What Are the Key Differences between FINRA and MiFID II Best Execution Rules?

Concept

The Divergent Philosophies of Best Execution

At the heart of global financial markets lie two distinct yet related regulatory frameworks governing the principle of best execution ▴ the Financial Industry Regulatory Authority (FINRA) rules in the United States and the Markets in Financial Instruments Directive II (MiFID II) in the European Union. While both aim to protect investors by ensuring that firms execute client orders on the most favorable terms, their underlying philosophies and practical applications diverge significantly. Understanding these differences is paramount for any firm operating across these jurisdictions, as compliance with one does not guarantee compliance with the other. The divergence is a reflection of the different regulatory approaches and market structures in the US and the EU.

FINRA’s approach to best execution, encapsulated in Rule 5310, is rooted in the principle of “reasonable diligence.” This standard requires firms to diligently seek the best market for a security and to buy or sell in that market so that the resulting price to the customer is as favorable as possible under the prevailing market conditions. The emphasis is on the process of seeking the best outcome, with a degree of flexibility in how firms achieve this. The “reasonable diligence” standard allows for a more principles-based approach, where firms have some discretion in determining the most appropriate execution strategy for their clients, provided they can demonstrate that their process is sound and consistently applied.

FINRA’s “reasonable diligence” standard contrasts with MiFID II’s more prescriptive “all sufficient steps” requirement, highlighting a fundamental difference in regulatory philosophy.

MiFID II, on the other hand, imposes a more stringent and prescriptive standard of “all sufficient steps.” This requires firms to take every possible measure to obtain the best possible result for their clients. The framework is more rules-based, with a greater emphasis on transparency, data collection, and reporting. MiFID II’s “all sufficient steps” requirement is a higher bar to clear, demanding a more exhaustive and demonstrable effort from firms to ensure they are achieving the best possible outcome for their clients. This includes a detailed analysis of a wide range of execution factors and a continuous monitoring of execution quality.

The Role of Market Structure

The differences in the best execution rules are also a reflection of the different market structures in the US and the EU. The US market is characterized by a high degree of fragmentation, with a large number of trading venues, including exchanges, alternative trading systems (ATSs), and dark pools. This fragmentation makes it more challenging to determine the single “best” market for a security at any given time. FINRA’s “reasonable diligence” standard acknowledges this complexity, allowing firms to use their professional judgment to navigate the fragmented market landscape.

The EU market, while also fragmented, has a more integrated structure, with a greater emphasis on transparency and pre-trade price discovery. MiFID II’s “all sufficient steps” requirement is designed to promote competition among trading venues and to ensure that firms are not unduly influenced by factors other than the best interests of their clients. The directive’s extensive reporting and disclosure requirements are intended to provide regulators and investors with a clear view of how firms are executing orders and to hold them accountable for their execution quality.

Strategy

Navigating the Regulatory Divide a Strategic Comparison

For firms operating in both the US and EU markets, a nuanced understanding of the strategic implications of FINRA and MiFID II best execution rules is essential. The differences in the two regimes require a tailored approach to compliance, with a focus on developing robust policies, procedures, and systems that can accommodate the specific requirements of each jurisdiction. A one-size-fits-all approach is unlikely to be effective and could expose a firm to regulatory risk.

A key strategic consideration is the development of a comprehensive best execution policy. Under both FINRA and MiFID II, firms are required to have a written policy that outlines their approach to achieving best execution. However, the level of detail and the specific elements that must be included in the policy differ significantly.

MiFID II requires a much more granular policy, with specific information on the execution venues used, the factors considered in selecting those venues, and the relative importance of those factors. FINRA’s requirements are less prescriptive, but firms are still expected to have a well-documented policy that is regularly reviewed and updated.

A Tale of Two Policies

The following table provides a high-level comparison of the best execution policy requirements under FINRA and MiFID II:

The differences in the policy requirements highlight the need for a flexible and adaptable compliance framework. Firms should consider developing a modular policy that can be customized to meet the specific requirements of each jurisdiction. This approach can help to ensure that the firm is compliant with both FINRA and MiFID II, while also minimizing the administrative burden of maintaining separate policies for each regime.

The granular reporting requirements of MiFID II, particularly the RTS 27 and RTS 28 reports, demand a more sophisticated data management and analytics capability than is typically required under FINRA.

Another key strategic consideration is the management of conflicts of interest. Both FINRA and MiFID II have strict rules on conflicts of interest, but they approach the issue from different perspectives. FINRA’s rules are more focused on disclosure, requiring firms to disclose any potential conflicts of interest to their clients.

