Commentary: SEC's proposed regulation best execution isn't the best for institutional investors

Buried in a package of controversial, sweeping stock market reforms intended to protect individual traders from being ripped off by their online brokers, the Securities and Exchange Commission is proposing to eliminate long-standing protections for pension funds, endowments and other institutional customers.

The SEC's proposed Regulation Best Execution would exempt banks and brokers from best execution for a broad swath of trades with "institutional customers." The SEC should go in the opposite direction and strengthen best execution standards for not just brokers, but asset managers as well.

Brokers and asset managers have a fiduciary duty of best execution. You might think of this as the obligation to act in their customers' best interests when buying and selling securities. Most of the time, this means trying to get their customers the best prices.

And while these centuries-old fiduciary duties stem from common law, a broker's duty of best execution is codified by rules from the Financial Industry Regulatory Authority and Municipal Securities Rulemaking Board.

Now, however, the GameStop phenomenon of 2021 and heightened concerns with payments from exchanges and wholesalers to brokers for order flow has prompted SEC leadership to adopt its own best execution rule.

SEC Chairman Gary Gensler has made it clear that a new SEC rule would let the regulator set and enforce better standards. In theory, we agree.

Unfortunately, while the SEC's 439-page Regulation Best Execution proposal may arguably better protect some individuals trading through online brokerages, it does nothing to improve best execution for investment advisers. Worse, it would affirmatively remove obligations on brokers and protections for pension funds and institutional investors.

Despite the SEC chairman's claims that the SEC needs to have its own rule for best execution, nothing in the SEC's proposal requires investment advisers to even have best execution policies, or conduct any analysis, much less require any specific details.

Of course, many "best practices" have emerged over time including performing "transaction cost analysis" of trades, keeping track (separately) of "research" payments and "trade execution" payments, and other steps. But these steps — which may be admirable — are not universally required and can and do vary significantly across advisers.

While the SEC's examinations team has identified many weaknesses for investment advisers' best execution policies, procedures and practices, the SEC still has declined to even propose a rule or guidance, much less engage in any meaningful enforcement of its vague interpretation that advisers fulfill their fiduciary duty. In fact, when the SEC updated its interpretation of investment advisers' fiduciary duties in 2019, it dedicated only a single page (double-spaced and including lengthy footnotes) to the topic.

Rather than fill this void, however, the SEC has chosen to expose investment advisers and other institutional investors to greater risks by exempting a broker-dealer from having to comply with its own best execution obligations if "an institutional customer, exercising independent judgment, executes its order against the broker-dealer's quotation."

This is an entirely new exemption being proposed that weakens, rather than strengthens, best execution.

Over the years, there have been limited exceptions to best execution, such as when brokers receive unsolicited instructions from their customers to route to particular destinations without intervention and the broker follows the instructions.

This is something different. While the Commission may think that the new exemption is helpful to investors, it opens Pandora's box to abuses. The exemption, which would apply to trades in equities, fixed income, options and other derivatives, would allow brokers to effectively ignore "best execution" for a potentially large swath of their trades with institutional customers. There are no requirements that the quotations be anywhere near prevailing market prices (displayed or undisplayed) — or that the quotations be public or the same for different customers.

There would be no record-keeping requirements. There would be no disclosure requirements. There would be no mandate that brokers seeking to rely on the exemption, for example, notify the "institutional customers" that their trades may be at terrible prices. And worse, there may be no practical way for the customers to know that on their own.

While this massive new exemption would be a boon to big banks (as opposed to other markets intermediaries who may not commit capital as easily), it could also profoundly change the structure of the markets. Will banks seek to move more of their trading from the tightly regulated public exchanges and trading venues into more bespoke trading mechanisms, which may allow them to avoid "best execution"? While it isn't true that a watched pot never boils, it is true that an unwatched bank will seek to maximize profits off its clients' trading.

At the same time, not all investors are likely to be equally impacted. The institutional customers that have close connections to the banks, the market power to demand high execution quality, the ability to see enough of the market and the ability to perform their own analysis to police their brokers' execution quality may be able to mitigate their risks.

But while a trillion-dollar asset manager might think it will ultimately be okay without protections, what about everyone else?

Put another way, in the name of having its "own rule," the SEC has proposed a best execution rule for brokers that is materially weaker than FINRA's existing best execution rule with regards to protecting institutional customers; and the Commission has continued its decades-long streak of providing no rules or guidance on what best execution should mean for investment advisers.

For the sake of investors and the markets, we hope the agency reverses course on both fronts. The SEC should not materially lower best execution obligations on brokers' trades with institutional customers. It should eliminate the new proposed exemption, and it should also fill the real regulatory void in best execution — by finally proposing rules on what should be expected of investment advisers on best execution.

Tyler Gellasch is president and CEO of the Healthy Markets Association, a Washington, D.C.-based non-profit group of money managers, pension funds, brokers, exchanges and data firms that focuses on the transparency, efficiency and fairness of the capital markets. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.