Change is brewing in the way that sell-side order routing data is reported to institutional customers.

Broker-dealers will begin collecting vast amounts of data on January 1st for compliance with the revised SEC Rule 606 next year, shining the light on where brokers route U.S. equity orders in today’s highly automated, dispersed and complex national market system.

By contrast to existing 606 reports, which did not provide much information to institutions, other than list the percentage of orders routed to each exchange, the new 606 reports are much more granular.

On Nov. 2 2018, the Commission adopted amendments to Rule 606 of Regulation NMS to provide more meaningful disclosures that boost transparency for institutional investors into order routing and enable comparisons between different brokers.

While the final rule does not distinguish between retail and institutional orders, it breaks out reporting for “held” orders, in which a broker is held to a best execution standard and executes immediately, versus “not-held” orders, in which the broker has discretion over time and price. Retail investors tend to submit “held” orders, while institutions usually submit “not-held” orders, which are larger in size. This change ensured that the rule would capture child orders derived from larger  orders, wrote law firm Davis Polk its analysis of Rule 606.

The revamped regulation requires more extensive disclosures of order routing and execution data by broker dealers related to handling institutional customer orders including average rebates the broker received from, and fees the broker paid to, trading venues.

“There’s more visibility for the customer,” said David Chu, Vice President, Product Management at FlexTrade Systems. “Now a customer can ask, where did you route my order?” said Chu, who is working on the compliance project to assist broker-dealers utilizing the firm’s fully-hosted ColorPalette OMS and the customizable (fully-hosted or enterprise) FlexOMS. “They can also see if an order was routed to a venue that gives a rebate or a venue with a cheaper execution,” he said.

One of the most profound changes is the requirement in amendment 606 (b) (3) for “not-held” orders that broker-dealers must report the “look-through” data that results from using the order routing or execution services of another broker-dealer.

Compliance Delays

In April, the SEC pushed back the compliance deadline to Oct. 1 from May 20, allowing firms additional time to gather the data and develop and test their systems.  This delay was necessary because brokers were waiting for additional clarity and written guidance from the SEC  on the scope of the look-through data requirement and what constituted the definition of “discretion,” according to a letter from the Financial Information Forum.

In an Aug.2 letter, FIF and the Security Traders Association (STA) cited confusion with the data reporting obligation, and indicated that the vast majority of executing brokers are “not positioned” to provide the second-level routing data back to the initiating broker, and that some firms regard this data as “sensitive intellectual property.”

In the SEC’s FAQ posted on Aug. 16, it clarified that any initiating broker-dealer that utilizes algorithms or smart order routers (SORs) from another executing broker or executing venue is exercising discretion over the order and therefore, must report the downstream order-routing and execution data.

Sell-side firms received a second reprieve. On Sept. 4, the SEC granted a second temporary exemption “to provide additional time for broker-dealers to complete the development of systems and processes necessary to begin collecting the data required by the rule,” wrote the SEC in the order.

Now, the revised rule is slated to take effect on Jan. 1 for order routing of “held” orders under the amended 606 (a) and for “not-held” orders  under the amended 606 (b), while firms have until April 1, 2020 for collecting the second-level routing data.

“The industry is definitely moving forward,” said Chris Montagnino, Managing Director of Compliance Services with Jordan & Jordan.

Pain Point: Look-Through Data

But, the sell-side’s biggest pain point is around providing the “look-through” data which happens when an order is routed by the first broker-dealer to a second broker to use an algorithm and that algo routes to an exchange, an ATS, or another destination. “The challenging part is getting all the downstream broker dealers and algo providers to report that information back to the originating broker dealer,” said FlexTrade’s Chu.

What’s Ahead in 2020?

“In  January, the  requirement is to bring the Rule 606 (b) (3)  reporting data for the first-level or first -route or wherever the firm routes to directly, such as another broker dealer, exchange, or ATS, and list all venues and all of the relevant statistics for the venues that they are routing to directly,” explained Montagnino. “In April, the look-through piece comes in for not-held orders, which is when a broker is given discretion over time and price. That’s where if a broker is utilizing the services of another broker-dealer, their algos, [or] their smart-order routers, it is deemed to have discretion over the order,” said Montagnino.

“If an order is routed to a broker which is utilizing the services of a Clearpool, Merrill, or Goldman,  we need to know where it routed the order, how did  it slice up the order and route it out and all the relevant fills that came back and the costs associated  with all those fills,” said Montagnino.

Brokers Look to OMSs and 606 Data Vendors

To retrieve the mandated order routing and execution data, broker-dealers are relying on their order management systems (OMSs), which house much of this raw data, as well as specialized Rule 606 data reporting vendors.

