NASD NOTICE
TO MEMBERS 99-12:
BEST EXECUTION IN THE WORST OF TIMES
Recent NASDAQ high trade and share volume as well
as competitive pressures to provide swift executions, have placed added burdens on firms
that execute customer orders. In an effort to simply get the trade done, particularly
during volatile markets, some firms have provided poor execution. The typical defense is
that the choice was between a poor fill or none. The regulators and the public are not
sympathetic and have essentially espoused the old saying: a lack of planning on your part does not necessitate an emergency on
mine.
We recently reported on the NASD Notice to Members 99-11, which warned member firms to inform
investors of the increased risks associated with trading during turbulent market
conditions, especially when those members offer online services. NASD Notice to Members
99-12 (NTM) provides guidance as to the factors Market Makers should consider in
evaluating whether modifications to their order execution algorithms or procedures during
turbulent market conditions are consistent with the best execution of customer orders.
Smooth Sailing
Wholesale and Integrated firms often utilize
their own automated order execution systems for smaller customer orders of 3,000 shares or
less. These systems typically execute orders on a first-in-first-out basis (FIFO) and
afford priced orders priority on a price/time basis. Further, such executions must comport
with the SEC’s limit order display rule and the NASD’s limit order protection
rule. Similarly, firms that direct order flow have a best execution obligation to conduct
regular and rigorous review of the quality of executions of orders sent to correspondent
Market Makers.
Batten Down the Hatches
During extreme market conditions, where there
are large order imbalances and/or significant price volatility, many firms implement
procedures that are designed to preserve the continuous execution of customers’
orders while also lessening the exposure of the firm to extraordinary market risk.
| Some Responses Switch from an automated order execution mode to a manual execution
mode in which orders are generally routed through SelectNet to execute against another
Market Maker, passing on those prices to the customer.
Provide partial executions up to a certain size and,
if applicable, place the remainder of the order in a queue that is then processed on a
FIFO basis.
Reduce the size guarantee on individual stocks or
groups of stocks (i.e., Internet stocks) on a going-forward basis, irrespective of market
conditions at any given time. |
GETTING SHIPSHAPE
NASD Regulation believes firms should consider the
following five guidelines when evaluating whether their order execution algorithms or
procedures are appropriate during turbulent market conditions. Nothing in the guidelines
is intended to restrict firms from revising their execution algorithms for reasons
unrelated to market turbulence.
The treatment of customer
orders under any order execution algorithm or procedure must remain fair, consistent,
and reasonable
- Disclose
to your order entry firms (and customers if
applicable) the differences in your order execution algorithm or procedures during
volatile markets and explain the conditions that activate such procedures.
CAREFUL! Disclosure of alternative procedures that are unfair
or inconsistent with the firm’s best execution obligations would neither correct the
deficiencies with such procedures nor absolve the firm of potential best execution
violations.
- Modifications to order execution algorithms or procedures
designed to respond to turbulent market conditions may be implemented only when warranted
by market conditions.
CAREFUL!
Unwarranted and excessive activation of modified procedures could raise best execution
concerns. Be prepared to substantiate and document the reasons for such activation.
- "[b]roker-dealers therefore need to take steps to prevent
their operational systems from being overwhelmed by periodic spikes in systems message
traffic due to high volume. In particular, broker-dealers should not merely have sufficient
systems capacity to handle average-to-heavy loads."Securities and Exchange
Commission (SEC) Staff Legal Bulletin No. 8 (September 8, 1998) http://www.sec.gov/rules/othern/slbmr8.htm
CAREFUL! You must maintain enough
internal systems capacity to operate properly when trading volume is high but not
unprecedented. Frequent activation of modified order execution algorithms or procedures
because a firm has failed to maintain adequate system capacity to handle exceptional loads
may raise best execution concerns.
- NASD Rule 2320(d) provides that "[f]ailure to maintain or
adequately staff an over-the-counter order room or other department assigned to
execute customers’ orders cannot be considered justification for executing away from
the best available market . . . ."
CAREFUL! You will likely have the
burden of proving the facts and circumstances justifying your actions, when such decisions
result in lesser quality executions. Such concerns will probably arise whenever volatile
markets force firms to engage in manual executions.
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Questions or comments concerning NTM 99-12 should be
directed to the Legal Section of NASD Regulation’s Market Regulation Department, at
(301) 590-6410.
Definitions
wholesale firms: principally execute orders routed to them from other firms.
integrated firms: large retail business that also engage in market making and other activities.
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