Mar. 31, 2023
March 31, 2023 Thank you for the opportunity to comment on an what is an incredibly important topic. Broker dealers should have an obligation to honestly evaluate and discuss their conflicts of interest as part of their best execution processes. But the text of the proposed rule does not require broker dealers to do this sort of analysis on their conflicts. Instead, conflicted transactions are defined too narrowly, but also in such a way as to capture many transactions that do not actually involve any conflict of interest. Broker dealers should look at the conflict they have when handling client orders. This should be the case whether they are handling retail investor orders, those of institutional customers, or the agency orders of other broker dealers. Commonly discussed conflicts include routing a customer order to your own market maker to execute as principal, routing to a broker that provides you with payment for order flow (PFOF), transmitting customer orders to an alternative trading system operated by an affiliate. However conflicts exist in many other scenarios, such as when sending customer orders to an exchange in which your parent company may have an ownership stake, to meet or exceed exchange rebates or tiers, to another broker that provides discounted colocation or connectivity costs, or potentially when utilizing the routing services of a clearing firm that may have its own conflicts. An extreme example of a conflict would be routing orders as agent to another broker where there may be a n indirect or unknown financial relationship, such as a broker where ones brother is an execution services managing director. Any good best execution rule proposal should permit and require brokers to evaluate the myriad possible conflicts, rather than calling out specific types of conflicts. Additionally, an effective best execution process should recognize which conflicts of the broker dealer are disclosed (e.g. through a public Rule 606 document posted on the website of the firm, through an annual client disclosure, etc.) and which conflicts may not be known by customers. Disclosure of a conflict does not mean a broker dealer has absolved itself of the responsibility of discussing and evaluating the potential impact of the conflict on execution quality, but it can be a factor in that process. A rule that has elements that encourage brokers to disclose conflicts is helpful to customers when making an educated decision while choosing brokers. While it is appropriate for brokers to discuss and evaluate their conflicts as part of their best execution practices, it is counterproductive that the Commissions proposal defines retail investor transactions that occur with certain execution capacities as conflicted transactions. First, as discussed above, it is not the case that transactions that do not meet this narrow definition are free of conflict. A regulator should find that routing orders to the firm of an immediate relative is a potential conflict. But according to the Commissions proposal, execution capacity, routing to an affiliate, or PFOF alone are required to subject retail order execution to a higher level of scrutiny. That is problematic. Many of the potential conflicts listed above do not meet this definition. But these are not unconflicted transactions. But not all those transactions that the commission would define as conflicted transactions actually entail a conflict of interest. There are many, many riskless principal transactions involving the order of a retail customer where there is not a conflict of any of the types described above. These should not be deemed conflicted merely because of the transactions execution capacity. For example, ICE BondPoint is an alternative trading system which specializes in the execution of odd lot or retail sized fixed income trades. BondPoint does not do any proprietary trading its parent company is ICE, the same parent company as the NYSE. When a retail investor logs in to her retail broker dealer website account and clicks buy a bond, she may be directed to a search engine where she can select different characteristics of fixed income instruments, such as rating, duration, industry, etc. After the characteristics are selected, it is typical for a list of fixed income securities and prices to be displayed on the website. Sometimes (often) that inventory is offered by a dealer or an institutional customer via ICE BondPoint, to which the retail broker is a subscriber. If the retail investor chooses inventory offered by an institutional subscriber of BondPoint, the trade will be executed as riskless principal. As a riskless principal transaction involving a retail investor, the trade would be defined under the Reg Best Ex proposal as a conflicted transaction. This does not seem to make sense, as no actual conflict of interest exists. BondPoint executes such trades as riskless principal rather than agency for a simple reason. Fixed income has a different clearance and settlement process than equity securities. The trade would be executed by BondPoints MPID, VABD. BondPoint buys from the institutional customer and sells to the retail investors broker since fixed income transactions clear and settle differently from NMS equities, and it is more expensive to do so, BondPoint needs to build in a mark up to cover the additional clearing costs. The trade would be an agency trade in NMS equities, but in fixed income this is processed in a riskless principal capacity. Again, under the definition of the SECs proposal, this would meet the definition of a conflicted transaction, merely because of the execution capacity of the trade. Does the Commission believe there is a conflict in the type of execution described above? The end investor got the security she selected at the price she saw. There was no PFOF. It was an anonymous trade, ultimately between an institution and a retail investor facilitated by ATS with lit quotes. These are the exact types of trades the Commission seems to have been trying to encourage in equities. But because the Commission seems to have used execution capacity to analogize retail transactions in all other asset classes to the NMS equity framework of retail BD/wholesale market maker, the commission would create a conflict and subject both the retail BD and ICE BondPoint to an unworkable regulatory regime, as the ATS has no external routing mechanism. This will become increasingly problematic as the fixed income market becomes more electronic, limit innovation, and hinder a brokers ability to provide best execution. In conclusion, I think a best execution rule that contains a flawed framework like execution capacity for evaluating broker dealer conflicts would be a mistake, and I think one that defines conflict so narrowly could also be disastrous. Because of these reasons and others, I believe the Commission should eliminate any execution capacity based framework for evaluating whether a broker dealer has fulfilled its best execution responsibilities, and I believe the conflicted transaction framework to be problematic more generally. Execution capacity is not necessary nor sufficient for evaluating whether a broker dealer has properly considered its conflicts, as the BondPoint example shows. Sincerely, Tom Hochleutner