Rule 606, updated by the Securities and Exchange Commission (SEC) last year to require additional disclosures by broker-dealers to customers regarding the handling of their orders, has caused headaches for the sell-side since it was first proposed – largely due to the complexity of the original 334-page mandate. With the postponed October 1, 2019 deadline fast approaching, the new guidance from the SEC comes not a moment too soon. But what implications does it hold?
Back in November 2018, the SEC adopted amendments to Rule 606 of Regulation NMS (Regulation National Market System, a set of rules passed by the Securities and Exchange Commission to improve the US exchanges through improved fairness in price execution) to require broker-dealers to provide enhanced disclosure of – in part to encourage effective and competitive order handling and routing services, and in part (from a regulatory perspective) to better investigate the relationship between exchange and trading venue rebates and routing decisions.
The amendment separated orders into “held” (which must be executed immediately) and “not held” (which give the broker some level of time and price discretion) with different disclosure obligations for each. Upon customer request, the new Rule 606(b)3 requires broker-dealers to provide specific disclosures, within seven days, for the past six months regarding not held orders. This includes information such as fill rates, spread sizes, liquidity changes, net fees or rebates paid to and received from trading venues, and more.
Rule 606(a)(1) for held orders requires rather less detail, but enhances the order routing disclosures that broker-dealers must make publicly available on a quarterly basis – including:
- Splitting limit order information into marketable and non-marketable categories;
- More detailed disclosure of payments received from or paid to certain trading centres;
- Describing terms of payment for order flow arrangements and profit-sharing relationships; and
- Publishing the order routing reports on a website that is free and accessible to the public for a minimum of three years.
The rule raised a number of questions, particularly around options trades – including what definition the SEC would use for “venue”.
Firms must now publish both 606(a) and 606(b)3 reports on a bi-annual and quarterly basis, respectively, in place of the lengthy legacy 606 report. And unlike the previous incarnation, which was accepted in almost any format, the SEC will only accept the new reports in XML or PDF.
But it is not just the format of submission that has raised concerns. Originally due for implementation May 2019 along with the rest of the amendments to Reg NMS, the SEC in April delayed the compliance deadline until October in response to a request from the Financial Information Forum (FIF).
And finally, this week, that long-awaited guidance has been released. So what does it say?
Not held orders
Under Rule 606(b) the SEC has clarified the definition of “discretion” – which had been an issue for sell-side firms as the requirement for more detailed reporting applies specifically when firms have been deemed to “exercise discretion” over not-held orders routed to another broker-dealer. The new FAQs make it clear that in almost every circumstance, if your firm uses another broker’s smart order router (SOR) or algorithm, you will be subject to the disclosure requirements.
Venues was another key concern as identification within the industry can be mutable – some firms view the final executing exchange as their routing venue while others call it the consolidator to whom they route option orders. According to Chris Montagigno, Managing Director of Compliance Services at Jordan & Jordan, the answer may not be what you were hoping for. For those firms utilizing the SOR/algos of another firm (and therefore deemed to be exercising discretion), the SEC expects these firms to report not only the SOR/algo firms as venues but also to include the venues to which those SOR/algo firms subsequently routed their orders. This entails the reporting of two different levels of venues, differentiated into primary, secondary or execution – a big ask, especially as it still remains unclear exactly what type of information needs to be reported against each venue. It also means that brokers acting as venues for reporting purposes (e.g., providing SORs/algos) will need to provide more information to the brokers originating the orders, in order to help them meeting their compliance obligations – which could be tricky.
The guidelines also issue clarity on the information that must be disclosed around fees and rebates, including how to distinguish what to report for different venue types; as well as information on certain data questions around the liquidity aspects of the reporting requirements. Most notably, the SEC has confirmed that orders that neither take nor provide liquidity do not have to be included in the liquidity-specific sections of the Rule 606(b) report.
The biggest clarification here is again around venues. The new guidance states that an entity is considered a venue for 606(a) purposes only if that entity executes orders. That means that if orders are routed to a broker/dealer that does not execute them itself, it doesn’t count as a venue. However, a reporting responsibility still exists, and the originating broker must disclose the relationship on its Rule 606(a) report: including any payments, transaction fees etc. It has the option of doing so by incorporating 606(a) information from the agency broker directly into its own report, but retains the responsibility of ensuring that this does not materially misrepresent the ordering routing practice. Montagigno notes that this requirement raises yet more unanswered questions: Why must the agency broker dealer be referenced at all, if it is not considered a venue under the Rule 606(a) definition of venue? What if the agency broker dealer only has other broker dealers as clients – does it therefore have no obligation to generate a 606(a) report? How can the originating broker determine or report the order routing practices of the agency broker-dealer without having access to the underlying order routing data?
So what happens now? Well, the industry is still not very happy – or very clear on what is required.
On August 2, 2019, prior to the release of the latest guidance, FIF and the Security Traders Association (STA) filed a joint letter with the SEC requesting delays in the implementation of the new 606(a) and 606(b) requirements – until two months after publication of the guidance (around Q1 2020) for 606(a) and until six months post-guidance (around Q2 2020) for 606(b). However, no response has been issued and as of now, the implementation deadline for the new Rule 606 remains October 1, 2019.
No matter how confusing it may seem, firms therefore have little option but to move forward with their compliance efforts as best they can – which could lead to a last minute panic, as broker-dealers rush to engage with vendors who can help them to source and report the required data.