March 21, 2019

In The News

FinOps Report: SEC’s New Rule 606: Execution Transparency At a Cost

For brokerage trade operations, compliance, and IT managers giving fund managers a lot more detail about where and how their trades were executed to fulfill the US Securities and Exchange Commission’s enhancements to Rule 606 could turn into a major operational headache.

At issue is how much data broker-dealers have readily available, how much they hve to track down, and how they will compile the results. The SEC has not clearly defined some of the element it wants and given that the deadline for complying with the new Rule 606 is May 20 broker-dealers don’t have much time to spare. Trade operations, compliance and IT directors will need to quickly get their acts together.

The new Rule 606 will be regrouped into two report: one called 606(a) is for held-only orders where the trade is “held” to time or price for execution of equities and listed options contracts. The second 606(b)3 report is focused on not-held orders where the broker-dealer ha to execute the order and can use discretion.

Meeting the requirements of Report 606(a)1 — applicable mainly to retail investors– will be straighforward with one major exception: the definition of venue is unclear for options. It is the second on demand report of interest to institutional investors that is generating the mot angst because of all the additional data and statistical requirements.

“It seems that the SEC’s goal for fund managers and other investors is to have a set of standardized information for broker-dealers routing instructions that can be used across the industry,” says Michael Post, vice president of BXS, a New York-based firm focused on best execution reporting. “To do so clients need to know more details about their orders so that they can measure their broker-dealers’ performance.”

The new 606(b)3 report for the first time will flash a spotlight on fees and rebates received. Reading the new reports fund managers could weed out the “bad” broker-dealers who have clear conflicts of interest or route orders to destinations that benefit them, and not the clients.  However, as is the case with all new disclosure requirements, it remains to be seen whether the end justifies the means given all the extra work broker-dealers will have to do to gather all the additional data.

Broker-dealers must tell investors not only where they executed their orders, but the fill rate, whether the order was executed at the mid-point of bid and offer, whether it took or provided liquidity, and any fees or rebates. The problem: “Some of the requested information might be included in the FIX messages used to confirm executions, while some is not,” explains Chris Montagnino, managing director in charge of the compliance practice at financial services consultancy Jordan & Jordan in New York.

It is uncertain whether broker-dealers will automatically have fee and rebate information tied to each client and each broker based on the data they receive from trade venues. Montagnino say the information received from each venue could be on an aggregate, net fee, or rebate for the month rather than for each customer or transaction. What then? Montagnino recommends that broker-dealers gather an inventory of all venues routed to and review the types of details provided by the venues, including fees and rebates. Broker-dealers should be asking themselves the following questions: is the information provided by symbol or client; does the information include whether the trade is a liquidity taker or provider; and does the individual trade include the amount of fees and rebates. Once broker-dealers know where they stand, they have two options, says Montagnino. They can take the information now provided by the trading venues through the messages provided in the FIX protocol, combine it by the applicable rates charged by each venue and calculate the execution costs themselves. Alternatively, broker-dealers can ask the trading venues to help provide that information.

It is more likely that broker-dealers will end up doing all the work on their own. “It all comes down to having the right market data and documentation,” says Venu Palaparthi, chief compliance officer of Dash Financial Technologies, a New York-based executing broker offering real-time order routing and trade analytics. “Knowing how the trade was executed requires having contemporaneous market data. It amounts to information around the time the trade was executed, on which venue, whether it was sent to downstream broker-dealers, relied on third-party algorithms, and the fees and rebate schedules of each trading venue.” 

Not all the required data elements are easily understandable. Case in point; the SEC wants broker-dealers to include any information on actionable IOIs. An actionable IOI goes beyond a simple indication of interest or a suggestion that a client is interested in buying or selling a stock or options contract. The presumption the SEC makes in its explanatory release on the new Rule 606 is that when the client indicates additional elements about the order such as the symbol, whether it is  buy or sell order, the size of the order and the price of the order it could immediately be executed. Hence, the adjective actionable can be used.  However, the SEC’s explanation of an actionable IOI isn’t as clear cut to  implement as it sounds.

“The information on actionable IOIs won’t be hard to capture if the IOIs were made through electronic means such as a broker-dealer portal or order management/execution management system, but that’s not the case if it’s made through instant messaging,” says Mark Davies, chief executive of S3, a best execution reporting firm based in Austin, Texas. The reason: the applications might record the information on where a trade occurs but not every destination where a trade didn’t occur. 

