Frustrating, inconvenient, costly delays—a harsh reality of our world. We often associate delays with airports, public transportation or traffic. I once spent 6 hours on the tarmac at Logan Airport only to have the flight canceled due to mechanical issues. A delay, however, isn’t always detrimental. Sometimes delays give us a chance to deeply understand the root of a problem and help us formulate an appropriate plan of action. In the case of the recent surge in regulation in the U.S. financial markets—particularly for broker-dealers—606b and its repeated delays have been met with open arms.
Why were Wall Streeters happy about 606 rule amendments being delayed on three separate occasions over the past year? Quite simply, many were not ready. The regulation came at a time that order routing was changing at break-neck pace.
“Since legacy rule 606 came into being, the market structure has shifted substantially,” said Mark Davies, CEO of S3, which specializes in Transaction Cost Analysis (TCA) and Regulatory Reporting. As a result, data required by the regulation isn’t easy to come by.
How did we get here?
As exchanges started to get into the rebate war in 2007, they began to incentivize brokers to trade with them, raising rebates by as much as 50%. Some rebates were offered when brokers took liquidity as well as when brokers added liquidity. As a result, complexities were introduced in the traditional make/take model. A broker’s tier—based on their volume traded with a given exchange—can influence a broker’s decision on how to trade to ultimately reduce their execution cost or even make a profit. Such practices are well within the scope of best execution, as many customers use Not-Held orders to allow brokers to deviate from market price to achieve better overall execution for the entire order.
Since commissions have continued to shrink over the last two decades, brokers have had to carefully manage their margins. Overhauled rebate strategies have been part of that exercise, tackled in part by using algorithms. Enter Rule 606. The SEC decided to examine if rebate collecting is affecting execution quality or overall routing decisions. But this was easier said than done.
Following the introduction of Reg NMS in 2005, many firms have begun to rely on automated order routing via algorithms, which helped speed up execution, achieve the desired size, and satisfy specific requirements customers would enter into Not-Held orders. The automation helped the brokers optimize execution overall for themselves and their clients. Because many brokers use other brokers’ algorithms to achieve these goals, specific routing decisions are typically made downstream, so such data isn’t readily available.
In November of 2018, the SEC adopted amendments to Rule 606 in large part to solve this exact transparency issue, as well as require broker-dealers to provide additional disclosures to the buy-side.
“With the new regulations, the SEC is requiring a substantial amount of look-through—a firm must not only know where they route an order but in many cases, must know where their destinations route the orders,” added Davies. “This information hasn’t previously been available, so this represents a substantial effort to get all the necessary data.”
Are you ready?
While some firms have started collecting data for their Held orders, most firms will need to prepare for the Jan. 1 deadline for Not-Held orders to begin collecting data to comply with the new 606 rules. As 606 and Consolidated Audit Trail (CAT) are quickly approaching the December 2019 testing period, 2020 is going to be a busy time in our regulatory circle. Delays can be a blessing, but we must be cautious to avoid risk to our businesses, as regulators have given every indication that the days of delays are over. Firms have begun to raise awareness and urgency to the new regulation changes and are continuing to select vendors for their hosted 606 and CAT solutions.
Here are some items to help you get ready:
- Speak to your current 606 provider and ensure that you are covered for the new rules
- Gather information with your downstream providers to ensure they will be able to provide the correct data points required back upstream.
- Speak to your clients and inform them that you will be ready to provide 606b reports if they fall under the reporting guidelines.
From the buy-side’s perspective, TCA has been the asset manager’s focal point for measuring best execution, slippage and captured alpha for many years now. The new regulations are now standardizing those measurements. When MiFID II rolled out in January of 2018, execution transparency with regards to last market, last capacity and liquidity making/taking were made more available. Having a normalized industry standard with the new 606 ruling should help investment managers ingest the data to produce useful reports.
Written by Marcos Frisaura
Financial Markets Group