DECIMUS CAPITAL MARKETS, LLC

Off-Exchange Market Makers and Their Best

Execution Obligations
Concerns and Potential Solutions
presented to the SEC Investor Advisory Committee and the SEC Commissioners
[***DRAFT 06/01/2021***]
Stanislav Dolgopolov
• Chief Regulatory Officer, Decimus Capital Markets, LLC
• This presentation is based on my prior publications and involvement with several underlying issues and legal actions.

Copyright © 2021 Decimus Capital Markets, LLC

Decimus Capital Markets, LLC

The Reach of the Duty of Best Execution to Off-Exchange
Market Makers
• The business model of wholesaling in equity markets based on some combination
of such key elements as customized order flow arrangements with other broker-
dealers, aggregation and segmentation of order flow typically focused on retail
orders, PFOF arrangements, automated execution, provision of dark liquidity based
on matching the NBBO with potential price improvement, and order size
guarantees was in place by the early 1990’s.
• “Even though we stopped paying, we always have to answer the questions about
paying for order flow.” (Bernard L. Madoff, 2002)
• The division of labor between customer-facing brokers and wholesalers is not
surprising (outsourcing SOR, exchange connections, algos, market data, etc.).
• Typically, there is no direct customer-broker relationship between wholesalers and
ultimate customers, such as retail traders, but the duty of best execution can extend
to multiple parties in the execution chain.
• In the U.S. regulatory regime, the applicability of the duty of best execution to a
wholesaler may stem from (i) an explicit voluntary assumption of this duty, (ii) the
existence of a broad agency / executing broker relationship in the context of order
flow / order handling arrangements, or (iii) the reach of the regulatory framework
provided by FINRA as a self-regulatory organization.
 FINRA’s Regulatory Framework for Best Execution in
Wholesaling
• In 2006, the NASD had extended the reach of its best execution rule to executing
brokers, with a specific concern about captive order flow relationships in which
some wholesalers had explicitly disclaimed any best execution obligations.
Although such disclaimers / ambiguous statements had persisted for at least another
decade, several wholesalers have been vocal about their adherence to this standard.
• Interestingly, the SEC’s earlier investigation of Madoff’s (legitimate) market
making business was stalled because the regulators did not believe that the prior
version of the NASD rule applied to wholesalers at all. However, the firm itself had
made several representations about best execution (e.g., “Madoff’s Guide to Best
Execution”), which was relevant for the reach of this duty.
• Brokers “cannot transfer to another person their obligations to provide best
execution to their customers’ orders, although other firms may also acquire that
best execution obligation. . . . [However] the routing firm and the executing firm
may have different best execution obligations.” (FINRA RN No. 15-46)
• For instance, a customer-facing broker rerouting all order flow can get away with
“a regular and rigorous [i.e., periodic] review,” but “[o]rders that a firm determines
to execute internally are subject to an order-by-order best execution analysis”
(FINRA RN No. 15-46), which covers many executions by wholesalers.
A Regulatory Comparison with “Systematic Internalisers”
in Europe Under MiFID II
U.S. Wholesalers SIs Under MiFID II
best execution yes, and they cannot be yes, but negotiable for certain
obligations disclaimed sophisticated parties
customized order yes yes, based on the applicable
flow relationships “commercial policy” with weak
non-discrimination constraints
dark v. lit dark liquidity mandatory quotes for a
liquidity minimum size, but a significant
chunk of liquidity is dark
PFOF permitted effectively (but not explicitly)
prohibited, with some
observable PFOF-like practices
agency-based permitted prohibited
order rerouting
the tick size not constrained by Rule 612 subject to the marketwide tick
regime (no quotes / hidden orders), size regime for quotations,
but subject to the Manning executions, and price
minimum price improvements improvement for all order sizes
 Weak Spots for Best Execution in Wholesaling

• Enforcement Actions: Without any broad generalizations, recent enforcement

actions brought against customer-facing brokers and wholesalers describe a gamut
of abuses in wholesaling, such as data feed / odd-lot arbitrage, insertion of delays,
monetization of price impact, trading ahead, and improper order matching, with
disclosure violations and concerns about execution quality in the background.
• Overlapping Regulations: The duty of best execution is separate from other
regulatory norms and obligations applicable to wholesalers (e.g., reporting
obligations under Rules 605 and 606, the trade-through rule, the order display rule,
or the changes introduced by the Market Data Infrastructure release). Compliance
with such regulatory norms and obligations, including the use of available
exemptions or exceptions thereunder, does not create a safe harbor for best
execution.
• Zero-Commission Trades: Aside from any concerns about gamification or the
Keynsian notion that “casinos, in the public interest, should be inaccessible and
expensive,” the zero-commission model has been somewhat distortionary in
combination with PFOF. One unfortunate symptom is the practice of explicit
disclaimers of the (non-disclaimable) duty of best execution by some customer-
facing brokers accompanied by finger-pointing at wholesalers.
 Weak Spots for Best Execution in Wholesaling: Part II

