The SEC’s revised requirements around order-routing transparency pose a series of challenges for brokers—the greatest of which may be collaborating to track orders through the maze of brokers and execution venues prior to execution, without specific guidance or mandates from the regulator.

The financial services industry gets more nervous about compliance deadlines for new regulations than a chef preparing a meal for an influential food critic who’s just had root canal. Right now, it’s the Securities and Exchange Commission’s (SEC’s) revamped Rule 606 of Regulation NMS, in particular, that brokers are fretting about.

The rule, which covers reports that provide transparency around order-routing, was originally scheduled to take effect in May. The industry, though, was offered a last-minute reprieve, as the SEC decided to extend the compliance date to October 1, 2019, after market participants requested clarification on specific data as part of the reports, and extra time to implement the changes. The SEC conceded to a delay, but it has yet to provide clarification on some of the new elements it expects as part of the reports, which officials say will be delivered in the form of a collection of frequently asked questions (FAQs).

The industry is still worried, because without those FAQs, brokers may still have trouble meeting the new compliance deadline, despite the delay, and may have to work together to collect and share the data required by the SEC.

Mark Davies, CEO of S3, a provider of execution analytics and transaction cost analysis software, who has been involved in data industry body the Financial Information Forum’s (FIF’s) efforts to obtain clarity and a workable deadline from the SEC, says the industry has already put together a potential set of Q&As that the SEC could use, but no progress has yet been made.

“The number one thing the industry wants to know is when are those FAQs coming out,” Davies says, “[W]e need that information fairly soon, because otherwise it just kicks the can down the road without giving us a more accurate target to hit.”

Chris Montagnino, managing director of compliance services at management and data consultancy Jordan & Jordan, which administers the FIF, says participants are already coding as much as they can to portions of the rule that are clear, but an inflection point is nearing to ensure that they are adhering to the rule as the SEC intended.

“Without the clear guidance from the SEC, brokers may report their activity differently,” he says. “And then you would not be comparing apples to apples, so the reports would be useless.”

Old Dog, New Tricks

SEC Rule 606—originally known as Rule 11Ac1-6—has been around in its current form since 2000, when it was introduced to improve public disclosure of order-routing practices by requiring broker-dealers to file public quarterly reports of how they routed non-directed orders, and to provide client-specific information as requested by buy-side customers.

The new reports cover execution in “not-held” orders—orders where a buy-side firm gives its broker discretion over the price and time of execution, and where the broker may execute some of the trade as principal or route some or all to another broker. So the report provides details on the shares sent to the broker, how many of those were executed by the broker as principal, and how many were routed to other venues, and to which venues.

The reports also include more detailed information on order routing (e.g., total shares routed, total shares marked immediate or cancel, shares further routable, and average order size routed), information on order execution (e.g., total shares executed, fill rate, fees and rebates, and numerous other execution metrics), as well as metrics specifically relating to orders that add or remove liquidity.

Getting different systems to work together will be tougher, and specifically, getting different broker systems to talk to each other will be the biggest challenge.

Ray Ross

The reason for the increased reporting complexity is that the US markets are now substantially more complex than when the original rule was introduced. “We have a market where different venues and order types have different fees. … So the purpose of the rule is to show what routing decisions are being made,” says Ray Ross, founder and CTO of New York-based agency broker Clearpool.

Here’s how it works today: A buy-side firm knows what it pays Broker 1; Broker 1 then chooses to route the buy-side firm’s order to Broker 2, and knows what it pays Broker 2. However, Broker 2 may also choose to onward-route the trade to Broker 3, who may even enlist a fourth broker, whose fees Broker 1 is unaware of. In addition, any broker involved in this chain may choose the destination it routes to based on which venue offers a rebate, rather than based on which delivers best execution.

“Today, when you get an execution report, you can see where a trade ended up. And a broker may route it to 10 different dark pools before it actually executes … but only the execution gets sent back to the client,” says S3’s Davies.

Announcing the revised rule in November 2018, SEC chairman Jay Clayton said that in the 18 years since Rule 606’s introduction, technology has driven “significant changes” in how US equities markets function, adding that the amendment will make it easier for investors to evaluate broker execution quality “and ultimately make more informed choices about the brokers with whom they do business.”

