This is the fourth installment of a content series sponsored by S3
Tick tock. Tick tock.
If time is a clock of the heart as pop singer Boy George croons, then Wall Street’s clock must be buzzing frantically.
As the deadline for Rule 606 as it stands rapidly approaches and new Amendments go into effect, the vast majority of Wall Street, mostly the sell-side, are asking for more time to prepare.
In a recent Traders Magazine online poll that asked, “Are you ready to comply with the new updates required by the amended Rule 606?,” only 14 percent of those polled said they were ready for the upcoming changes. Twenty four percent of respondents said they were b=not ready and almost 2/3 or 62% percent said they could use more time.
To recap, on Nov. 2, 2018, the Securities and Exchange Commission amended Rule 606 under Reg NMS to require additional disclosures by broker-dealers to customers regarding the handling of their orders. The intent of these amended rules is to provide more detailed and standardized information to customers—with a focus on institutional customers—thereby allowing a more effective assessment of how broker-dealers are carrying out their best execution obligations and the impact of a broker-dealer’s order routing decisions on the quality of their executions.
As has been well documented here and in the financial media, the onus of Rule 606 compliance falls on the sell-side and they must be able to provide the wider breadth of data the buy-side will be entitled to. And with approximately eight weeks before the US Security and Exchange Commission’s update of Rule 606 goes into effect, sell-side firms still need much guidance to meet the 334-page mandate.
“The phrase ‘conflict of interest’ comes up 76 times in the release,” said Mark Davies, CEO of S3, during a recent industry call hosted by the Security Traders Association. But what exactly constitutes a conflict?
The routing-disclosure rule requires the affected brokers to issue the new 606(a)(1) and the 606(b)(3) reports.
Brokers who handle any held customer order flow likely will have to issue 606(a)(1) reports, which are updated versions of the legacy 606 report, according to Davies.
It differs from the previous report, which requires firms to include the trade’s destinations as well as if the orders were market or limit orders, in that the 606(a)(1) must consist of whether the trade was a market, marketable limit, or non-marketable limit order as well as any fees or rebates directly associated with the trade.
Unlike the original 606 reports, which firms could publish in almost any format as long as it included the necessary data, the SEC will require firms to issue reports in XML and PDF formats only.
The 606(b)(3) report is wholly new and requires any firm to report actionable IOIs, further routable information, fill rates, spread sizes, whether the order adds or removes liquidity, net fees or rebates, and the total lifetime of the order within seven days of any client’s request.
However, if less than 5% by shares of a firm’s order flow is not held or if the client requesting the report has traded less than $1 million per month in the past six months, firms do not have to publish a 606(b)(3) report.
“This is extremely substantial versus what was previously required,” noted Davies. And thus the issue at hand for the sell-side.
The SEC has given guidance on the 606(a)(1) report in regards to equity trades, but several unanswered questions remain concerning how to report options trades accurately.
“Would the SEC consider orders routed to auctions as marketable orders or should firms take a large traders approach, which is the premium paid for the option," Davies asked. These are two different issues, he added.
The 606(a)(1)’s definition of “venue,” also has left many firms scratching their heads as some firms identify the final executing exchange as the routing venue while other identify the consolidator to whom they route option orders as the venue.
"In the legacy world which one you pick is not a big deal,” said Davies. “But with the new requirement, it becomes far more complicated due to the financial arrangements since we need to know the total fees paid or rebate received were. Now, you need to disclose the proprietary business information that your firm has with a wholesaler or disclose the substantially more complex information of what the consolidator's relationship is with the exchanges are."
The industry has spent most time to date with the regulators, approximately 80% he estimated, seeking guidance on Rule 606(b)(3)’s requirement to disclose details on the routing decisions which firms had discretion.
The answer is simple for firms that take orders and only sends them to an executing broker: They do not need to disclose.
If a broker has a full and continuous market data feed, a full suite of trading algorithms, and a smart order router as well as directs every child order to its final executing venue, it has complete discretion and would need to disclose the information.
“The problem is that this is not representative of the actual world in which we live,” said Davies. “The actual world fall somewhere in between. If you decide to route to one algo provider over another, is that discretion? If you instruct an algo provider to be aggressive, is that discretion?"
Given the increased complexity of the update 606 reports and the vast amount of guidance the industry is still requesting, Davies expects that many firms will not be able to continue generating the reports internally.
"They are going to need to use a vendor," he said. "Some firms will be able to do it themselves, but it is no longer a trivial matter. The 606(b)(3) report multiples by that again."
Jack Miller, Head of Trading at Baird said it wasn’t much of a surprise to hear that some on the sell-side want more time to get ready for Rule 606 compliance. He said there is always a bit of a scramble when a compliance deadline approaches, so the lack of perceived readiness on the part of the sell side is not a total surprise.
“While making 606 relevant to the institutional audience – and updating it for today’s post-NMS market structure - has been talked about for years, the requirements were only published by the SEC in November,” Miller began. “So there has been a relatively short timeframe to get brokers, venues, and the vendor community to coordinate an approach and develop solutions. We still have 6 weeks until the May 20 compliance date, so I would expect the sell side’s collective readiness to improve in the coming weeks.”
However, Miller said the final stretch to the deadlines wouldn’t be without incident or challenge. There are still some important points of clarification required, he explained, for example, disclosure requirements around downstream brokers and details around IOIs – so this will likely have the industry working right up until the deadline, with best practices continuing to evolve well beyond the compliance date.
“We can also think about “readiness” in the context of business philosophy around disclosure,” Miller continued. “The 606 enhancements are part of a continuing march toward greater and greater transparency around routing practices. While 606 now codifies requirements and standards around the disclosure of this information, many brokers have already been providing much of this information – such as whether orders added or removed liquidity, fees paid and rebates received – to clients who increasingly expect this level of transparency.”
That said, Miller concluded that it remains to be seen how central a role the customer-specific reports described in 606(b)(3) will play in the dialog between the buy side and sell side around best execution – despite the best efforts of regulators to address the concerns of the buy side in a standard report format, every clients’ needs are different and best ex doesn’t exist independent of context.
“But at the very least the new requirements will accelerate the trend toward greater transparency and empower the buy side with important information to assist in the execution process,” he said. “Through that lens as an industry we are ready and eager to drive a collaborative conversation around best ex.”
