On July 13, 2016, the U.S. Securities and Exchange Commission (SEC) voted unanimously to propose amendments to Rule 606 of Regulation NMS1 to enhance order handling information available to investors.2 The proposed amendments to Rule 606 would require broker-dealers to disclose their handling of “institutional orders” upon request and in an aggregate quarterly report, as well as expand existing disclosure obligations related to retail customer orders.
The proposed disclosures regarding institutional orders would require a broker-dealer to provide its customer detailed order handling information, including a wide variety of performance metrics such as the fill rate and the number and percentage of shares receiving price improvement at each venue. A broker-dealer would also be required to aggregate information regarding its handling of institutional orders across all customers and make this report publicly available each quarter. These quarterly reports would allow for a standardized comparison of each broker-dealer’s performance with respect to institutional orders against its competitors.
The proposed amendments would require significantly greater disclosure of a broker-dealer’s financial incentives to route both retail customer and institutional orders to a particular trading venue. For example, a broker-dealer would be required to disclose the average net execution fee or rebate it receives at each venue for institutional orders and the net aggregate amount of any payment for order flow received at each venue for retail customer orders.
If the proposal to amend Rule 606 is adopted, broker-dealers will face significant costs related to the generation of the institutional order reports. Nonetheless, the proposal largely reflects industry support for expanded and standardized routing disclosure, so it appears reasonably likely that some version of the proposal will be adopted.
Background – Rule 606 Today
Currently, Rule 606 requires broker-dealers to disclose order routing information with respect to non-directed “customer” orders. A customer order generally means a non-broker-dealer order for less than $200,000 for equities or $50,000 for options. Accordingly, the existing disclosure obligations under Rule 606 only apply to smaller-sized orders, i.e., retail orders.
The current reporting obligations require quarterly disclosure by broker-dealers of, among other things, the identity of the venues, such as exchanges or alternative trading systems, to which five percent or more of retail orders are sent and certain statistics such as the number of market orders or limit orders sent to each venue. Broker-dealers are also required to disclose the material aspects of their relationship with each such venue, including any payment for order flow arrangement or profit-sharing relationship.
Under Rule 606, broker-dealers must also disclose, upon the request of a customer, the identity of the venue to which the customer’s orders were routed for execution and certain related information for the six months prior to the request.
The Impetus for the Proposal
Because Rule 606 disclosures only apply to smaller-sized retail orders, institutional investors executing
larger-sized orders generally did not benefit from the rule. Although certain large institutional investors may be able to leverage their market size to obtain order routing information from their broker-dealers, smaller institutional investors may not have this bargaining power. Accordingly, there is no standardized order handling information with respect to institutional orders.
In addition, because of their larger size, institutional orders tend to be routed and executed using algorithms that break their orders into smaller orders that are sent to a variety of venues. This may lead to information leakage, whereby a institutional investor’s interest in buying or selling a particular security may be revealed to the market before its order can be fully executed. Information leakage may lead to additional costs as other market participants, aware of the presence of large institutional order, may use this information to their advantage. Thus, understanding how or where a broker-dealer routes large orders is particularly important to institutional investors.
The above concerns, among others, prompted the Investment Company Institute (ICI) and the Securities Industry and Financial Markets Association (SIFMA) to propose certain enhancements to Rule 606 in 2014.3 The SEC appears to have taken notice, as its proposed rules closely track the ICI/SIFMA proposal with a few exceptions.
Disclosures Related to Institutional Orders
As noted, the proposal would require broker-dealers to provide their customers with standardized information about their handling of institutional orders and execution quality. Under the proposal, an institutional order would generally be defined as a non-broker-dealer order for a quantity of NMS stock with a market value of at least $200,000. The term “NMS stock” generally includes all stocks listed on national securities exchanges. Notably, the disclosure obligations for institutional orders would not extend to transactions in options.
Customer-Specific Report on Institutional Order Handling
Upon the request of a customer, a broker-dealer would be required to provide specific monthly data for the previous six months relating to: (i) the handling of the customer’s institutional orders at the broker-dealer, e.g., the number of shares internalized by the broker-dealer; (ii) the routing of the customer’s institutional orders to other venues; (iii) the quality of execution of those institutional orders; and (iv) whether the customer’s institutional orders added or took liquidity and the average net execution fee or rebate. The metrics relating to quality of execution include: the fill rate; the total number and percentage of shares executed at the midpoint; and the total number and percentage of shares priced on the side more (and less) favorable to the institutional order.
