Disclosure is the rage in financial markets regulation and the latest set of proposals relate to order handling rules.

Regulators are seeking to boost transparency into the order routing practices of broker-dealers and trading venues that reroute their orders in U.S. listed equities across exchanges and other trading venues.

As many know, on July 13, the U.S. Securities and Exchange Commission proposed a rule requiring broker-dealers to publically disclose on their web sites information about the execution and handling of institutional orders.  The proposal also expands existing disclosures for retail investors, including payment for order flow information, not previously provided.

The proposed disclosure rule “for the first time will force brokers to provide standard data on where they send institutional clients’ orders to be completed,” reports Bloomberg in “SEC Proposes in Making Brokers Reveal Where Client Orders Go.”

The SEC’s proposal calls for amending Rule 605 and 606 of the Regulation National Market System (Reg NMS) in order to require broker-dealers to provide more detail on the routing and execution of institutional orders for the prior six months.

Under the new rule, broker-dealers would also need to make the aggregated reports on the handling of institutional orders publically available on a quarterly basis.

The new rules will compel broker-dealers to provide that data upon the request of a customer for institutional orders that are at least $200,000 in value.  These customer-specific reports would contain specified monthly data for the past six months.  They will require detailed order handling information for each venue where the broker routed institutional orders for the customers, and would need to be broken down by passive, neutral and aggressive order routing strategies. Brokers will have up to seven days in which to respond to a request from an institutional customer.

Some of the data elements about order routing will include total shares routed, total shares routed marked immediate or cancel, total shares routed that were further routable and average order size routed.

Fill rates are an important piece of information.  If a broker-dealer were routing institutional orders with large average sizes to venues that had low fill rates, this could indicate that the broker-dealer’s order routing strategy was not designed to minimize information leakage.

Retail investors will also see an expansion of the current disclosures including more details on rebates and other incentive payments received by broker-dealers from execution venues or paid to such venues.

Broker dealers will be required to report the net aggregated amount for payment for order flow received for the 10 venues to which the largest number of non-directed orders were routed for execution, and for any venue in which five percent or more of orders were routed for execution.

Why is the SEC expanding order routing disclosure?

U.S. equity market structure has changed significantly since the adoption of Rule 606 in 2000. “Order routing practices have evolved as markets have become more automated, dispersed and complex,” stated the SEC in the 87-page proposed order handling disclosure rules. “In 2000, a large proportion of listed equity securities was routed to a few mostly manual, trading centers, and it was rare that such orders would be re-routed to other venues,” wrote the SEC. Fast forward to today, and the trading of U.S. equity markets is fragmented across 12 highly automated exchanges, more than 40 alternative trading systems and over 200 over-the-counter market makers.

Yet, in a speech at The Securities Traders Association (STA) Market Structure conference in September, SEC chair Mary Jo White said “broker-dealers are required to disclose little about their institutional order routing practices. With the large number of exchanges and other venues that trade NMS stocks, all investors should know more about how their brokers negotiate this dispersed landscape,” White said.

Existing Rules 605 and 606 contain fundamental flaws, wrote James Angel, Professor of Finance at Georgetown University’s McDonough School of Business, in a comment letter published on the SEC’s web site. “The resulting disclosures, while interesting to academics, have been totally useless for retail investors,” said Angel.

“The rules were designed in the pre-modern era to bring some transparency to order routing and execution practices.”

But in practice, Angel contends that retail investors were “unaware of the reports and few had the expertise to interpret them,” adding that the data was too raw.

Institutional investors have been clamoring for more transparency into order handling practices, especially after a series of dark pool investigations and fines alerted them to conflicts of interest.  In 2014 Tabb Group reported that nearly three-quarters (72%) of buy-side firms surveyed were not satisfied with the transparency level in broker dark pools, versus 28% who were satisfied. In 2015, half (51%) of the buy-side respondents were satisfied with the level of disclosures/transparency received from their brokers, while 49% were not.

Industry Reactions

Industry participants weighed in on the proposals during the public comment period, which ended Sept. 26, citing several flaws in the proposed revamp.

“Standardized information about the manner in which brokers handle orders can help customers evaluate broker routing decisions, potential conflicts of interest, and the quality of trade executions,” wrote Mark Bryant, SVP, Deputy General Counsel, Fidelity Investments.

But Fidelity and others contend the new rules would not capture all of the institutional order execution activity. They also object to the SEC’s usage of algorithmic strategies, such as aggressive, neutral and passive, as ways to categorize the orders, because these are subjective decisions, and these strategies could differ among various brokers.

