“Can I Can See Clearly Now?” (by David Weisberger, IHS Markit)

A word cloud of any speech by regulators or market structure pundits would feature the word “transparency” prominently.   A common refrain: “Sunlight is the best disinfectant” is universally supported in these discussions.   When the conversation turns to regulation, however, the excuses start to fly.  Most favor other people making disclosures but not so much themselves.

This tendency is on full display in the SECs current proposal on Institutional Order Routing, which is actually two proposals that have been fused into one.  The first aims to make the production of an industry produced report template a legal requirement. The second would require a series of changes to public order routing disclosures under Rule 606 and, to a lesser extent, Rule 605.

This conflation of two distinct rules is quite unfortunate, as they are designed for rather different purposes and therefore should be structured separately. The institutional routing report proposed in the rule was first designed by the Investment Company Institute[1] on behalf of their asset manager members and was later supported by SIFMA.  The primary goal of this routing report is to provide enough data regarding routing activity to enable intelligent conversations between the asset managers and their broker dealers.  It was never intended to be a report that provides sufficient information for making routing decisions, and it certainly was not designed to be a comparison tool for the public. Unfortunately, the SEC proposal contains a massive exemption (all orders under $200,000) and, at the same time, extended the requirement to produce the report to a much broader investor group than a reasonable cost benefit would suggest.  As a result, in our soon-to-be-released comment letter, we call specifically for limiting the legal requirement to produce this report to Qualified Professional Asset Managers[2] (as defined by ERISA rules) and to include all Not Held, non-directed orders, regardless of size.

The other part of the SEC proposal is to “fix” Rule 606 to provide better public disclosure of orders. While there are some good ideas in this part of the proposal, it falls short for both retail and institutional investors.  Before describing specific objections, it is important to highlight the most important aspect of the public disclosure rules:

Categorization matters most

The benefits of Rule 605 are well chronicled, but what is not generally appreciated, is that the retail brokerage firms that have driven these improvements, were not subject to the rule.  Those firms were not required under 605 to report, but they used it as a template.  Most firms set up best execution structures based on covered[3] orders, and then delved much deeper into the data that the rules required. In particular, retail brokers and market makers centered on a statistic that is not even required in the rule called “effective over quoted” spread or “EQ.”  They used this data to pit market-makers against each other, with the intended result of significantly better execution quality.

Thus, when we analyze the potential to reform Rule 605 and Rule 606, the key consideration is not the details of what data is required, but rather which orders are “covered” and how they should be grouped in order to make statistically valid comparisons.

To help illustrate this point, marketable orders under 605 are much harder to compare than market orders since they include both Immediate or Cancel (IOC) orders and orders that are valid for the rest of the trading day unless subsequently cancelled (DAY) and there are no statistics on the unexecuted quantity of those orders.   The result is that execution quality has improved for market order execution quality more than for limit orders, whether marketable or not.

So, what does this mean for Rule 606 reform and, specifically, the SEC Order Disclosure proposal?

The most important aspect of this rule will be how orders are categorized, and the current proposal fails on that score.   Instead of trying to define retail by a notional value, we believe that “Held” orders should be treated as retail, while institutional orders should be identified as “Not Held”.  Within “Not Held” orders, we propose to organize reporting based on the orders routing brokers receive, as follows:

• Not Held “Working” – This includes all orders sent to sales traders or directly to institutional algorithms. The key distinguishing characteristic of these orders is that they are not expected to be immediately executed.  There are, however, some circumstances, such as the discovery of natural liquidity, where these orders could be executed quickly.

• Not Held “Routable” — These are orders which are received by a broker, with instructions to use their smart order router for the entirety of the order. This would include all orders marked “routable” that are handled by the affiliated brokers of exchanges.

• Not Held “Directed” – These are orders where the client has instructed the broker both the price and the specific market to which the order should be routed. It is extremely important to segregate these from other not held orders as the reporting broker has no discretion on these orders.

• Within each “Not Held” category, we propose that all child orders should be included, without exception, within the following aggregated categories, for each venue that they route to, along with basic execution metrics such as fill rates, effective spread and realized spread:

Market (Day and IOC)

Marketable (Day and IOC)

Non-Marketable (Displayable or Not)

For “Held” (retail) Rule 606, we propose that routing firms show similar statistics at the aggregate level with the same categorization, while providing the payment for order flow information at the venue level.  The reason for this difference is that retail investors will have no say in the specific venue decisions, but should include the aggregate numbers in their choice of routing brokers.  Professional asset managers, however, do have the ability to make decisions, along with their routing brokers, on the specific routing decisions made.

In conclusion, we are proposing that the next iteration of Rule 606 reports should be grouped by Held or Not-Held orders, with aggregated metrics of execution quality for Held orders and venue by venue metrics for Not-Held.  The most important parts of this recommendation, however, are to accurately group orders and to require reporting to separate IOC and day orders, marketable and non-marketable orders.  If the SEC implements this basic categorization, it will be a major step forward.

[1] https://www.ici.org/pdf/28480.pdf

[2] See http://www.investopedia.com/terms/q/qpam.asp

[3] Covered orders under Rule 605 are defined here:  https://www.federalregister.gov/documents/2000/12/01/00-30131/disclosure-of-order-execution-and-routing-practices