While this is something that the buy side has been clamoring for—and even many brokers have championed—there are significant bumps in the road that have slowed 606’s progression down.

Complexities

There are two key technical challenges associated with the regulation: first, collecting and sharing the data, and second, presenting the data.

The second challenge is the easier of the two: The new data requirements are not expected to significantly impact the structure or format of the current Rule 606 reports, but merely add some new data fields.

Collecting that data, however, is the bigger challenge. Brokers will need to disclose to each other the destinations (broker or trading venue) to which they route an order—known as “look-through” information—as well as any fees or rebates associated with those destinations, which is one of the areas requiring clarification, J&J’s Montagnino says.

There are still questions around exactly which costs should be reported, including commissions, execution fees, and/or rebates. It should be noted, though, that the SEC has already said the new disclosures will provide “the average rebates the broker received from, and fees the broker paid to, trading venues,” adding that brokers must describe “any terms of payment for order flow arrangements and profit-sharing relationships.”

“To be able to generate six months of data on-demand is going to be a real task. … That’s the heavy lift right there.”

Peter Weiler

But under the current rule, there is no established process for collecting and sharing that data, and in its proposed revision, the SEC does not prescribe a way of doing it.

“There is no mechanism for collecting where something was routed by a downstream broker and what relationships exist—that simply doesn’t exist today. … And ultimately, the onus is on Broker 1, and Broker 2 is under no obligation to support Broker 1,” Davies says. “There is a substantial amount of friction in this ‘look-through’ information about what relationships brokers have: It may be competitive information, or may be stored elsewhere. … Currently, that information doesn’t get shared—it’s internal and proprietary. Some brokers say they won’t disclose it to other brokers, which means clients (Broker 1) can no longer route to that destination (Broker 2).”

One of the fundamental questions left to be addressed by the SEC’s FAQs is how brokers will provide transparency around where every child order eventually executes, when the rule seemingly does not impose any obligation on the downstream brokers to share that information, Clearpool’s Ross says.

He notes that they already provide a whole host of other information not covered by the rule—such as quote stability and cost information about what markets charge—in real-time, end-of-day and end-of-month reports. And while Clearpool already provides clients with details of where orders were routed and the performance of each venue, via a web portal, the real challenge is getting disparate systems at the various broker-dealers and third parties to talk to one another.

“The specific file formats will be a small implementation,” Ross says. “[But] getting different systems to work together will be tougher, and specifically, getting different broker systems to talk to each other will be the biggest challenge. The brokers will be focused on providing services to their clients, not on providing information to another broker’s clients.”

Without any specific mechanism in place, the burden for collecting data falls on the buy-side client’s primary broker. “For a broker to provide a report back to its buy-side client, it may have to aggregate order-routing information from two or three other brokers it uses for execution. To get all that [information] into one report may be challenging,” says Curtis Pfeiffer, chief business officer at New York-based algorithmic execution technology provider Pragma Securities. The vendor already sends nightly execution reports to clients, and Pfeiffer stresses the need to understand the relationships between parent and child orders for vendors that work with between 10 and 15 brokers, each of whom may pass orders to three other brokers.

Unless the SEC’s upcoming FAQs stipulate otherwise, the industry will be forced to work together—or not—to fulfill firms’ obligations under the rule.

“It’s a three-part process: the customer, the broker, and the broker’s broker, and they have to figure out a way to work together. Everyone is trying to figure out the letter of the law, not just the spirit of the law,” says Peter Weiler, co-CEO of Abel Noser. “To be able to generate six months of data on-demand is going to be a real task. It requires brokers to combine multiple sources of client routing and trade records, both FIX order messages and market data, and it all needs to be stored in a secure and searchable database—and that’s pretty complicated. That’s the heavy lift right there.”

Even with all this uncertainty, though, 606 hasn’t received the kind of pushback that some other mandates have encountered.

Welcome Change

Unlike many new regulatory initiatives, the industry has been—at least publicly—positive about the new rule. Instead of resisting implementing new rules because of the cost or reporting burden, brokers seem genuinely supportive of the proposed changes, but are nervous about the amount of time needed to implement them, and how certain data-collection processes will work.