MiFID II, on the other hand, takes a more prohibitive approach, with a general ban on the receipt of payments for order flow (PFOF) and other inducements that could influence a firm’s order routing decisions. This difference in approach has significant implications for a firm’s business model and its relationships with execution venues.

• FINRA’s Approach to Conflicts of Interest ▴ FINRA’s rules on conflicts of interest are primarily disclosure-based. Firms are required to disclose any material conflicts of interest to their clients, including any PFOF arrangements. The focus is on providing clients with the information they need to make an informed decision about their relationship with the firm.
• MiFID II’s Approach to Conflicts of Interest ▴ MiFID II takes a more prohibitive approach to conflicts of interest. The directive generally prohibits firms from receiving any remuneration, discount, or non-monetary benefit for routing client orders to a particular trading venue. This is intended to ensure that firms’ order routing decisions are based solely on the best interests of their clients.

Execution

The Operational Realities of Dual Compliance

The operational challenges of complying with both FINRA and MiFID II best execution rules are significant. The differences in the two regimes require firms to implement a range of systems, controls, and processes to ensure that they are meeting their obligations in both jurisdictions. This includes everything from order routing and execution to data management and reporting.

One of the most significant operational challenges is the management of order routing. Under both FINRA and MiFID II, firms are required to have a process for selecting the most appropriate execution venue for each client order. However, the criteria for selecting a venue differ significantly.

FINRA’s “reasonable diligence” standard gives firms more flexibility in their order routing decisions, while MiFID II’s “all sufficient steps” requirement demands a more rigorous and data-driven approach. This can be particularly challenging for firms that operate a centralized order routing system for both their US and EU businesses.

A Deep Dive into Execution Factors

The following table provides a more detailed comparison of the execution factors that firms must consider under FINRA and MiFID II:

The explicit inclusion of costs as a key execution factor under MiFID II is a significant difference from FINRA’s rules. This requires firms to have a detailed understanding of the all-in costs of execution, including not only the explicit costs, such as commissions and fees, but also the implicit costs, such as market impact and opportunity costs. This can be a complex and data-intensive exercise, requiring sophisticated transaction cost analysis (TCA) tools and methodologies.

The operational burden of MiFID II’s reporting requirements, including the quarterly RTS 27 reports from execution venues and the annual RTS 28 reports from investment firms, is a major consideration for any firm operating in the EU.

Another significant operational challenge is the management of data and reporting. MiFID II has extensive data collection and reporting requirements, which are designed to provide regulators and investors with a clear view of how firms are executing orders. This includes the quarterly RTS 27 reports from execution venues, which provide detailed information on execution quality, and the annual RTS 28 reports from investment firms, which summarize the top five execution venues used for each class of financial instrument. These reporting requirements are far more extensive than anything required under FINRA and can be a major operational burden for firms.

1. RTS 27 Reports ▴ These are quarterly reports that must be published by execution venues, providing detailed information on the quality of execution for each financial instrument traded on the venue. The reports include data on price, costs, speed, and likelihood of execution.
2. RTS 28 Reports ▴ These are annual reports that must be published by investment firms, summarizing the top five execution venues used for each class of financial instrument. The reports must also include a qualitative assessment of the execution quality obtained from those venues.

The data and reporting requirements of MiFID II require firms to have a robust data management and analytics capability. This includes the ability to collect, store, and analyze large volumes of data from multiple sources, as well as the ability to generate the required reports in a timely and accurate manner. This can be a significant investment for firms, but it is essential for ensuring compliance with MiFID II.

Reflection

Beyond Compliance a Framework for Execution Excellence

The complexities of navigating the divergent best execution rules of FINRA and MiFID II can be a significant challenge for any firm. However, by taking a strategic and proactive approach to compliance, firms can not only meet their regulatory obligations but also enhance their execution capabilities and deliver better outcomes for their clients. The journey to dual compliance is an opportunity to build a more robust and sophisticated execution framework, one that is grounded in data, transparency, and a relentless focus on the best interests of the client.

Ultimately, the goal of any best execution framework should be to create a virtuous cycle of continuous improvement. By investing in the right people, processes, and technology, firms can gain a deeper understanding of their execution quality, identify areas for improvement, and make more informed decisions about how and where to execute their clients’ orders. This, in turn, can lead to better performance, lower costs, and stronger client relationships. The regulatory divide between FINRA and MiFID II may be a challenge, but it is also an opportunity to build a truly world-class execution capability.