulation NMS, each trading market must route an order to another market offering the National Best Bid and Offer (NBBO) if the quote offered by the market that initially receives the order is not the NBBO. For this reason, the NBBO can be met for both institutional and retail investors in the US market, regardless of which trading market the order is initially transmitted to.
Need for classifying best execution criteria by investor type
The following are reasons why each country has established regulations to classify investors by type and apply the best execution criteria to each investor group.
First, applying simplified criteria to retail investors is believed to be more appropriate for protecting them. In an environment where the market structure is complex and transactions are executed in various ways, such as in the US or Europe, it is difficult for investors to get a clear understanding of the transaction execution process and such an environment may pose a conflict of interest between broker-dealers and investors. This necessitates tighter regulations to protect investors. The US applies the price-first principle to all investors by setting up the NMS and preparing the regulation for meeting the NBBO, while the MiFID II has adopted higher criteria for best execution only for retail clients to strengthen retail investor protection by taking into account the characteristics of investors.
Japan and Australia, which have a simpler market structure compared to the US or Europe, also stipulate that price and transaction costs should be overriding considerations to efficiently protect retail investors. In Japan, exchange-centered transaction execution practices have continued for a long time, and even after the establishment of the Proprietary Trading System (PTS), Japan’s alternative trading system (ATS), the level of market fragmentation has been kept low for more than a decade. However, trading markets have recently diversified, thanks to the increase in the share of PTS and the operation of dark pools exclusively for retail investors. Furthermore, a Smart Order Routing (SOR), a process of executing orders after searching for the trading market offering the best price among multiple trading markets such as dark pools, has been put in place. Accordingly, there has been a growing need for protecting retail investors and the regulatory framework has been modified to judge best execution practices with a focus on price.
Second, considering the general features of orders from retail investors, order execution based only on total consideration hardly undermines actual profits in most cases. Retail investors usually tend to trade stocks that are small in size and have high liquidity. As a result, there is a high chance that orders from retail investors are executed at the highest price. The chances are slim that retail investor orders frequently cause shocks to the market, lowering the possibility of order execution and significantly increasing clients' implicit transaction costs.For this reason, orders from retail investors can be satisfactorily executed only by taking into account price and explicit transaction costs, and the execution result is generally expected to show little difference from when complex variables are considered.
Third, if the best execution criteria for retail investors are simplified, it would be easier for broker-dealers to carry out the best execution and prove the results and for investors to evaluate whether their order is executed on the best terms. Calculating price and explicit transaction costs is much simpler than delivering the effect of price improvement, market impact costs, and the possibility of execution and settlement. This makes it easy and convenient to compare and select trading markets, which can streamline the best execution process. In addition, broker-dealers can easily prove the result of the best execution to clients, while investors can evaluate the result more conveniently. This may reduce the burden on retail investors and broker-dealers in the entire process of best execution implementation, order execution and assessment.
Fourth, it is notable that if a client gives a specific instruction regarding the best execution criteria, the instruction is the overriding priority for a broker-dealer. Therefore, retail investors’ choice is not fundamentally restricted. Even if the best execution policy for retail investors stipulates that price and costs are major considerations, a broker-dealer should follow a client’s instruction if the client requires it to give priority to other factors. For example, a certain retail investor, unlike an ordinary retail investor, may wish to place orders in large volume or trade stocks with considerably lower liquidity. In this case, the investor may instruct a broker-dealer to prioritize market impact or the possibility of execution over price and direct transaction costs. However, the broker-dealer must provide a full explanation of the investment practice to the investor since following a retail investor’s instruction does not always lead to better results.
Implications
For the establishment of the multiple trading market system, it is necessary to continuously overhaul and refine the regulatory environment. The best execution principle is a crucial provision that promotes investor protection by preventing broker-dealers from prioritizing their own interests over those of clients. When the best execution principle works smoothly, the overall market grows through mutual competition among various trading markets and the resultant benefits would end up reaching investors. Before a new market system is introduced, the opinions of regulators and the financial industry should be fully considered to create regulatory incentives for broker-dealers to route client orders to the market that can deliver the best results.
