The Financial Institution Regulatory Authority's release last November of Regulatory Notice 15-46, as well as the Municipal Securities Rulemaking Board's Rule G-18 that went into effect last week, are clear signs of the increasing importance of best execution obligations for the fixed income market. The new requirements are similar to existing regulations in the equities and options spaces – evaluate each order, compare execution prices to the prevailing market, and have a formal process for reviewing and documenting any exceptions. Unfortunately, the regulations fail to call for or help establish what is missing in the fixed income market – a consolidated quote feed.
The structural issues that previously prevented the creation of a consolidated fixed income quote feed are being overcome. Executions used to only be performed manually, now many are entered and executed using electronic platforms. Broker-dealers used to only provide quotes in response to a specific request; now many publish their quotes on automated trading systems (ATS). Whereas the vast number of individual CUSIPs previously limited the percentage of active securities on which a firm could reasonably quote, now many firms use complex market making algorithms to automatically adjust their quotes on thousands of CUSIPs simultaneously.
Technological advances have created multiple large ATS's, each with hundreds of firms generating hundreds of millions of quotes per day. But unlike the licensed equities and options exchanges that are required to publish their quotes via the Securities Information Processor (SIP) and Options Price Reporting Authority respectively, fixed income ATS's are under no such obligation. This lack of accountability is a substantial barrier to the industry's ability to provide clients with true best execution.
It is unreasonable and impractical for all fixed income broker-dealers to individually subscribe to every current and future ATS in order to access their quote feeds, which, even after being purchased, must either each be reviewed individually for each trade or require additional technology to consolidate into a single feed. The listed option market currently has 14 exchanges, but a firm need only to subscribe to a single OPRA market data feed to receive a consolidated National Best Bid or Offer (NBBO) across all exchanges. No independent connections or subscriptions are required for each individual exchange. Instead, new exchanges are automatically added, and the single feed is universally accessible to all firms and regulators, providing a consistent baseline against which to measure executions.
Implementing such an elegant and powerful solution for fixed income is challenging because the ATS's are not exchanges, and do not have the same licensing and oversight requirements. However, the implementation of new best execution regulations provides an opportunity. Under the new regulations, the opportunity exists for FINRA and MSRB to expand the already widely distributed Trade Reporting and Compliance Engine, or TRACE, feed to include quotes from ATS's. This integrated quote and trade feed would function similar to OPRA in being the universal starting point for all best execution measurements.
To encourage current and future ATS participation, the regulations should exempt firms from the requirement to evaluate or interact with any quote that is not distributed via the new, integrated feed. This exclusion provides greater clarity for firms regarding which quotes they should be monitoring to meet their best execution obligations, while not limiting private firms from operating separate liquidity pools outside of the consolidated quote feed if they so choose.
It would be naive to pretend that best execution for fixed income can work exactly like it does for equities and listed options, where virtually all quotes, orders, and executions are purely electronic. The large number of CUSIPS, low trade frequencies and high average notional values of fixed income securities do not lend themselves to the same level of automation. But it would also be incorrect to delay providing the industry with a widely distributed, consolidated, and affordable quote and trade feed simply because a large number of quotes, orders, and executions are currently handled manually.
