April 29, 2021

Thought Leadership

In the SEC’s Ongoing Quest for Transparency, Rule 605 Reform Is a Logical Next Step

Ben Calev, Co-Founder and CTO

It’s one of those adages that holds true both within our industry and in everyday life: knowledge is power. In order for our markets to operate at peak efficiency, participants must have the ability to assess their performance, compare it against their peers and ask the right questions of their counterparties.

Ask anyone on the Street about the most consequential regulatory reforms that have been implemented in recent years and it won’t be long before they mention the amendments to SEC Rule 606, originally adopted in 2018 and implemented last year. The updated rule takes a multi-pronged approach to strengthening order routing disclosure requirements for broker-dealers. This came about in part because of how rapidly equity markets have evolved over the past two decades, with the rise of dark pools and other off-exchange venues, the emergence of HFTs as the primary source of liquidity, the evolution of smart order routing technologies, the ongoing race to zero commissions, and so on all playing a role driving the change.

The new requirements include separating reporting for held orders and not-held orders, allowing for greater insight into the differences in how retail and institutional orders are routed. It also requires disclosure of rebates received from and fees paid to trading venues. While the amendments have increased compliance burdens for the sell side, there is a general consensus that they have benefitted investors and the industry as a whole.

But if Rule 606 has been adapted to meet the current moment, its counterpart – Rule 605 – remains stuck in the Dark Ages. While both rules were passed in 2000, Rule 605, which requires market centers to make available monthly reports on their order executions, has not changed since its inception. As a result, these reports are not a reliable indicator of execution quality as the concept exists today.

Dig into the Rule 605 reports and you’ll understand just how inadequate they are – they provide little more than a vague idea of how market centers are executing only certain types of orders. To restore their status as a valuable tool for market participants, a few key reforms are needed:

Odd lot data – The lowest fill increment category captured by Rule 605 reports is 100-499 shares. For a rule that seeks to provide a snapshot of execution quality for retail orders, this threshold falls well short of capturing all relevant transactions, especially given the rise of discount brokerages whose primary value proposition is enabling individuals to make small, frequent trades at little to no cost. It is imperative that these reports capture odd lot data to align with the evolution of the retail investing space, especially given the considerable increase in high-priced stocks over the past few years.

More details on timing and spread – Rule 605 reports capture data on a stock-by-stock basis, including execution price relative to public quotes, price improvement and effective spreads, aggregated by month. In this day and age, those aggregate numbers simply encompass too much data to be useful for deriving insight – the frequency must be increased considerably. They also track execution time in increments – seconds – that are out of step with the speed of markets today. In addition, they do not include quoted spread. While this number can be derived based on the other stats, the reports should be as intuitive and transparent as possible. Put simply, the industry has gotten a lot better at the type of analysis that Rule 605 seeks to augment through data, but the requirements simply haven’t kept pace.

Breakdowns by sending party – While execution data is captured by stock and by month, Rule 605 reports do nothing to indicate where these orders originate. It is therefore impossible to assess broker-dealers based on the price improvement they are receiving from a given market maker. This is a key consideration for retail investors, who often find themselves having to choose between multiple platforms offering free trading. Including breakdowns by sending party in the reports would give them a better sense of the real cost of executing their trades.

More accessible formats – Market centers are only required to distribute Rule 605 reports as unformatted electronic data files, as opposed to readable forms. That may work for institutional investors, but recent years have seen the rise of a large and growing segment of the market that does not have universal access to the tools needed to use the reports. If transparency is the goal, this is a natural place for reform.

Amending Rule 605 will also help restore the original intention for the rule, which was for it to work in tandem with Rule 606. In theory, an investor should be able to use Rule 606 reports to learn where their brokers route orders and Rule 605 reports to determine what level of performance they can expect. The discrepancy in detail between the two reports as they currently exist only serves to reinforce the inadequacy of Rule 605. Reform will help both reports function as intended: as part of an overall look at the full lifecycle of a trade from routing to execution.

Beyond the functional reasons for Rule 605 reform, the SEC should consider taking action as part of its overall push towards transparency. While recent years have seen numerous actions in this direction, the GameStop controversy shows that the industry still has work to do to change the public’s perception of the markets as an opaque and insular space governed by black boxes. The SEC can buy itself a lot of goodwill by making a public push for a needed reform that benefits investors, even if there isn’t a direct tie-in with the payment for order flow debate that’s currently raging.

Market centers also stand to benefit from amendments to Rule 605. Venues and market makers that consistently offer price improvement can tout this as a selling point and allow their clients to set clearer expectations. Ones that do not consistently offer price improvement may be more incentivized to do so, making the entire industry stronger.

At the time of its implementation, Rule 605 represented a milestone in fostering transparency and insight into the equities market – and now, the SEC must strengthen its requirements so it can occupy this role again. As long as the rule remains in its current form, the industry will be missing crucial pieces of the best execution puzzle.