In particular, brokers who believe they do a good job of executing client orders are keen to live up to Clayton’s promise of allowing investors to make more informed choices based on broker execution quality, and to be able to demonstrate that, whereas under the current rule, an order may pass through multiple brokers prior to execution, and that executing broker may have no direct contact with the client.

Still, the FAQ remains a sticking point.

As an industry, it took us quite a while to digest it, and we never got to that next level of questions before the final rule came out

Mark Davies

The timeline for implementation of the revised rule has already been fraught with challenges: Though the SEC outlined its proposals in 2016, it adopted the finalized rules in November 2018, and stipulated a compliance deadline of May 20, 2019, giving firms a mere six months to prepare for the changes. Industry participants say that without the still-pending FAQ guidance, and because some were expecting a second round of comments and feedback before announcing the final rule—though an SEC spokesperson says a second round of comments is not customary—that timeframe was simply impractical, so firms and groups like FIF lobbied hard for an extension, impressing upon the SEC the scope of the challenges.

“As an industry, it took us quite a while to digest it, and we never got to that next level of questions before the final rule came out,” Davies says. “So it took a few months before there was industry consensus on the depth of information required.”

The compliance deadline extension to October means that firms’ first quarterly public reports under the new regime will be due by January 31, 2020, and the first 606(b)(3) client-specific reports available by November 7, 2019, assuming no further delays.

Subject to receiving sufficient guidance from the SEC, “if you have the right tools in place, you should be able to be ready within the timeframe. We’re making sure that … we can add support for look-through information if required. From our perspective, it allows us to do more testing on clients’ data and ensure they are entirely happy before going live,” Davies says.

Unintended Benefits

The regulation also has further-reaching and potentially useful implications for buy-side firms beyond best execution, because the data will provide a clearer picture of the most efficient brokers to route an order to market.

“I think the best execution [component] and the transparency into rebates arrangements were anticipated, but the ability to compare and contrast execution results by broker and venue was not anticipated,” says Michael Earlywine, senior vice president of channel partner sales at Abel Noser Solutions. Whereas buy-side firms can currently only see limited statistics from the broker they deal directly with, “when a client can see 25 brokers’ routing and fill data in a standardized format, the results are bound to reveal that some brokers are more efficient in how they leverage the various execution venues.”

S3’s Davies adds that while the SEC’s original intent may have been to expose potential conflicts of interests between routing brokers and execution venues—and that is still very much the point for the regulator—the resulting data will indeed make it easier for buy-side firms to select the best broker(s) to route orders to, based on the information they glean from the Rule 606 reports.

But Pragma’s Pfeiffer warns that the information gleaned must be considered in specific contexts when reviewed as part of a buy-side firm’s best-execution policies. “Depending on whether someone’s goal is to minimize impact or very aggressively source liquidity, the report could look very different. So the buy side needs to be mindful of what its objectives are, and how that affects the report,” he says.

Each of these benefits relies on firms being willing and able to share the required data, which may yet prove the sticking point that prevents the rule from realizing its full potential. And, as previously noted, some may be unwilling to part with that information—a position that attracts sharp criticism from other players.

“If you as an executing broker are unable or unwilling to provide Rule 606 data, it will put into question who can use your services,” Earlywine says, though he adds that he suspects some holdouts are simply waiting to see how much self-exclusion will hurt their business, and that the effect will ultimately be “self-correcting”—i.e., that firms will realize that the benefits outweigh the burden.

Ross offers a harsher ultimatum, suggesting that the rule may re-shape the broker landscape, and force brokers to re-think their roles. “Brokers will have to look at this and decide whether they can understand where orders are going—and if it’s to a routing broker, whether they can provide that level of transparency and allow you to make configuration changes to where orders go on a client-by-client basis,” he says. “If a broker can’t comply, it feels like they shouldn’t be executing and handling client orders.”

Ultimately, if broker–chefs can’t properly combine the ingredients to satisfy the critic’s taste buds, or can’t keep track of customer orders, then—while it may not be as clear-cut as “if you can’t stand the heat, get out of the kitchen”—they may need to reassess their role in the kitchen.