How Do Regulatory Bodies View Best Execution for Assets without Public Prices? ▴ Question

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Concept

The obligation of best execution is a foundational principle of market integrity, yet its application to assets lacking continuous public price dissemination presents a significant operational and philosophical challenge. For instruments such as corporate bonds, municipal securities, and certain crypto assets, the concept of a single, verifiable “best” price at any given moment is an abstraction. Regulatory bodies, including the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC), do not grant exemptions for opacity.

Instead, they intensify their scrutiny on the process a firm employs to navigate these markets. The core regulatory expectation shifts from achieving a specific, observable price to demonstrating a systematic, evidence-based effort to secure a “resultant price to the customer is as favorable as possible under prevailing market conditions.”

This perspective reframes the compliance question entirely. The focus moves from the outcome (the price) to the architecture of the execution process itself. Regulators are less concerned with whether a firm captured a theoretical, unknowable best price and more concerned with the design and rigor of the system used to seek it out. This involves a demonstrable, repeatable, and auditable methodology for price discovery and liquidity sourcing.

The proposed SEC Regulation Best Execution underscores this direction, aiming to codify a more prescriptive, rules-based framework that compels firms to establish, maintain, and regularly review detailed best execution policies and procedures. For assets without public prices, this means the firm’s internal framework is the primary subject of regulatory examination. The integrity of the execution process becomes the proxy for the quality of the execution itself.

Regulatory scrutiny on illiquid assets centers on the demonstrable rigor of a firm’s price discovery process, not the attainment of an unobservable perfect price.

The inherent difficulty lies in defining “prevailing market conditions” when they are not broadcast on a public tape. In the context of a U.S. Treasury bond or a thinly traded municipal security, market conditions are a composite of dealer inventories, recent comparable trades (if any), and the specific risk appetite of a limited number of counterparties at a specific moment. Therefore, a firm’s duty is to construct a system that can effectively poll that fragmented landscape.

This requires a structured approach to soliciting bids or offers, documenting the responses, and justifying the ultimate execution decision based on a range of factors beyond price alone. The regulatory view is that in the absence of a public market, the firm must create its own private, competitive market for each transaction and maintain a complete record of that process.

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Strategy

Developing a compliant best execution strategy for assets without public prices requires creating a robust, evidence-based operational framework. The central pillar of this strategy is a comprehensive set of policies and procedures that are not merely declarative but are deeply integrated into the firm’s trading workflow. FINRA Rule 5310 provides a non-exhaustive list of factors that must be considered, which, when applied to illiquid assets, demand a specific and nuanced interpretation. The strategy is to build a system that can defend its execution choices by documenting its consideration of these factors in a structured manner.

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Adapting Execution Factors for Illiquid Markets

A successful strategy translates abstract regulatory factors into concrete operational workflows. The firm’s internal policies must detail how traders approach price discovery, counterparty selection, and order handling for these specific asset classes. This involves a qualitative and quantitative assessment that balances competing priorities to achieve the most favorable outcome for the client.

The following table outlines how standard best execution factors are re-calibrated for the unique characteristics of assets that lack public pricing mechanisms:

Execution Factor	Application in Public Markets (e.g. Equities)	Strategic Application in Non-Public Markets (e.g. Bonds)
Price	Comparison to the National Best Bid and Offer (NBBO); seeking price improvement.	Demonstrating a competitive bidding/offering process; documenting multiple dealer quotes; benchmarking against comparable securities or recent trade data (e.g. TRACE for corporate bonds, though with a delay).
Speed of Execution	Minimizing latency to capture a fleeting price; high-speed routing decisions.	Often a lower priority than certainty of execution; speed is measured in terms of timely access to available liquidity rather than microseconds.
Likelihood of Execution	High for liquid securities; assessing fill rates for limit orders.	A primary consideration; securing a complete fill at a firm price may be prioritized over attempting to work an order for a marginally better price, which risks the market moving away.
Size of the Order	Managing market impact; using algorithms to break up large orders.	Identifying counterparties with sufficient inventory or appetite to handle the full size; managing information leakage to prevent adverse price movements.
Trading Characteristics of the Security	Volatility, liquidity profile, spread width.	Credit quality, duration, covenant structure, issuer details, and overall market depth for that specific security or sector.

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The Mandate for Systematic Reviews

A core component of the regulatory expectation is the “regular and rigorous” review of execution quality. For assets without public prices, this process is inherently more qualitative but no less important. Strategically, this means establishing a Best Execution Committee or a similar governance function with a formal mandate. This committee must meet at least quarterly to review trading data and assess the effectiveness of the firm’s policies and procedures.

Data Collection ▴ The strategy must include the systematic collection of all relevant data for each trade. This includes the number of dealers queried, the prices they provided, the time of the quotes, the final execution price, and the rationale for the decision.
Comparative Analysis ▴ The committee should analyze execution quality across different counterparties and trading protocols. While direct comparisons are difficult, the analysis can identify trends, such as which dealers consistently provide the best pricing in certain sectors or maturities.
Policy Revision ▴ The review process must be a feedback loop. If the committee identifies that a particular routing decision or counterparty consistently leads to suboptimal outcomes, the firm’s policies and procedures must be revised accordingly. This iterative process of review and revision is a key element that regulators look for in an examination.

