On December 14, the SEC unveiled its largest and most comprehensive set of proposed reforms to the US equity markets since Reg NMS was instituted in 2005. While these proposals were introduced as separate rule filings, they are interconnected, making it difficult for the industry to formulate opinions and provide input. Over the next few months, robust discussion and education will be necessary as firms assess the way forward.
One such discussion took place on Wednesday, December 28, as Security Traders Association (STA) hosted an open call entitled “SEC Equity Proposals: Disclosure of Order Execution Information (Rule 605)”. The featured speaker was Mark Davies, Co-Founder and CEO of S3, a full-service compliance and trade analytics software company.
Rule 605: Overview and Key Changes
The four proposals that SEC Chair Gary Gensler and his four fellow Commissioners voted on last month addressed a range of issues such as Rule 605, tick sizes, access fees, price transparency, retail auctions and best execution. Davies, in conversation with STA President & CEO Jim Toes, talked through the details of the Rule 605 proposal and how it intersects with two of the other new proposals, Regulation Best Execution and the Order Competition Rule.
To start the call, Toes provided an overview of Rule 605 and explained how the SEC’s proposed amendments amount to a dramatic evolution.
“The proposal has six amendments that either expand, redefine or eliminate elements of the existing Rule 605, all with the intended goal to modernize and enhance execution quality reporting that would better help the public compare and evaluate execution quality among different market centers and broker-dealers,” stated Toes.
Principles vs. Prescription
Toes then asked Davies to offer perspective on how the Rule 605 and Reg BestEx proposals complement one another and what industry parties they affect. Davies explained that while the latter is a broad, principles-based regulation that is relevant to broker-dealers trading any asset class, the former is an update to a preexisting and fundamentally very prescriptive rule: it will apply almost exclusively to equities trading.
“Rule 605 is essentially a sub-component of Reg BestEx – 605 review will be necessary for compliance with Reg BestEx, which is appliable to all securities covered by the SEC,” said Davies.
To dig deeper, Toes and Davies examined how the proposed amendments to Rule 605 compare to recommendations made by the industry in a series of three Financial Information Forum (FIF) letters. Of these letters, one issued in January 2019 included several ideas that were reflected in the SEC’s recent proposals, such as the addition of orders from outside of market hours, odd lots, large orders and short-sale orders. Another suggestion by FIF that ended up in the proposals was separating out IOCs to minimize skewed data. Lastly, mentioned Davies, the SEC added a measurement on size improvement in accordance with FIF recommendations.
In one of the proposed amendments to Rule 605, the SEC suggests new categories for how information should be captured and reported. Davies explained, “Something interesting they did was come up with the idea of an ‘executable’ order – basically, a non-marketable limit order becomes executable when it enters the spread, rather than having to cross the spread.”
Other amendment details that Davies spoke on included the addition of stop orders and fractional shares, which he noted have “become a substantial part of retail trading, but not something we’ve seen the SEC address directly until now.” He also talked about the proposed addition of a summary report, saying, “It’s hard to say if the report is something that will be realistically consumed by retail traders… I’m interested to see what comment letters come out in response to the first report.”
Other Considerations: Auctions and Options
The conversation then turned to the link between the 605 proposal and the Order Competition Rule, which would introduce auction operators into the equity markets. All of these new regulations include components designed to reduce conflicted transactions, but the Order Competition proposal would be the most impactful rule by far in terms of putting guardrails around payment for order flow (PFOF).
“We know the SEC wanted to go after PFOF, and instead of outright banning it, they seem to be using a number of mechanisms to curtail its use,” observed Davies.
The discussion closed with a look at how the proposals might affect options trading. Despite being mentioned in a 2014 letter from FIF, the amendments to Rule 605 contain no mention of options. The SEC did, however, address options in Regulation BestEx. The text stipulates that a wholesaler routing its order flow to an exchange so that an affiliated market maker can interact with it must show rigorous proof of best execution.
With comment letters due on March 31, this open call won’t be the last discussion on the Rule 605 and Reg BestEx proposals. To stay up to date, follow STA on Twitter or LinkedIn, or sign up for their email list.