Commentators unanimously agreed that defining retail orders worth less than the threshold of $200,000 and institutional orders as higher than $200,000 would result in not capturing all of the order flow.

The proposed institutional order handling report would include the routing of all child orders derived from institutional orders even if those child orders are under $200,000, wrote Fidelity’s Bryant. However, any institutional customer’s non-child order with a market value of $200,000 or less would not be included in the report, wrote Bryant.

On a Securities Traders Association (STA) call in August, David Weisberger, managing director and head of global analytics for IHS Markit, said the definition of retail vs. institutional orders is not the same as it was 20 or 30 years ago. “Retail is clearly no longer self-directed investors or wire house broker types,” said Weisberger, pointing to asset-based fee advisors, independent investment advisers, retail firms and wealth managers, all of which manage retail orders. Weisberger said he looked at sample data from top retail and wholesale market-making firms that showed that over 20% of retail orders by value derive from orders over $200,000.

That is a pretty large percentage that would be classified as institutional, which would mean that every retail firm out there would have significantly more reporting requirements than they should,” he said.

By contrast, institutional orders no longer exclusively rely on large orders, since the buy side often trades algorithmically and can control these orders technologically, he said.  “Order management and execution management systems are much more sophisticated and provide much more control for buy-side traders,” he said.

A random sample of 100 buy-side firms found that 65% of all the orders sent from the buy-side to the sell-side broker were for less than $200,000, said Weisberger.

Georgetown’s Angel suggested that disclosures for retail investors do not go far enough and ought to include execution quality statistics, not just order routing information. Angel wrote that confirmations should display the NBBO at the time of order receipt and calculate the difference between the time the order was received and the execution price. Angel also wants the broker to report the percentage of the order executed inside and outside the bid-ask spread, average execution time, and number of complaints received relative to the number of orders.

The question is what is the difference between retail and institutional orders?

According to Weisberger, the difference is in the level of protection that’s accorded to the orders themselves. Retail orders are subject to Manning rules and limit order display rules that protect these orders.  Manning is a short name for a FINRA rule that prohibits placing the firm’s own interest ahead of the interests of a client. If a firm is holding a customer’s limit order, the firm cannot ignore the order.  The firm cannot trade for its own account at a price that would satisfy the customer’s limit order.

A better way to gather statistics on order routing would be to use the characteristics of how orders are routed, according to Weisberger. “There is no way to pick a dollar value,” he said.

“Rule 606 should be focused on routing brokers with aggregated statistics in broad categories that are statistically comparable. It means that it is based on the types of orders that brokers receive and work for clients,” said Weisberg.

Weisberger and several other commentators agreed that “held” and not-held” orders as the way to differentiate retail and institutional orders is a better solution than what the rule proposes.

A held order is a market order that must be promptly executed so that the request is immediately filled, so therefore, the broker has little discretion, according to Investopedia. A not-held order is a market-or limit-order that gives the broker or trader both time and price discretion to attempt to get the best possible price.

With not-held orders there are three types that broker-dealers need to know today, said Weisberger.

1. High touch, medium touch or routing orders
2. No-touch, low touch or DMA orders
3. Directed orders, where the client has instructed the broker on the price and venue to which the order is to be routed

“If you broke out your high-touch orders and those separately routable orders that use your smart order router, and broke out those orders that are directed in trading, it would be a far better way of breaking out the orders than what the SEC has in the current rules, which is trying to devise strategies based on active, neutral or passive. And those change every day,” said Weisberger on the STA call. This already is more or less in every order management system, he added.

It should not be difficult for sell-side firms to respond to these requests because they already have all of this order routing information available for their OATS reporting.

Any FINRA member that handles or executes orders in NASDAQ or over-the-counter listed-securities has OATS reporting responsibilities. Many sell-side firms already rely on their OMS providers to handle the OATS reporting.

They need to submit all of this data to OATS on a daily basis.  Even if a broker sends a client order to 20 different venues and cancels two orders, the information is already there and being submitted to Nasdaq by OMS providers.

The only missing piece is a mechanism to send this data back to the buy side.

As the SEC moves toward a data-driven approach to regulation, it would not be surprising if in the future, buy-side firms want this information on a weekly, daily or even on a real-time basis.

Some buy-side firms will rely on their transaction cost analysis (TCA) providers to crunch the data. Eventually, providing transparency into this data from brokers and market centers will clear up confusion as to where orders are routed and completed, giving investors more control over how their orders are handled.