In addition, each broker-dealer should establish the best execution policy and procedures in preparation for the emergence of the alternative trading system (ATS). What is needed in this respect is the establishment of appropriate best execution criteria for retail investors by referring to the cases of countries that have mandated the establishment of the best execution policy for retail investors based on the total consideration. Considering the high share of retail investors and their strong activity in Korea’s market, the real challenge is to set up the best execution criteria suitable for retail investors.
1) Even if there is no stipulated best execution regulation or it is impossible to directly compare trade terms under the single market structure, financial investment business entities are subject to the duty of best execution. Making the best effort for the interest of clients, regardless of market conditions or structure, is the obligation that financial investment business entities should comply with in good faith. However, the more complex the structure of the trading market, the more complicated and ambiguous the criteria for best execution and thus, explicit standards are needed.
2) The US SEC has been recently conducting a structural reform to overhaul the process of order pricing, transaction execution and information disclosure in the stock market. On December 14, 2022, four enactments and amendments were publicized, including the best execution criteria enactment.
The best execution regulation was introduced in May 2015, more than a decade, but it hardly had practical binding power until this year. Given that the key to the best execution regulation is the process of finding the most favorable terms for clients among several options, such a process rarely makes a significant difference under the single trading market structure where comparable markets do not exist.1) This year, however, Nextrade announced its plan to commence full-scale operation in the second half of 2024 at the earliest after gaining preliminary and primary approvals and thus, it has become urgently necessary for each financial investment business entity to set up the regulation and implementation system for best execution.
A clear understanding of the duty of best execution and the establishment of reasonable and efficient compliance plans are crucial for investors as well as financial investment business entities that are obliged to comply with the duty of best execution. Against this backdrop, this article intends to enhance market participants’ understanding of the best execution duty in response to changes in the market environment and discuss desirable plans to introduce the duty. In particular, policy measures for best execution will be explored to protect retail investors in the increasingly complex market structure.
The best execution duty for a broker-dealer
The duty of best execution applies to the entire process ranging from a broker-dealer’s receipt of a client's order to order execution. The procedures for compliance with the best execution duty can be subdivided into pre-execution, execution and post-execution as follows.
A broker-dealer should establish appropriate policies and procedures for best execution before order execution and publicize relevant matters in advance. It needs to provide a clear and detailed explanation of how and in which market an order from a client is executed to help the client better understand order execution procedures.
Based on the best execution policy, a broker-dealer executes an order to ensure that the order contract is signed on the best terms. However, executing an order for the best results does not necessarily mean that the execution of all orders must produce the best results. What a broker-dealer needs to do is to demonstrate that it has set up appropriate criteria to consistently select the conditions that will bring about the best results and has taken measures sufficient to draw the best possible results.
After an order is executed, the outcome of order execution should be assessed. Whether the best execution is carried out should be examined on a regular basis, and if there is a need for improving the best execution criteria, the criteria should be amended accordingly. Additionally, upon the request of a client, a broker-dealer should evaluate the compliance with the best execution regulation and provide the evaluation result for the client.
Major countries’ criteria for judging best execution for retail investors
A broker-dealer should establish a specific best execution policy to comply with the best execution obligation. But it is impossible to give a single answer that applies to all orders, as to what the best terms are. This is because the best trading terms may vary, depending on the characteristics of each order, the trading market conditions, the type of clients, and separate instructions demanded by clients.
For this reason, a broker-dealer should establish quantitative and qualitative criteria for best execution. It needs to present a list of trading markets for order routing and determine the selection criteria and relative importance of trading markets. It is also necessary to examine determinants of best execution, such as price, cost, speed, the possibility of execution, order size, etc., by subdividing orders by financial instrument and type of investors. Furthermore, the process for determining the relative importance of each determinant should be prepared and disclosed.
