08.02.2016
By John D'Antona

SEC Raising Bar on Trade-Order Transparency

Buy-side traders are on the verge of getting a deeper and fuller look into how their orders are routed.

The U.S. Securities and Exchange Commission has formally proposed changes to some of the Order Protection Rules as put forth in Reg NMS. The regulator has submitted changes specifically to Rule 606, often referred to as a component of the broader Order Handing Rules proviso.

Many industry professionals have said that these rules, 605 and specifically 606, require changes from their initial form as written under Reg NMS. With so much trading occurring in dark pools and internalized by broker desks, and multiple rebate schema deployed by the 40+ trading venues, the buy side – both institutional and retail – has demanded more light be shed on how brokers process and execute their orders.

“I believe a lot of what is wrong with Reg NMS starts with the Order Protection Rules and 605-6,” James Angel, associate professor of finance at the McDonough School of Business at Georgetown University. “These rules need to be fixed for the current market structure. Its about time.”

Acknowledging the need for change, SEC Commissioners voted recently, 3-0, to propose amendments to Rule 606, which requires brokers to report certain statistics about how they route retail-size customer orders (i.e. less than $200,000). The gist of the new proposals is to mandate executing brokers disclose information about how they handle and route customer orders in listed equities and ETPs that are of institutional size.

It’s time to shed light on a dark area, in other words. And both retail and institutional investors can benefit from these changes, even in this proposed stage, as investor confidence in the equity marketplace remains skittish. According to Andrew Upward, head of market strategy at Weeden & Co., the SEC’s proposals “seem like a very good place to start, their limitations and risks notwithstanding.”

The SEC first wants brokers to complete and submit customer-specific institutional reports. In this new provision any institutional investor who requests a report on handling practices must receive one that is standardized. It would include thing such as: number of shares routed, average order size and amount executed, fill rate and size, any rebate paid or received and resting time.

According to the SEC, this report would only contain data from that specific client’s orders over the previous six calendar months. The broker would need to provide the report within seven business days of the request, and it would need to include data only on the orders worth $200,000 or more on a parent-order basis (such orders are labeled “institutional orders,” and the sending of such an order makes the customer an “institutional customer”). If an institutional order is sliced up into child orders, data on all of the child orders would need to be included regardless of their size.

Furthermore, Upward told Markets Media that the data would need to be broken out by month, by venue and by strategy, with “aggressive,” “neutral” and “passive” as the three strategies.

“The new disclosures should be effective as a conversation-starter, as a check on the claims made by one’s broker, and as a new stream of data that will enrich market participants’ understanding of how orders are routed,” Upward said. “Buy-side traders and trading analysts should have a field day looking at how their brokers use different venues to post, cross the spread or interact at midpoint, how long they tend to rest orders on maker-taker venues versus inverted venues, and what their net fees and rebates are. They’ll be able to tell how much of their flow is being executed in a broker’s dark pool, how much is being exposed via actionable IOIs, and what their execution sizes and fill rates are at each venue. And the monthly periodicity should allow for meaningful trend analysis that can be tied back to exchange fee changes.”

The new proposal would also require brokers to publish to their website the same information in the reports – – handling, routing and execution data by month, venue and strategy – across all institutional orders executed over the previous quarter. The publishing date would be 30 days after the end of the quarter.

The SEC also wants a formal definition of the term actionable indication of interest or IOI. This would clarify how many shares are published or advertised when an IOI is shown on behalf of a buy-side trader.

“To define the term, the SEC is proposing to use the definition that it outlined in its Regulation of Non-Public Trading Interest proposal in 2009,” Upward explained. “Specifically, an actionable IOI would be defined as “any IOI that explicitly or implicitly conveys all of the following information with respect to any order available at the venue sending the IOI: symbol, side, a price equal to or better than the NBBO, and a size of at least one round lot.”

The last proposed action item is an enhancement to quarterly retail reports, which brokers already provide. The SEC wants brokers to provide clarity on the usage of marketable or non marketable orders, rebates received or paid and any fees applicable to order flow. This would all be done on a monthly basis.

The 60-day comment period for these proposed changes began on July 27th and ends September 24th. The Commission is not bound by any timeframe when it comes to voting on the proposal and that’s assuming the proposals are approved.

“The new disclosures should be effective as a conversation-starter, as a check on the claims made by one’s broker, and as a new stream of data that will enrich market participants’ understanding of how orders are routed,” Upward said. “Buy-side traders and trading analysts should have a field day looking at how their brokers use different venues to post, cross the spread or interact at midpoint, how long they tend to rest orders on maker-taker venues versus inverted venues, and what their net fees and rebates are. They’ll be able to tell how much of their flow is being executed in a broker’s dark pool, how much is being exposed via actionable IOIs, and what their execution sizes and fill rates are at each venue. And the monthly periodicity should allow for meaningful trend analysis that can be tied back to exchange fee changes.”

But there is a downside to all this disclosure, Upward cautioned. Too much data and cause a case of data overload and some buy-side reports might severely contrast with what the brokers will be providing. Deciphering the data could prove troublesome and cause initial conflict between data providers and users.

“Despite the risks and limitations, the proposed disclosures will have a positive impact and should be approved – albeit it with some tweaks,” Upward said.

 

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