Under the proposal, a broker-dealer would have to disclose quality of execution metrics for each venue in the aggregate and broken down based on an institutional order’s routing strategy. Specifically, a broker-dealer would be required to group institutional orders, in a consistent manner, into either: (i) passive strategies, i.e., strategies that emphasize minimizing the price impact; (ii) neutral strategies; and (iii) aggressive strategies, i.e., strategies that prioritize speed of execution over price impact. The SEC believes that organizing the institutional order reports based on routing strategy may provide customers with more useful information that takes account of customers’ varying needs at a particular point in time, e.g., a customer might use an aggressive strategy when trying to quickly liquidate a position. A broker-dealer would be required to document the specific methodologies it relies upon for assigning a particular strategy to one of these categories and preserve these methodologies as part of its books and records.
Of particular note is the requirement that a broker-dealer disclose the average net execution fee or rebate for a customer’s institutional orders. The SEC believes that requiring disclosure of the average net execution fee or rebate may shed light on the economic incentives of a broker-dealer in handling institutional orders and may help institutional investors assess any potential conflicts of interest a broker-dealer may face. For example, the SEC stated in the proposal that an institutional investor would be able to assess the average net execution fee at a particular venue in light of performance of that venue on other metrics such as the venue’s fill rate.
The proposal would also require certain disclosures regarding the number of institutional orders exposed by a broker-dealer through an actionable indication of interest (actionable IOI) and the venues where they were exposed. Under the proposal, an actionable IOI would generally be defined as any indication of interest that conveys the: (i) symbol; (ii) side, i.e., buy or sell; (iii) a price equal to or better than the prevailing best bid or offer; and (4) a size of at least one round lot, i.e., 100 shares. Because actionable IOIs effectively communicate all of the material terms of an institutional order and thus have the potential to result in information leakage by signaling the presence of the institutional order, the SEC generally believes that customers would find such disclosures useful in assessing a broker-dealer.
Publicly Available Aggregated Report on Institutional Order Handling
Under the proposal, broker-dealers would also be required to publicly disclose the institutional order information described above on an aggregated basis across all customers for all institutional orders received. A broker-dealer would be required to post these reports on a website that is free and readily accessible to the public for a period of three years from the date of initial posting.4
The proposed aggregated institutional order handling report would not disclose the customers of the
broker-dealer. The SEC stated that it believes that the design of the report would not provide other market participants with information that would allow them to reverse engineer a broker-dealer’s proprietary order handling techniques.
Enhancements to Disclosures Relating to Retail Orders
To enhance the existing disclosure requirements of Rule 606, the proposal would rename the term “customer order,” i.e., a non-broker-dealer order for less than $200,000 for equities or $50,000 for options, to “retail order.” The two most significant changes to the existing Rule 606 reporting requirements with respect to retail order are to require separate reporting of marketable versus non-marketable limit orders, and greater detail with respect to the financial incentives that might influence the broker-dealer’s routing decisions. Under the proposal, broker-dealers would be required to post these reports on a website that is free and readily accessible to the public for a period of three years from the date of initial posting.
Rule 606 does not currently distinguish between marketable limit orders, i.e., orders that are immediately executable against the prevailing best bid or offer, and non-marketable limit orders, i.e., orders priced such that they are not immediately executable. Whether an order is marketable or non-marketable is a significant factor in determining how a broker-dealer will route the particular order. For example, a broker-dealer may post a non-marketable order on a venue that provides a rebate for adding liquidity. Consequently, the proposal would require existing Rule 606 reports to distinguish between these types of limit orders to allow customers to better assess a broker-dealer’s routing determinations.
Payment for Order Flow
To enhance disclosure obligations relating to a broker-dealer’s financial incentives, the proposal would require that a broker-dealer disclose the net aggregate amount of any payment for order flow received or payment from any profit-sharing arrangement based on each order type, e.g., market order, marketable limit order etc., for each venue to which it sends five percent or more of its retail orders. These payments or rebates would be disclosed both as a total dollar amount and on a per share basis.
The SEC is proposing to require that a broker-dealer provide greater detail surrounding its discussion of the material aspects of its payment for order flow or profit-sharing relationship with each venue to which it routes retail orders. Specifically, a broker-dealer would be required to include in this discussion a description of the oral or written terms of the arrangements that may influence the broker-dealer’s order routing decision, including: (i) incentives for equaling or exceeding an order flow volume threshold; (ii) disincentives for failing to meet minimum order flow volume thresholds; and (iii) agreements to send a minimum amount of order flow to a particular venue.
Comments on the proposal should be received on or before September 26, 2016.