Each country specifies various factors to be factored in to establish the best execution criteria in its best execution regulation. Even within a single country, the specific form of best execution varies by the judgment of broker-dealers. Notably, one common feature is that most countries stipulate that differentiated best execution criteria should be prepared by classifying investor groups. It is possible to categorize investors into different groups, such as dividing them into retail clients and wholesale clients or retail clients and professional clients. But such categorization methods are hardly differentiated, considering that they aim to distinguish retail clients who have a low understanding of the financial market or products from professional clients with experience and knowledge in risk assessment.
The following are the best execution regulations for retail investors by country. The European Commission specifies that the introduction of the MiFID II (Markets in Financial Instruments Directive II) mainly aims at protecting investors and that investor protection measures should be adjusted to suit each investor. As for order execution of retail investors, the MiFID II explicitly simplifies the criteria for determining the best outcome based on the total consideration, including the price of financial instruments and execution-related expenses (MiFID II Article 27(1) of the MiFID II). In this case, the total consideration is defined as the combination of the price of financial instruments and execution-related expenses. Expenses for order execution are borne by clients and include items directly related to order execution such as fees generated from the trading market, commissions imposed by a broker-dealer and liquidation and settlement fees. A professional investor makes a decision after considering relevant factors such as price, costs, speed, and feasibility. Like Europe, Australia prescribes that a retail client order should be executed based on the total consideration (MIR 3.8.1(1)).
Japan has recently revised its best execution principle to apply the price-first principle to retail investors and has enforced the revised principle starting from January 2023. As is the case with best execution regulations adopted by other countries, Japan’s Financial Instruments and Exchange Act (FIEA) requires financial instrument traders to specify how to execute client orders on the best trading terms and the reason for selecting an execution method (Article 40-2(1) of the FIEA, Article 16-6(2) of the Enforcement Decree of the FIEA). If an order from a retail client is executed under terms other than the most favorable terms, the FIEA requires the trader to provide the reason for selecting such terms (Article 124 of the Cabinet Office Ordinance on Financial Instruments Business, etc.). In other words, Japan rarely forces financial instrument traders to uniformly adopt the best execution policy that puts a priority on price, but it encourages them to change to the price-first principle by requiring traders to state the reason for not prioritizing price when executing retail client orders.
Meanwhile, the duty of best execution in the US is not stipulated under the current law. The Financial Industry Regulatory Authority (FINRA) and the Municipal Securities Rulemaking Board (MSRB), which are self-regulatory bodies, establish regulations and guidelines for best execution, and the Securities and Exchange Commission (SEC) makes a statement regarding them.2) However, the US has put in place the National Market System (NMS) and a regime prioritizing price in order to improve transparency and implement effective regulatory integration. According to the Order Protection Rule of Regulation NMS, each trading market must route an order to another market offering the National Best Bid and Offer (NBBO) if the quote offered by the market that initially receives the order is not the NBBO. For this reason, the NBBO can be met for both institutional and retail investors in the US market, regardless of which trading market the order is initially transmitted to.
Need for classifying best execution criteria by investor type
The following are reasons why each country has established regulations to classify investors by type and apply the best execution criteria to each investor group.
First, applying simplified criteria to retail investors is believed to be more appropriate for protecting them. In an environment where the market structure is complex and transactions are executed in various ways, such as in the US or Europe, it is difficult for investors to get a clear understanding of the transaction execution process and such an environment may pose a conflict of interest between broker-dealers and investors. This necessitates tighter regulations to protect investors. The US applies the price-first principle to all investors by setting up the NMS and preparing the regulation for meeting the NBBO, while the MiFID II has adopted higher criteria for best execution only for retail clients to strengthen retail investor protection by taking into account the characteristics of investors.
