This is the third article in a sponsored content series from S3. The first article was a Chat with S3 CEO Mark Davies; the second article was Sell Side Raises Bar on Trade Surveillance.  

Dude, where’s my order?

How was it handled? And why did you send it where you did?

All pertinent questions today’s buy-side trader is asking his sell-side counterpart in the current market structure. And now the U.S. Securities and Exchange Commission agrees and is making changes to its Order Handling Rule disclosures – Rule 606 – and making more data and reports available to the investing community. Whether one is a mega money manager with tens of billions under management or a small Mom-and-Pop office, you’re about to get more in your inbox.

Order routing has been driven and shaped by significant technological innovations that have completely changed the way markets function and the way broker/dealers trade. The original rules did not provide the requisite level of transparency needed to provide investors with the proper insights to make informed decisions regarding their trading partners and strategies. This has led to a cottage industry of vendors and others looking to assist the buy-and sell-side with the looming reams of new data as to where orders were sent and how they were handled.

S3 is one such company, providing trading compliance solutions to monitor and analyze trade execution and surveillance for equities, options, and fixed income securities. The firm, led by Chief Executive Officer Mark Davies, recognizes the need for order handling disclosure and recently announced the launch of its own Order Handling reports designed to meet the Securities and Exchange Commission’s (SEC’s) new Rule 606 reporting requirements.

Originally envisioned, Rule 606 states “broker-dealers that route customer orders in equity and option securities are required to make publicly available quarterly reports that, among other things, identify the venues to which customer orders are routed for execution. In addition, broker-dealers will be required to disclose to customers, on request, the venues to which their individual orders were routed.”

On November 2, 2018, the SEC upped the reporting ante and announced new regulations governing disclosure of order handling practices by broker dealers with a compliance deadline of May 20, 2019. In addition to requiring considerably more data and calling for changes in report formatting, these new rules apply to significantly more market participants than previous regulations have, and the new reports are substantially more complex, making them difficult to produce in house.

https://www.sec.gov/news/press-release/2018-253

Under REG NMS, the 606 will now be broken into two separate reports specific to the clients’ order flow.

606(1)(a) will be required to report only HELD order flow(A HELD order is one where the trader is “held” to the duty of best execution – meaning they have to provide a prompt execution at the best possible price.)

606(b)(3) will be mandatory for NOT HELD order flow(A NOT-HELD order is an order that gives the broker-dealer both time and price discretion.)

The new disclosures are designed to help clients understand how their orders are routed, what fees/rebates are associated with their broker’s chosen venues and what impact (if any) these decisions had on the execution quality received.  Previously, firms were not obligated to disclose this information.  This level of information, in the hands of a client, will help explore the advantages/disadvantages of rebates and exchange fees and empirically prove whether or not such payment for order flow affects quality of execution and ultimately the quality of US equity markets.

Chris Montagnino, Managing Director of Compliance Services at Jordan & Jordan explained that the big challenge here is that broker-dealers will now be required to provide, upon request, a detailed report to a client about the routing of their orders during the prior six months, including specific detail on any fees/rebates passed through to the client.

“Many firms likely already have fee/rebate information that can be gathered for reporting but being able to link such information on a client-by- client, order-by-order basis can prove challenging for a lot of firms,” Montagnino said.

Mark Davies, CEO of S3, told Traders Magazine that S3 now offers a premium Best Execution and Surveillance solution and therefore, wants to ensure that his clients are prepared for these changes well in advance of the SEC deadline.

“S3 first began providing the precursor to the current 606 reports as part of the Best Execution Suite in 2004 and is now the market leader for multi-asset best execution and surveillance,” Davies said. “The new 606(a)(1) held order flow reports will be available at no additional charge to clients who subscribe to the S3 Best Execution Suite. While additional data will be required in order to generate the necessary reports, S3 is well equipped to assist clients in preparing the necessary data, ensuring a seamless transition to the new order handling reporting format.”

