March 3, 2020

Thought Leadership

Looking Beyond Rule 606: Rule 605

The SEC recently amended Rule 606 to ensure it continues to provide transparency amid today’s increasingly complex marketplace. But Rule 605, which remains untouched since its introduction, is antiquated and underutilized. In an industry where the hallmark of success is predicated on cutting-edge technology, innovation, and reinvention within a dynamic environment, the slow pace of Rule 605 reform seems untenable.

It was November 2000. A time when the NYSE maintained the largest market share of traded volume, ECNs and ATSs were just beginning to come of age, algorithmic ‘black-box’ trading was in its infancy, and AOL e-mail was the most popular method of electronic communication.

November 2000 was also marked by the SEC’s adoption of Rule 11Ac1-5 (subsequently becoming Rule 605), which required market centers to make available standardized, monthly reports containing statistical information about their order executions. During that same time the SEC also adopted Rule 11Ac1-6 (now Rule 606), which mandated broker-dealers to publicly disclose the identity of market centers to which they route orders on behalf of customers. Both rules promoted visibility and thus encouraged competition among market centers and forever altered the manner in which the sell side would determine where it would send its orders. “Best execution” became an industry mandate as it was the duty of those investment services firms to ensure the best execution possible for their buy-side customers’ orders.

The intense scrutiny of market centers by those seeking best execution spurred competition, innovation, and technology that would have an undeniably positive effect on the individual investor experience, as evidenced by order executions now taking place in milliseconds and often at prices better than the displayed quote. Therefore, one can say “mission accomplished” in light of the vast improvement of execution quality over the past 19 years.

However, since the introduction of Rules 605 and 606, equity markets have evolved substantially, with new stock exchanges coming on, the growth of ECNs and ATSs, and the emergence of dark pools and high-frequency trading. Add to the mix fintech firms using technology and innovation aimed to compete with traditional financial institutions. This complex set of linkages within an interconnected market system offers a virtual menu of routing destinations, strategies, and order types, and was the impetus for the recent amendments to Rule 606, which will now provide greater transparency, clarity, and information.

That leaves us with Rule 605. Untouched since its introduction, it’s antiquated and underutilized.

The current version of Rule 605’s statistical measurements focus primarily on price and time, overlooking other key factors such as enhanced liquidity, market impact, adverse selection, slippage, and probability of limit-order execution, to name a few. The rule covers only a fraction of available order sizes, order types, and time-in-force instructions, with a limited comparison of trading centers. Further, these statistics can be misinterpreted, misrepresented, and easily manipulated due to advances in technology and methods employed to cosmetically enhance results. In an industry where the hallmark of success is predicated on cutting-edge technology, innovation, and reinvention within a dynamic environment, the slow pace of Rule 605 reform seems untenable.

In order to assist investors and brokers in properly evaluating the execution quality of market centers and thus make more informed routing decisions, Rule 605 must be updated to reflect today’s marketplace. We can start by recasting ‘covered orders’ to include such order types as stop/loss, stop/limit, pre-opening, and market-on-close orders. Execution speed measurements currently classified by ‘seconds’ should be categorized by milliseconds. And expanding order size coverage to include odd-lots (1-99 shares) and orders of more than 10,000 shares would encompass a greater universe of trades.

An aspect of the current rule that runs contradictory to the spirit of the regulation and of “public disclosure” and “transparency” is that a market center need not make its monthly reports available in a readable form but rather only as an unformatted electronic data file (ASCII files) on its website. Market centers do have the option to make arrangements with other entities, such as a third-party vendor, to perform the functions necessary to make their reports available to the public, but the unclear guidance has introduced a host of other inconsistencies. Differences in market data feeds, rule interpretations, and NBBO time-stamping often result in dissimilar sets of performance statistics produced by vendors for the same client data file. A universal set of guidelines with respect to market data and quote assignment would provide a remedy to such variances. Lastly, if full disclosure and transparency are the goal of the Commission, posting performance statistics on a website or another independent public domain should become a requirement and not an option of the market center.

Third-party vendors have played a significant role in the publication of market centers’ statistics, and in doing so have also introduced hybrids of original Rule 5 measurements that have proved more valuable in the assessment of performance and quality than the original rule’s metrics. One such example is Effective/Quoted Spread Ratio, which incorporates two Rule 5 measurements, Effective-Spread and Quoted-Spread. The “EQ” as it’s commonly known, factors into account the spread at the time of order receipt, which brokers believe is a more useful measurement when determining a market center’s provision of price improvement, liquidity, and mitigation of price slippage. The marketplace’s reliance on this all-encompassing statistic would necessitate it becoming part of a Rule 605 revision.

The Commission’s adoption of 11Ac1-5 at the beginning of the new millennium has proven an unquestionable success in terms of improving execution quality, as any comparison of 2000 versus 2019 will attest. Market centers also have benefited, by being given an inside look at competitors’ performance, which has increased competition and driven innovation and which further contributed to the positive results.

For decades during the 20th century the year 2000 was seen as the embodiment of the future as one imagined what the world would look like in the next millennium. However, in many ways, 2000 now appears an ancient time, particularly in the technological world and in financial markets. Therefore, it’s imperative that the rules governing the financial markets are up to date and reflect the many changes over time. Especially when those rules were conceived and written during an “ancient”  time before iPhones, Twitter & Facebook.