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Execution

The execution of a best execution policy for illiquid assets is a matter of operational discipline and meticulous record-keeping. It is the tangible manifestation of the strategy, transforming documented procedures into a live, auditable trading process. The primary objective is to create a contemporaneous record that justifies every trading decision, demonstrating that the firm exercised “reasonable diligence” to ascertain the best available terms for a client. This process must be embedded in the trader’s workflow, supported by technology, and overseen by a compliance function that understands the unique structure of these markets.

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The Anatomy of a Compliant Trade File

For every transaction in an asset without a public price, the firm must be able to reconstruct the entire life cycle of the order. This “trade file” or “execution file” is the principal evidence presented to regulators to defend the firm’s execution quality. It must be assembled in real-time or near-real-time and contain sufficient detail to allow a third party to understand the market conditions the trader faced and the rationale behind their actions. The absence of this documentation is a significant red flag for regulators, as it suggests an ad-hoc process rather than a systematic one.

A complete and contemporaneous trade file is the ultimate defense, transforming the abstract duty of best execution into concrete, verifiable evidence.

The following table details the essential components of a robust execution file for a hypothetical corporate bond trade, serving as an operational checklist for the trading desk:

Data Field	Description	Regulatory Purpose
Security Identifiers	CUSIP, ISIN, and full bond description (issuer, coupon, maturity).	Unambiguously identifies the instrument being traded.
Client Order Details	Timestamp of order receipt, order size (face value), and any specific client instructions (e.g. limit price, all-or-none).	Establishes the beginning of the best execution obligation and the specific parameters of the client’s mandate.
Pre-Trade Analysis	Notes on current market color, recent TRACE prints in similar securities, any relevant credit news.	Demonstrates the trader’s awareness of the “prevailing market conditions” before seeking quotes.
Counterparty Quotations	A log of all dealers contacted, the time of the request, their bid/offer response, and the size of their quote.	Provides concrete evidence of a competitive process and the effort to “ascertain the best market.”
Execution Details	The timestamp of execution, the chosen counterparty, the final execution price, and the total size filled.	Documents the final outcome of the price discovery process.
Execution Rationale	A clear, concise note from the trader explaining why the chosen counterparty and price were the most favorable. This could include reasons like “best price for the full size,” or “only firm bid available.”	The most critical field. It connects all the other data points and explains the trader’s judgment, fulfilling the core obligation.
Post-Trade Review	Comparison to subsequent TRACE prints; notes for the quarterly “regular and rigorous” review.	Shows that best execution is an ongoing process of review and improvement, not a one-time event.

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Systematizing the Process

While manual record-keeping is possible, it is prone to error and inconsistency. A robust execution framework relies on technology to systematize this process. Order Management Systems (OMS) or Execution Management Systems (EMS) should be configured to:

Automate RFQs ▴ Automatically send out requests-for-quote to multiple dealers simultaneously.
Capture Quotes ▴ Electronically capture all dealer responses, including price, size, and time, directly into the order blotter.
Enforce Documentation ▴ Require traders to complete a justification note before an order can be marked as complete.
Generate Reports ▴ Create the necessary reports for the Best Execution Committee’s quarterly reviews, aggregating data by counterparty, asset class, and trader.

By embedding the documentation requirements into the trading system itself, a firm ensures that the execution process is consistent, auditable, and aligned with the regulatory expectation of a disciplined, evidence-based approach to achieving best execution in markets defined by their opacity.

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References

U.S. Securities and Exchange Commission. “Regulation Best Execution.” Federal Register, Vol. 88, No. 18, January 27, 2023.
Financial Industry Regulatory Authority. “FINRA Rule 5310 ▴ Best Execution and Interpositioning.” FINRA Rulebook.
Goodwin Procter LLP. “SEC Proposes New Regulation Best Execution ▴ Brokers Must Achieve ‘Most Favorable Price’ for Customers; Heightened Obligations for Conflicted Retail Transactions.” Insights & Resources, March 3, 2023.
Financial Industry Regulatory Authority. “Regulatory Notice 15-46 ▴ Guidance on Best Execution Obligations in Equity, Options and Fixed Income Markets.” November 2015.
FINRA. “2023 Report on FINRA’s Examination and Risk Monitoring Program.”

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Reflection

The regulatory framework for best execution in opaque markets compels a fundamental shift in perspective. It moves the locus of value from the unattainable ideal of a perfect price to the tangible reality of a superior process. The construction of a compliant execution system is an exercise in architectural integrity, where every policy, procedure, and technological choice contributes to a structure capable of withstanding intense scrutiny.

The ultimate goal is an operational framework that produces not just favorable outcomes for clients, but also generates the evidence to prove it. This system becomes more than a compliance tool; it is a strategic asset that provides a decisive edge in navigating the most complex and least transparent corners of the financial markets.