In the first quarter of 2020, new regulations are scheduled to go into effect which amend SEC Rule 606 to require that broker-dealers disclose “enhanced information about the way they handle investors’ orders.”1 Broadly speaking, these amendments will collectively enable managers to:
This article begins with a brief description of the genesis and rationale for the new rules2, then explains why asset owners (in addition to their investment managers) should care about these rules, and concludes with a set of questions every asset owner should ask their managers to better safeguard the assets of their fund. [Also see companion article: SEC Rule 606 A Brief History]
The new Proposed Rules were published in July 2016.4 A little over two years later, after an extensive comment period in which more than 100 in-person meetings were held and/or written comments were submitted, the Final Rules were adopted in November 2018. From Chairperson’s White’s initial comments, through the adoption of both the Proposed and Final Rules, the SEC has consistently articulated three considerations driving their regulatory action. Specifically, in the increasingly complex market structure many managers had complained to the SEC about the extent to which broker-dealers’ routing decisions were influenced by incentives offered by trading centers to attract order flow, that inefficiencies in order-execution algorithms and smart order-routing systems were potentially resulting in information leakage, and that the complexity and opacity of order-routing practices were frustrating the managers’ ability to monitor execution quality.5
Specifically, the SEC noted, “sophisticated market participants closely monitor order and execution activity throughout the markets, looking for patterns that signal the existence of a large institutional order, so that they can use that information to their trading advantage.”6 Broker-dealers should employ tactics to minimize this dynamic to the greatest degree possible, which necessarily entails balancing the need to sufficiently expose the manager’s trades (to achieve execution), against the risk that such exposure might cause prices to move in a less favorable direction. Just as important, as part of their fiduciary obligation to obtain best execution, managers have a concomitant duty to ensure their broker-dealers achieve that optimal balance.
With respect to conflicts of interest, the SEC recognized that managing this risk was a key component of achieving best execution. To wit, broker-dealers faced a number of potential conflicts when handling manager orders, which in turn, could influence their order-routing practices. The SEC therefore felt that access to standardized information was critical in helping managers navigate those challenges.7 Equally important, the SEC felt such transparency would discourage broker-dealers from making inappropriate use of the managers’ orders, minimize information leakage, and mitigate any conflicts of interest.8
Ultimately, the SEC opined that the increased transparency engendered by the new rules was necessary to enable managers to assess best execution, minimize the risks associated with conflicts of interest, and manage the impact linked to information leakage. More to the point, the SEC noted that managers were fiduciaries to their asset owner clientele (e.g. mutual funds, pension funds) and therefore had a fiduciary obligation to act in the best interests of their clients and seek best execution on each trade.9 In emphasizing the importance of this obligation, the SEC stated that managers needed to execute asset owner trades “in such a manner that the total cost or proceeds are the most favorable under the circumstances.”10
Importantly, the notion that increased transparency into broker-dealer order-routing practices can improve execution efficiency is more than just esoteric theory. In January 2019, FINRA published a quantitative study on the costs associated with broker order-routing practices.11 The purpose of the study was to ascertain whether broker-dealers favored their own ATSs when routing customer orders, and if so, whether that impacted the level of costs incurred on those trades.
As noted in Table 1 below, the top third of brokers (in terms of utilizing affiliated ATS venues) sent 64% of their orders to ATSs, with half of that amount being routed to their affiliated ATS. In contrast, brokers who did not use affiliated ATSs sent just 10% of their overall orders to ATSs. Further, the brokers who utilized affiliated ATSs needed to route their shares to an average of 17 different venues before being executed. Conversely, brokers who did not use affiliated ATSs routed their shares to less than five venues before being executed.12
Thus, the study found that managers could select brokers based on their past experience with brokers.19 Indeed, the study specifically referenced the new rules adopted by the SEC, stating, “Our study provides empirical support for recent regulatory initiatives that attempt to improve the disclosure of potential broker conflicts and increase transparency on handling of institutional order flow.”20
In this regard, the SEC warned that while many managers currently employ transaction cost analysis (TCA) to help assess execution quality, these efforts were limited by the data currently available. Indeed, the SEC explicitly opined that the data available pursuant to the new rules would help make the managers’ TCA efforts more effective. In particular, the SEC stated, “While many institutional customers regularly conduct … transaction cost analysis (TCA) of their orders to assess execution quality against various benchmarks, the …comprehensiveness of such analysis could be enhanced with more granular order handling information.”21 From a compliance perspective, the SEC also felt the new disclosures would assist managers in verifying that their broker-dealers followed the managers’ order handling instructions.22
While the new rules are designed to assist managers in navigating the risks discussed above, asset owners need to understand that information will be disclosed only if managers request it.23 If a manager doesn’t specifically request this data, broker-dealers don’t have to provide it.
This was not an oversight by the SEC. Instead, they made clear that the rules were not intended to require automatic provision of the reports in the absence of such a request.24 In explaining their rationale, the SEC noted that some managers may not want to review this data, and the rules were therefore intended to, “strike an appropriate balance between broker-dealers and customers, and does not … require the disclosure of order information when it is not requested by the customer.”25
Equally important, unless asset owners are trading the securities themselves (i.e. through an internal trading operation), they are prohibited from requesting this data from broker-dealers. Indeed, the SEC specifically denied a request to extend the rules to end users such as asset owners, stating, “the Commission does not believe it is appropriate to require a broker-dealer to create individualized order handling reports for and make its execution data available to an end user with whom the broker-dealer may have no direct relationship.”26 Rather, the SEC stressed that the rules should only require the “broker-dealer to provide detailed information to the person that is responsible for making the routing and execution decisions…”27