• Rerouting Practices: Potential concerns include rerouting to affiliated trading

venues, such as dark pools, or other trading venues while prioritizing the fee-rebate
structures. Another question is whether wholesalers efficiently access liquidity
across different trading venues and price points while rerouting certain large orders
(e.g., routing techniques and the use of ISOs), as illustrated by the controversy
surrounding IEX’s D-Limit order type.
• Price Improvement Practices: As wholesalers often engage in “back-to-back”
transactions with customers and external trading venues, “reasonably available” PI
needs to be passed on to customers. Moreover, it is critical for PI to be measured
and benchmarked properly, and there should not be any systemic redistributions or
offsets in PI between different types of orders or customers (e.g., oversized orders
v. odd-lot orders).
• Odd-Lots: As observed by a former wholesaler executive, wholesalers realize
nearly risk-free profits from discrepancies between round-lot and odd-lot prices,
which makes odd-lot order flow especially valuable. However, odd-lot orders are
subject to best execution (without overreliance on Rule 611) and a “type-of-order
basis” review under FINRA Rule 5310, with the counterargument that odd-lot
quotes inside the NBBO are rare being highly doubtful.
 Weak Spots for Best Execution in Wholesaling: Part III

• Front-Running: The narrative of front-running in the context of (smaller / non-

market moving) retail orders makes little sense, although the controversial theory of
potential frontrunning of customer orders by wholesalers based on aggregated
confidential information from stop-loss order books has been floated.
• Use of Different Data Feeds: As pointed out in the SEC’s and FINRA’s guidance,
any use of different data feeds by a wholesaler should not disadvantage customer
orders via arbitrage-like trading strategies. Moreover, as emphasized by several
wholesalers and other stakeholders, the use of private data feeds in addition to the
SIP is probably required to meet the best execution standard.
• Multiple Functions of Wholesalers: Potential concerns, in addition to improper
information-sharing more generally, could be presented by such additional roles of
wholesalers as operators of dark pools and, as a more questionable theory, DMMs.
• Delays: One consideration relates to potentially gameable delays, such as the
conversion of marketable into nonmarketable orders or vice versa, which is
compounded by the outdated ceiling for reporting off-exchange transactions in
FINRA Rule 6380A, which currently stands at “as soon as practicable but no later
than 10 seconds.”
Potential Regulatory Solutions (in Addition to the Scrutiny
of Best Execution Practices)
• Banning PFOF and / or the Zero-Commission Model?: A blanket ban might end
up looking eerily reminiscent of the pre-“Mayday” era (that’s May 1, 1975) with its
regulatory policing of minimum commissions and “Byzantine” commission-sharing
practices. Likewise, a wholistic review of all types of monetary and non-monetary
inducements and incentives offered by different trading venues would be required.
• A Pass-Through for PFOF?: Aside from its deterrent effect, a mandatory pass-
through to customers is likely to present a major implementation / allocation
problem and could lead to further debates about less transparent / non-monetary
inducements or the value of “free” / subsidized services provided to customers.
• Enhanced Disclosure: A promising path is a further refinement of the reporting
requirements under Rules 605 and 606, such as a more granular / stock-by-stock
precision. Another improvement could entail standardized disclosure of key
economic terms of order flow arrangements between customer-facing brokers and
off-exchange market makers, such as price improvement targets or price
improvement-PFOF splits, as these terms are subject to explicit negotiations.
• Reexamining Rule 604: Although Rule 604 contains an exemption for displaying
odd-lot orders, its (uncertain) use may run counter to best execution and should be
contrasted to the rationale for the exception for block orders.
 Potential Regulatory Solutions: Part II

• Reforming the Tick Size Regime: As a lesson from the European regulatory
regime, its sophisticated pricing grid simultaneously applies to quotes, price
improvement, and executions of SIs, which could be a transplanted contribution to
a plain level field for different types of trading venues. This refinement would
address the inherent laxity for price improvement practices of wholesalers vis-à-vis
securities exchanges and ATSs dating back to the adoption of Regulation NMS.
• Consolidation v. Segmentation / Lit v. Dark: A much more difficult task lies in
crafting more systematic reforms—or abstaining from them altogether—related to
regulatory limits to segmentation and consolidation of different types of order flow,
whether on- or off-exchange. Such measures could entail mandatory exposure of
retail orders in the lit markets or other forms of competition on an order-by-order
basis. One needs to be mindful of the limits to social engineering for identifying a
proper balance between competition among marketplaces and competition among
orders and, likewise, a proper balance between lit and dark liquidity.
• Empirical Evidence: A great starting point for answering these difficult questions
is offered by the recent whitepapers authored by Hitesh Mittal and Kathryn Berkow
of BestEx Research (“The Good, the Bad & the Ugly of Payment for Order Flow”)
and Jenny Hadiaris of Cowen (“Retail Trading – What’s Going On”).
 Decimus Capital Markets, LLC
Additional Publications

HAIM BODEK & STANISLAV DOLGOPOLOV, THE MARKET STRUCTURE CRISIS: ELECTRONIC
STOCK MARKETS, HIGH FREQUENCY TRADING, AND DARK POOLS (2015)

Stanislav Dolgopolov, Wholesaling Best Execution: How Entangled Are Off-Exchange

Market Makers?, 11 VA. L. & BUS. REV. 149 (2016), https://ssrn.com/abstract=2744904

Stanislav Dolgopolov, Off-Exchange Market Makers and Their Best Execution Obligations:
An Evolving Mixture of Market Reform, Regulatory Enforcement, and Litigation, NYU J.L. &
BUS. (forthcoming 2021), https://ssrn.com/abstract=3781668

Copyright © 2021 Decimus Capital Markets, LLC

Decimus Capital Markets, LLC