(Lexology) The U.S. SEC voted to adopt amendments requiring broker-dealers to provide investors with new and enhanced disclosures regarding handling of customer orders.
As previously detailed in Sidley’s Client Update at the time of proposal, the primary focus of the newly adopted amendments is to provide a level of transparency not previously required for institutional customer orders while providing necessary updates and enhancements to disclosures for retail customer orders under Rule 606 of Regulation NMS.1 In a significant conceptual change, the amendments require broker-dealers to make institutional customer disclosures for all “not held” orders, as opposed to orders above $200,000,2 as originally proposed.3
Specifically, the amendments to Rule 606 require a broker-dealer, upon a request of a customer who places an order giving such broker-dealer discretion with respect to price and time (i.e. a "not held" order4), to provide its customer with a standardized set of individualized disclosures concerning the handling of the customer's orders.
These disclosures will provide the customer with information about the broker-dealer's order routing decisions and statistics regarding order execution, including information on fees paid and rebates received from trading venues.
In addition, the amendments enhance previously existing requirements that broker-dealers provide public quarterly reports on retail customer order routing.
The rule now requires such reports to cover NMS stock orders of any size that are submitted on a held basis. It continues to cover any order, whether held or not held, for an NMS security that is an option contract with a market value less than $50,000.
Background and further information on the amendments are below. In addition to changes related to Rule 606, the amendments provide a new retention requirement for reports produced pursuant to Rule 605 of Regulation NMS.
The amendments are published on the SEC’s website and will be published in the Federal Register. The amendments will become effective 60 days from the date of publication in the Federal Register, and the compliance date will be 180 days from the date of publication in the Federal Register.
Background and Impetus for the Proposal
Prior to the amendments, Rule 606 disclosures applied only to small orders, meaning many institutional investors obtained only limited benefit from the rule. While certain large institutional investors may be able to leverage their market size to obtain order routing information from their broker-dealers, smaller institutional investors do not typically possess this bargaining power.
Absent rules mandating disclosure, it is sometimes difficult for these smaller institutional investors to obtain order handling information, and for those institutional customers who have received order handling information, the data from broker-dealers does not follow a standardized format.
Because of their larger size, institutional orders tend to be routed and executed using algorithms that break large orders into smaller, “child” orders that are sent to a variety of venues. Institutional investors worry that the dissemination of these orders may lead to information leakage, in which an institutional investor’s interest in buying or selling a particular security may be revealed to the market before the order can be fully executed. Information leakage can lead to additional costs as other market participants seek to use this information to their advantage. As a result, institutional investors often give their brokers not-held orders so that the broker has discretion in handling them to avoid signaling the rest of the market. Thus, understanding how a broker-dealer routes not-held orders is particularly important to institutional investors.
The above concerns, among others, prompted the Investment Company Institute (ICI) and the Securities Industry and Financial Markets Association (SIFMA) to propose certain enhancements to Rule 606 in a letter to the SEC in 2014.6 This letter significantly influenced the framework of the original rule proposal and thus the adopted amendments, which are detailed below.
New Required Customer-Specific Report for Handling of Not-Held Orders Intended to Cover Institutional Customer Order Flow
Subject to certain de minimis exceptions,7 new Rule 606(b)(3) requires broker-dealers to provide a customer, upon request, a report on the broker-dealer’s handling of the customer’s NMS stock orders submitted on a not-held basis for the prior six months, divided into separate sections for a customer’s directed and nondirected orders.
The report must include the following general information: shares sent to the broker-dealer; shares executed by the broker-dealer as principal for its own account; not-held orders exposed by the broker-dealer through actionable indications of interest;8 and the venue or venues to which not-held orders were exposed, provided that the identity of such venue or venues may be anonymized if the venue is a customer of the broker-dealer.
The report will also include the following information for each venue to which the broker-dealer routed not-held orders for the customer, in the aggregate:
- Information on order routing:
- total shares routed
- total shares routed marked "immediates" or "cancel"
- total shares routed that were further routable
- average order size routed
- Information on order execution:
- total shares executed
- fill rate (shares executed divided by the shares routed)
- average fill size
- average net execution fee or rebate (cents per 100 shares, specified to four decimal places)
- total shares executed at the midpoint
- percentage of shares executed at the midpoint
- total shares executed that were priced on the side of the spread more favorable to the not-held order
- percentage of total shares executed that were priced at the side of the spread more favorable to the not-held order
- total shares executed that were priced on the side of the spread less favorable to the not-held order
- percentage of total shares executed that were priced on the side of the spread less favorable to the not-held order
- Information on orders that provided liquidity:
- total shares executed of orders providing liquidity
- percentage of shares executed of orders providing liquidity
- average time between order entry and execution or cancellation, for orders providing liquidity (in milliseconds)
- average net execution rebate or fee for shares of orders providing liquidity (cents per 100 shares, specified to four decimal places)
- Information on orders that removed liquidity:
- total shares executed of orders removing liquidity
- percentage of shares executed of orders removing liquidity
- average net execution fee or rebate for shares of orders removing liquidity (cents per 100 shares, specified to four decimal places)
Enhanced Disclosures for Held Orders Intended to Cover Noninstitutional or Retail Customer Order Flow
The amendments prescribe the previously required public quarterly reports to now cover NMS stock orders of any size that are submitted on a held basis.
These reports must still cover any order, whether held or not held, for an NMS security that is an option contract with a market value less than $50,000. In addition, broker-dealers must report the following:
- separate routing information for marketable limit orders versus nonmarketable limit orders — previously, limit orders were not disaggregated in this manner
- routing information by calendar month instead of quarterly (and no longer categorize NMS stocks by listing market)
- a new category of data detailing separate routing information for NMS stock orders for securities included in the S&P 500 Index versus other NMS stocks
- a new set of information for the 10 venues to which the largest number of total nondirected orders were routed for execution and for any venue to which 5 percent or more of nondirected orders were routed for execution:
- the net aggregate amount of any payment for order flow received, payment from any profit-sharing relationship received, transaction fees paid, and transaction rebates received, both as a total dollar amount and per share for nondirected market orders, nondirected marketable limit orders, nondirected non-marketable limit orders and other nondirected orders and
- an enhanced discussion of the terms of any payment for order flow and any profit-sharing arrangements that may influence a broker-dealer’s order routing decision, including the following newly-required topics:
- incentives for equaling or exceeding an agreed-on order flow volume threshold
- disincentives for failing to meet an agreed-on minimum order flow threshold
- volume-based tiered payment schedules
- agreements regarding the minimum amount of order flow that the broker-dealer would send to a venue
Required Format of Rule 606 Reports and Retention of Public Reports Produced Pursuant to Rule 606(a) and Rule 605 Reports
The reports required under new Rule 606 must be made available using an XML schema and associated PDF renderer published on the SEC’s website. In addition, the public quarterly order routing report required by new Rule 606(a) and the public order execution report required by Rule 605 of Regulation NMS must be posted on a website that is free and readily accessible to the public for a period of three years from the initial date of posting on the website.
The enhanced disclosures provide increased transparency both as to broker-dealers’ routing practices and potential conflicts of interest. The added disclosures give investors more complete and consistent data points with which to evaluate and compare the practices of not only their broker-dealer but of competing broker-dealers.
This is likely to lead to more innovation and unique arrangements as broker-dealers seek to distinguish their services.