Japan and Australia, which have a simpler market structure compared to the US or Europe, also stipulate that price and transaction costs should be overriding considerations to efficiently protect retail investors. In Japan, exchange-centered transaction execution practices have continued for a long time, and even after the establishment of the Proprietary Trading System (PTS), Japan’s alternative trading system (ATS), the level of market fragmentation has been kept low for more than a decade. However, trading markets have recently diversified, thanks to the increase in the share of PTS and the operation of dark pools exclusively for retail investors. Furthermore, a Smart Order Routing (SOR), a process of executing orders after searching for the trading market offering the best price among multiple trading markets such as dark pools, has been put in place. Accordingly, there has been a growing need for protecting retail investors and the regulatory framework has been modified to judge best execution practices with a focus on price.
Second, considering the general features of orders from retail investors, order execution based only on total consideration hardly undermines actual profits in most cases. Retail investors usually tend to trade stocks that are small in size and have high liquidity. As a result, there is a high chance that orders from retail investors are executed at the highest price. The chances are slim that retail investor orders frequently cause shocks to the market, lowering the possibility of order execution and significantly increasing clients' implicit transaction costs.For this reason, orders from retail investors can be satisfactorily executed only by taking into account price and explicit transaction costs, and the execution result is generally expected to show little difference from when complex variables are considered.
Third, if the best execution criteria for retail investors are simplified, it would be easier for broker-dealers to carry out the best execution and prove the results and for investors to evaluate whether their order is executed on the best terms. Calculating price and explicit transaction costs is much simpler than delivering the effect of price improvement, market impact costs, and the possibility of execution and settlement. This makes it easy and convenient to compare and select trading markets, which can streamline the best execution process. In addition, broker-dealers can easily prove the result of the best execution to clients, while investors can evaluate the result more conveniently. This may reduce the burden on retail investors and broker-dealers in the entire process of best execution implementation, order execution and assessment.
Fourth, it is notable that if a client gives a specific instruction regarding the best execution criteria, the instruction is the overriding priority for a broker-dealer. Therefore, retail investors’ choice is not fundamentally restricted. Even if the best execution policy for retail investors stipulates that price and costs are major considerations, a broker-dealer should follow a client’s instruction if the client requires it to give priority to other factors. For example, a certain retail investor, unlike an ordinary retail investor, may wish to place orders in large volume or trade stocks with considerably lower liquidity. In this case, the investor may instruct a broker-dealer to prioritize market impact or the possibility of execution over price and direct transaction costs. However, the broker-dealer must provide a full explanation of the investment practice to the investor since following a retail investor’s instruction does not always lead to better results.
Implications
For the establishment of the multiple trading market system, it is necessary to continuously overhaul and refine the regulatory environment. The best execution principle is a crucial provision that promotes investor protection by preventing broker-dealers from prioritizing their own interests over those of clients. When the best execution principle works smoothly, the overall market grows through mutual competition among various trading markets and the resultant benefits would end up reaching investors. Before a new market system is introduced, the opinions of regulators and the financial industry should be fully considered to create regulatory incentives for broker-dealers to route client orders to the market that can deliver the best results.
In addition, each broker-dealer should establish the best execution policy and procedures in preparation for the emergence of the alternative trading system (ATS). What is needed in this respect is the establishment of appropriate best execution criteria for retail investors by referring to the cases of countries that have mandated the establishment of the best execution policy for retail investors based on the total consideration. Considering the high share of retail investors and their strong activity in Korea’s market, the real challenge is to set up the best execution criteria suitable for retail investors.
1) Even if there is no stipulated best execution regulation or it is impossible to directly compare trade terms under the single market structure, financial investment business entities are subject to the duty of best execution. Making the best effort for the interest of clients, regardless of market conditions or structure, is the obligation that financial investment business entities should comply with in good faith. However, the more complex the structure of the trading market, the more complicated and ambiguous the criteria for best execution and thus, explicit standards are needed.
2) The US SEC has been recently conducting a structural reform to overhaul the process of order pricing, transaction execution and information disclosure in the stock market. On December 14, 2022, four enactments and amendments were publicized, including the best execution criteria enactment.