In this second article of our series on the growing regulatory focus on best execution, we’re taking a quick look at the recently adopted amendments to the SEC Rule 606 “that will require broker-dealers to disclose to investors new and enhanced information about the way they handle investors’ orders.” 1 Despite the changes and delays common to regulatory evolution, the new 606 reporting requirement deadlines are fast approaching. More importantly, the updated rule holds the potential to transform the traditional broker/client relationship.
Specifically, the SEC has amended Rule 606 of Regulation NMS to require a broker-dealer, upon a customer’s request, to provide within seven days a six-month detailed summary of their “not held” orders (an order in which the customer gives the firm price and time discretion), filtered by the top ten venues used on behalf of that client. This report needs to include details of the fees and rebates associated with the client orders and should further disclose any special pricing relationships used by the broker when executing that customer’s specific orders.
Upon first look, one would be forgiven for dismissing the changes as marginal improvements to what is now a rather basic report. The current (soon to be legacy) report, by all accounts, is of limited use to most customers. However, a review of SEC comments from 2016 sheds light on the SEC’s motivation behind the additional requirements and hints at a much more substantial intent. The SEC, it would seem, has recognized a need for more detailed best execution analysis as markets become faster, more algo-driven and increasingly complex to navigate.
The SEC’s 2016 rules proposal references TCA no fewer than 41 times. In one instance, they note:
“An additional benefit of having the institutional order handling information available upon request is that institutional customers could combine the order handling information with existing TCA or enhance their TCA.” 2
The SEC goes on to further note that, in referring to routing details:
“This could assist the customers in assessing the execution quality provided by their broker dealers. In summary, the Commission preliminarily believes that proposed Rule 606(b)(3) may complement and enhance all customers’ evaluations of institutional order handling quality, including those of customers who use TCA.” 3
So, while the rule is a regulatory responsibility for brokers, its origin was highly influenced by the desire to encourage and facilitate more detailed TCA analysis by managers. As such, generating and then evaluating this new data set needs to be done in the context of TCA for both brokers and managers.
Peeling back the first few layers of regulatory speak reveals a focus on transparency around routing and execution practices that is unprecedented to date. The ramifications of the need for a broker to share accurate and detailed disclosures will affect the industry on numerous levels, both on the sell-side and the buy-side. In addition to the added on-demand data analysis required with the amended rule, there may be numerous instances where simply revealing raw trade data to a customer without providing context and peer analysis could end up providing less clarity, rather than more. In fact, we’re already hearing from numerous sell-side clients who recognize the impending need for execution quality analysis to contextualize the raw venue data the modified rule requires.
Below, we take a closer look at the implication of SEC Rule 606(b)(3) for both brokers and managers.
The public facing reporting requirements have been expanded to require trade data to be published on held orders per venue, segmented by S&P 500 and non- S&P 500 membership, and will now include specific details of any rebate programs and their usage. For the institutional brokerage community, the dataset required should be a fairly simple and short report. For market makers and brokers whose counterparties are often other brokers, the public facing report could become quite complex.
The most dramatic change to the rule is the newly adopted Rule 606(b)(3) client facing report. This report must be made available to the client within seven days of their request and must include spread capture, fees and rebates by venue, routing choices and resting times.
Yet with our modern market structure, as many traders will tell you, the presence or absence of fees and rebates do not necessarily dictate the quality of execution. Rather, fees and rebates point to the existence of competing pricing models within the exchange marketplace. While providing this new dataset to their client is a regulatory necessity, framing this information in the context of pertinent benchmarks and details about execution quality might carry more importance.
The report is meant to help customers understand better how their orders are routed and handled. It should also help them, as the SEC notes in their press release dated November 2, 2018, “more effectively assess the impact of their broker-dealers’ order routing decisions on the quality of their executions, including the risks of information leakage and potential conflicts of interest.” 4
The client-specific report needs to include the following new dimensions:
From the broker’s point of view, details on fees and rebates can be particularly misleading without any accompanying context. This is particularly true with the IOI data, which is reported on an aggregate basis with little connection to execution results.
It is worth noting that brokers who use a third-party algorithm platform will see a further disconnection and complication in providing the raw data the SEC is demanding. So far, the commitments from algo providers to pass along detailed routing information have ranged from sympathetic to reluctant. One remedy that seems to be gaining traction involves these companies providing completed 606 reports. While this approach allows the algo providers to protect their proprietary routing practices, it creates additional complications for the brokers as they will need to map and consolidate these “completed” reports into their final summary reports for public and client distribution.
Even though the amended rule’s report requirements logically lead to best execution analysis, the data required by the amended rule is raw in nature and stops short of anything that directly measures the quality of execution. Yet, without an execution benchmark, the fee/rebate data provided will do little to to reveal how well a broker navigates our complex market structure. If best execution is the ultimate goal, then rebate, fee, and IOI data clearly needs be considered in the context of the outcomes.
For the investment manager, SEC Rule 606(b)(3) provides an extraordinary opportunity to look behind the curtain. In fact, many would argue that this opportunity might actually be a responsibility.
While the amended rule does not mandate it, the buy-side can, and probably should, request their 606 data for incorporation into their best execution processes. That said, the resulting raw 606 data, including venue routes and fees/rebates, will not arrive with a built-in way to handicap or effectively compare the results across brokers. Usage of differing fee and rebate structures by brokers may be an indication of a problem, or it could simply reflect a variance in the location of liquidity of different securities. Along with the complexity of indexing a broker’s fees/rebates relative to their best execution results, there is also the mechanical need to consolidate multiple broker 606 reports via the only two formats now allowed, PDF and XML. Considering market norms, the new 606 Rule could be a heavy lift unless the raw report arrives with accompanying contextual data typically provided by a robust TCA program.
Again, much like the broker situation, if best execution is the ultimate goal, then the buy-side will need to compile and digest their 606 data in order to answer important questions like, is superior execution with rebates better than average execution without them? Or even more to the point, how does the buy-side benchmark the venue use of their sell-side partners, and how do they react to the output?
The raw data provided by a broker may not provide enough color for a full analysis of the trading results. But in our current regulatory environment, ignoring this (raw) data is likely not a viable option. While the amended rule simply requires brokers to make additional routing data available to their buy-side counterparts, the implications are far-ranging. Market participants may require considerable effort and resources, both to consume the routing data and act upon it. Putting this new found transparency into context will be a challenge, but the results will no doubt be compelling.
For the past 35 years, Abel Noser has been helping firms understand, measure, and monitor their trade data. As the regulatory hurdles of best execution grow in complexity, we stand ready to help firms embrace their regulatory responsibilities and implement the processes required, from the trading desk to the compliance office. Abel Noser’s peer benchmarks empower managers with the tools and context needed to define and monitor best execution.
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