03.15.2019
By Rob Daly

Sell Side Struggles with Rule 606

With approximately eight weeks before the US Security and Exchange Commission’s update of Rule 606 goes into effect, sell-side firms still need much guidance to meet the 334-page mandate.

The new rules, which the regulator issued in November 2018, is the latest tool the SEC has deployed to investigate the relationship between exchange and trading venue rebates and routing decisions.

Mark Davies, S3

“The phrase ‘conflict of interest’ comes up 76 times in the release,” said Mark Davies, CEO of S3, during an industry call hosted by the Security Traders Association.

The routing-disclosure rule requires the affected brokers to issue the new 606(a)(1) and the 606(b)(3) reports.

Brokers who handle any held customer order flow likely will have to issue 606(a)(1) reports, which are updated versions of the legacy 606 report, according to Davies.

It differs from the previous report, which requires firms to include the trade’s destinations as well as if the orders were market or limit orders, in that the 606(a)(1) must consist of whether the trade was a market, marketable limit, or non-marketable limit order as well as any fees or rebates directly associcated with the trade.

Unlike the original 606 reports, which firms could publish in almost any format as long as it included the necessary data, the SEC will require firms to issue reports in XML and PDF formats only.

The 606(b)(3) report is wholly new and requires any firm to report actionable IoIs, further routable information, fill rates, spread sizes, whether the order adds or removes liquidity, net fees or rebates, and the total lifetime of the order within seven days of any client’s request.

However, if less than 5% by shares of a firm’s order flow is not held or if the client requesting the report has traded less than $1 million per month in the past six months, firms do not have to publish a 606(b)(3) report.

“This is extremely substantial versus what was previously required,” noted Davies.

The SEC has given guidance on the 606(a)(1) report in regards to equity trades, but several unanswered questions remain concerning how to report options trades accurately.

Would the SEC consider orders routed to auctions as marketable orders or should firms take a large traders approach, which is the premium paid for the option, he asked. “It doesn’t really matter. we just need to know how they want us to do it.”

The 606(a)(1)’s definition of “venue,” also has left many firms scratching their heads as some firms identify the final executing exchange as the routing venue while other identify the consolidator to whom they route option orders as the venue.

“In the legacy world which one you pick is not a big deal,” said Davies. “But with the new requirement, it becomes far more complicated due to the financial arrangements since we need to know the total fees paid or rebate received were. Now, you need to disclose the proprietary business information that your firm has with a wholesaler or disclose the substantially more complex information of what the consolidator’s relationship is with the exchanges are.”

The industry has spent most time to date with the regulators, approximately 80% he estimated, seeking guidance on Rule 606(b)(3)’s requirement to disclose details on the routing decisions which firms had discretion.

The answer is simple for firms that take orders and only sends them to an executing broker: They do not need to disclose.

If a broker has a full and continuous market data feed, a full suite of trading algorithms, and a smart order router as well as directs every child order to its final executing venue, it has complete discretion and would need to disclose the information.

“The problem is that this is not representative of the actual world in which we live,” said Davies. “The actual world fall somewhere in between. If you decide to route to one algo provider over another, is that discretion? If you instruct an algo provider to be aggressive, is that discretion?”

Given the increased complexity of the update 606 reports and the vast amount of guidance the industry is still requesting, Davies expects that many firms will not be able to continue generating the reports internally.

“They are going to need to use a vendor,” he said. “Some firms will be able to do it themselves, but it is no longer a trivial matter. The 606(b)(3) report multiples by that again.”

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