The SEC’s suggestion that the broker-dealer can rely on its knowledge of the client’s previous trading patterns to consider an indication of interest as a marketable IOI is also prompting some concerns. Davies, who spoke at a conference hosted by the industry trade group Security Traders Association provides the following example to highlight the murkiness: the client says it wants to buy 100,000 shares of stock XYZ, but it doesn’t offer the price. If the client has made the same requests previously, according to the SEC, the broker-dealer could reasonably assume that the client would accept the trade at the midpoint of the quote. Voila, the IOI has just become a marketable IOI. How do brokerage compliance managers feel about that interpretation: a bit queasy they tell FinOps Report.

Last but not least comes the most controversial part of the new Rule 606: providing details on the discretionary trades. On the surface, the word discretion implies the broker-dealer has a say on where the order was routed and how it was executed. That’s definitely the case if the broker-dealer executed the order itself. But what about if the order were routed to another broker-dealer or used a third-party algorithm? Here’s how the SEC explains discretion in its release about changes to Rule 606; if a broker-dealer forwards customer orders to another broker-dealer and the second broker-dealer exercises all discretion then the first BD isn’t required to provide disclosures. Such a simplistic example is open to plenty of interpretation, say compliance experts. Does that mean if an introducing broker-dealer uses another broker-dealer’s smart order router or algorithm with an instruction of aggression without further instruction it doesn’t have discretion. Is the following example a discretionary order? An introducing broker routes a large not-held order to an executing broker-dealer and specifies the use of a VWAP algorithm with certain parameters the SEC might think so. However, that’s not what some compliance managers would say because the introducing broker wouldn’t know how many child orders.  

Introducing brokers could always ask their executing brokers to pass back details on each transaction including associated costs/rebates and then compile statistics necessary for a new 606(b)3 report. They must then take their chances the executing broker will cooperate. “There is no denying that the ultimate customer of the introducing broker-dealer would benefit immensely from having the same information as the direct customer of the executing broker,” says Dash Financial Technologies’ Palaparthi. “However, the SEC’s rule doesn’t oblige the executing broker-dealer to provide this information to the introducing broker.”

Given the lack of regulatory incentive, the executing broker could cop out of any extra disclosure on the grounds that providing such information would jeopardize its competitive edge. What then? “The SEC believes that market forces will ensure destinations will provide the necessary information or risk losing business,” says Davies. Broker-dealers who can’t handle all of the extra data and interpretative requirements can always try using a third-party service such as those provided by Jordan & Jordan, BXS, Dash Financial Technologies and S3. All claim to be able to gather all of the data necessary to generate 606(b)3 reports. However, even using a vendor isn’t a panacea. “It is an easy answer for handling certain additional requirements such as new data points and adding new market data,” cautions Montagnino. “Vendors can certainly make life easier for broker-dealers by assisting them with the task of gathering data and link it with the order/transactional data, but firms will have to play an active role in the process.” The reasons: the additional data on payments and rebates may not exist in a format that is easily transferable to a 606 report and broker-dealers may not have the data  readily available to send to a vendor. 

As is the case with outsourcing any regulatory reporting work, broker-dealers need to ensure their potential service providers can deliver what they promise. BXS’ Post recommends that a broker-dealer ask its vendor about whether it can pay for just what it needs– Rule 606 compliant reports– rather than an entire suite of compliance products; whether its platform has the ability to scale for large data volumes; and whether it can easily be used by more than trading desk specialists. 

Given the tremendous amount of legwork that has to be done to comply with the new Rule 606, broker-dealers can only hope that their third-party service providers or in-house operations, IT, and compliance teams are ready. The Financial Information Forum, a New York-based industry group focused on regulations, has asked the SEC for guidance on some of the more unclear aspects of the new requirements including the fuzzy terminology. 

Broker-dealers can only hope that their fund managers and institutional clients actually understand all the information in the Rule 606 reports thy are generating. In some cases, broker-dealer compliance and trading desks might have a lot more explaining to do with the fund management firms’ own compliance and trading managers. S3’s Davies says that his firm offers fund managers the option of tying the information on their Rule 606(b)3 reports to additional transaction cost analysis reports to give them an even better understanding of whether their broker-dealers may have a conflict of interest in their order routing decisions.

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