SEC, FIF Seek End to Rule 606 Compliance Confusion

A meeting between the Securities and Exchange Commission and industry body the Financial Information Forum on Thursday, September 12 to finalize details of how brokers can comply with the trade routing transparency requirements of SEC Rule 606, ended in confusion as the regulator and industry disagreed over interpretations of some aspects of the rule, and which approach would ultimately deliver most transparency for investors.

Rule 606, which aims to eliminate any conflicts of interest when brokers route client orders to other brokers and execution venues by capturing execution data and the path it took—taking into account any fees or rebates that might sway a routing decisions—has already been delayed until the start of next year as firms struggled to make sense of the regulation, and the SEC took longer than expected to create a document of frequently asked questions (FAQs) to help brokers understand their obligations.

However, the FAQs may have created more questions than answers.

“After the extension, and on reading the FAQs, we realized there is some confusion around the look-through piece, and firm’s legal obligation,” says Mark Davies, CEO of Austin, Texas-based trade analytics software vendor S3, who was part of the FIF delegation at the meeting. “What we did get answered is that by January 1, you are required to collect data on and disclose all of the routes that you place. And from April 1, you will be required to report on any destination that you have discretion over.”

However, he says there was a misunderstanding between FIF and SEC staff over how to represent different levels of data. For example, when it comes to the code applied to identify each type of order routing action, FIF interpreted the rule to mean that in any instance, the first time a trade is routed by the initiating broker, the recipient would be designated as a primary routing venue (PRV). However, the SEC clarified that if an order executes on that first route, it should instead be designated as execution venue/secondary routing venue (EV/SRV).

In addition, orders ultimately routed to the same execution venue via different brokers (or even by the initial broker) could also create confusion because the buy-side client may not understand which execution was achieved by which broker, because all would be designated EV/SRV.

“This is a problem because this rule is about identifying conflicts of interest… for example, a broker chooses to route to another broker or execution venue because they will receive a rebate or pay less for execution, rather than because they will receive better execution quality,” Davies says. “That’s the reason for the look-through—the SEC’s stance that you need to know the reasoning by the executing broker. The industry has accepted that, and we’re building to that requirement. What we discovered in the meeting is that a direct conflict [where the originating broker routes to a specific broker or execution venue because of some incentive] and an indirect conflict [when a downstream broker routes to a specific broker or execution venue because of some incentive] should be indistinguishable in the report—and that’s what we’re disputing.”

Though there is no difference in the technical challenges associated with each, Davies says the SEC’s interpretation will result in greater confusion once the reporting comes into effect, because investors will not know where any conflict occurred.

Another aspect of the rule clarified by the SEC at the meeting is that orders should be reported based on execution, not on where they are routed. For example, if a customer sends an order for 100,000 shares to a broker, which executes 10,000 of those on an exchange, 10,000 on an ATS, and routes the remaining 80,000 to another broker, the first broker would file a Rule 606 report for the 20,000 shares it executed itself, and noting that the other 80,000 had been routed, but does not have to report executions conducted downstream from the second broker.

Davies says FIF will respond to the issues in writing to see if the SEC is open to changing its approach, but adds that “Barring anything else from the SEC, we will move forward with what they’ve said, even though we feel it is not the most effective mechanism for reporting what they’ve asked for.”

Also, he does not believe the latest disputes will affect the compliance deadline. “On January 1, we’ll be producing reports that should meet the SEC’s requirements. Whether those reports are useful to the buy side—and help firms make business decisions—is another matter. The conversation [resulting from these reports] should be “Why did you make this decision?’ not ‘What does this number mean?’” he says. Tweaking the reports in the manner proposed by FIF based on its understanding of the SEC’s FAQs would make them “far more valuable,” he adds.