Along with the new Rule 606 solution, the firm also introduced a Not Held Compliance Suite. This suite will include the new on-demand 606(b)(3) reports and S3’s Transaction Cost Analysis (“TCA”). With these new reports, S3’s Best Execution Suite and the Not Held Compliance Suite ensure that S3 clients will meet all the requirements of the new SEC order handling disclosure rules for both held and not held order flow.

Spencer Mindlin, Capital Markets Analyst at Aite Group says that while demand for the reports and solutions such as S3’s are available, he doesn’t expect a cottage industry to develop around these reports and their processing. He told Traders Magazine that these new disclosures and the amendments to Rule 606 are unlikely to create a slew of new vendors.

“The skill to analyze this data is highly specialized and it can be an expensive endeavor for a new entrant to spin up and build the required infrastructure and software required to collect, clean, process, analyze the data,” Mindlin began. “There are several firms already in this space and providing independent transaction cost analysis. These firms are the ones most likely to be able to accommodate the additional disclosures in reports as a result of the amendments to Rule 606.”

In other words, while the data and report collation will be required reading by the buy-side, he does see advanced technology playing a role.

“Firms that want to have Rule 606 reports analyzed will want to go to the providers with the experience and scale to be able to perform the analysis properly and cost effectively. These are most likely the firms already with a critical mass of customers and have already made the investment required to perform this sort of work,” Mindlin said. “For sure, the industry might see a few new players enter and try to compete by using newer and cheaper technology or able to do perform an analysis with greater finesse. But I wouldn’t expect to see half a dozen new vendors pop up as a result of the additional disclosures in Rule 606 reports.”

So, who will need help parsing and interpreting all this fresh data?

Mindlin said the buy-side will continue to need help and only the largest of asset managers that are likely to try to perform this sort of analysis will do it with in-house resources. The remainder of firms will want to outsource this function to a specialized provider.

“The sell-side may need help too. While the large brokers will have the infrastructure to support and maintain reporting solutions, Tier Two brokers will turn to vendors to help with regulatory compliance,” he said. “These sorts of new rules create a boon for vendors who are happy to charge for solutions that brokers must buy in order to remain in business. The downside though is that every additional bit of regulatory burden brings additional costs to the participants and puts them one step closer to having to exit the business if they’re no longer profitable.”

But what about the data? Will the market become overwhelmed by an influx of new reports and information and see it’s collective eyes roll to the back of it’s head?

Mindlin thinks not and there’ll be no instance of analysis paralysis.

“The good thing about the additional Rule 606 data is that it will (hopefully) add additional transparency to how brokers route their orders,” he said. “There will likely be an initial rush to analyze all sorts of new data, and the brokers with poor routing logic will be forced to clean up their acts very quickly. But once the chips fall, it’s unlikely that there will be an ongoing need to scrutinize the data unless there’s a problem that requires attention.”

What can broker-dealers do now to prepare for what is sure to be interesting reading?

Jordan & Jordan’s Montagnino warned that broker-dealers who think that their vendor who currently provides 606 reports can seamlessly generate the new reports should think again. Certain data, including payment/rebate detail, is not maintained by the vendors and, in many cases, may not be maintained currently by the broker-dealers, he argued. And with the impending deadline of May 20, 2019 approaching, he named a few actions that broker-dealers can undertake if they have not already:

1) Gather an inventory of all venues where the firm has a relationship that results in fees/credits back to the firm;

2) Confirm the types of third-party algorithms/SORs utilized by the firm and how the traders utilize the algos/SORs, i.e., do they customize any requirements before placing orders?;

3) Review the type of detail that is currently provided by the venues regarding the fees/rebates.  Is the information provided by symbol, client, etc.?  Are fee/rebate details provided on an execution-by-execution basis? Does the detail include information broken out by liquidity providing executions versus liquidity taking executions?  Does your OMS provider include liquidity indicators on the execution records?

“Brokers should begin working with your developers or vendors on the new format and structure of the report to ensure you can obtain the necessary data to address new data requirements concerning marketable/non-marketable limit orders, actionable IOIs and orders that are further routable,” Montagnino said.

S3’s Davies agree that brokers should be working with their vendors and that S3 remains at the ready to handle all data regardless of formats.

“We’re here and ready to go,” Davies said.