Currently, an OMS has the primary level information, and gets the last market where the order was executed, including whether it added or removed liquidity, and it can calculate execution costs based on known fees, explained Chu. “But, if those algo providers routed the order to another venue or exchange, and that gets routed out further, we don’t have that secondary or third-level or fourth-level of information today,” said Chu. “There’s no structure to get that information today,” he said.

Gathering the information on these downstream orders has been a challenge, especially if brokers utilize more than one OMS or have an EMS, said Chu.

“If our clients use us solely for their trading, we have all the data in the OMS, so we would provide the data over to the 606 [data] vendor,” said Chu. “When some clients use another OMS or EMS, we have no visibility,” explained Chu When several systems are involved, 606 data vendors assist the brokers with consolidating the data from multiple systems. In this case, FlexTrade will provide the data on behalf of customers to firms such as IHS Markit, BestXStatistics, S3 and Abel Noser, which specialize in 606 data reporting. They will consolidate the order-routing information, calculate 606 statistics and publish the report  back to the client.

Brokers will be obligated to provide the buy side with on-demand reports under the new 606 (b) (3) showing where their orders were routed over the past six months, said Chu. Reports will indicate whether they used discretion, average order size, fill size, transaction costs, whether the order was maker or taker, cost/ plus exchange fees. “All of this data has to be calculated into 606 (b), said Chu, emphasizing that data has to be collected by Jan. 1.”

Data Reporting Challenges

But the January timing is not as difficult as April in that all that information resides in a given firm, said Montagnino.  “As a broker dealer you know where you route your orders, you can trace them, you’re are getting fills back from those routes. If you route to exchanges you have liquidity codes and associated fees that go with it. So, you can put all that together today, because it’s all inhouse,” he said.

However, when it relates to the April report, that is where reporting becomes more difficult, because firms don’t have that information, said Montagnino. “All you know is that you routed an order to Broker B, and you got back some fills, but you don’t know where they routed the rest of your order,” said Montagnino. “They don’t tell you if we routed your order 17 times to eight venues and we didn’t receive any executions,” he said.

“Anyone providing their algo services have to provide this information back to you for 606 going forward,” said Montagnino.

The rule is clear that the initiating broker-dealer is responsible for obtaining the data.  However, the executing broker dealer providing services is not required to provide a 606 report to another broker dealer, said Montagnino.

On the other hand, it would be bad for business if the broker providing a service does not provide the look-through information back to the originating broker who has a regulatory obligation to its customer, said Montagnino.

Protecting Proprietary Data

But some brokers providing algorithmic trading services and SORs, are concerned they will reveal confidential information as a result of providing this data back to the originating broker- dealer. “If they reveal how much of an order was sent to each destination and what the timing was, there’s the concern that some smart person can reverse engineer how their algorithms work, and that’s their secret sauce,” said Montagnino.

To resolve this issue, the industry is exploring alternative ways to get the data from the algo providers. Some algo/SRO providers don’t have a problem sending back a raw data – meaning they will provide a file to the broker-dealer for a specific customer ID, showing all the routes and related executions, said Montagnino.  However, some providers don’t want to pass back the raw data but are willing to provide summary-level statistics for 606 (b) on an order-by-order basis. Then the initiating broker would take those statistics and put it together with all the other orders for the customer and calculate the 606 (b) statistics.  In this scenario, the algo provider is not disclosing their “secret sauce” about execution routes, while still providing the summary information for the broker’s regulatory obligation, said Montagnino.

Currently, FIF is working with the industry on creating a template for inputting the information in a standardized format that will be acceptable to all, said Montagnino. In the Aug. 2 letter, FIF/STA said that more standardization of the format was necessary so that brokers could build automated systems to ingest and report the order/execution data on a regular (i.e., monthly) basis to customers.

Leveling the Playing Field

While compliance is a heavy lift for broker-dealers, the goal of the revised 606 is to shed light on institutional order handling. Existing 606 quarterly rules did not provide much information of value to institutional customers. Even the SEC acknowledged that advances in order routing technology, such as the usage of child orders and indications-of-interest, has made equity trading more complex since Rule 606 was first adopted in 2000.  With orders spread across 13 registered exchanges, more than 40 ATSs and over 200 over-the-counter market makers, it is difficult for asset managers to track how their orders are handled.

“Prominent asset managers already have access to this order routing data because they have the ability and the clout to demand it from their brokers,” said Montagnino. But, small-and-medium size firms may not have the clout to demand this level of detail, and this is about to change.

In 2020, money managers who lack transparency into their order routing, can opt to request individualized disclosures on where their orders were routed as well as the fees and rebates.  In the past, “they didn’t know if they got added or removed liquidity,” said FlexTrade’s Chu. This was never a requirement in the old 606, but now it is,” said Chu. When armed with more competitive order routing data, buy-side firms can start a conversation with their brokers about assessing the quality of their executions.