The US Securities and Exchange Commission’s decision to broadly define what makes a trade execution discretionary will force introducing and executing brokers to walk a thin tightrope when complying with its new Rule 606.
They will have to make some tough choices on how much information the executing broker can release on a trade order without giving away its secret sauce. The introducing broker must also prevent the data about the trade from falling into the wrong hands — someone other than the intended client.
The SEC’s explanation of the circumstances defining a discretionary trade appears in its FAQs following the publication of the amendments to Rule 606. Although trade execution specialists weren’t entirely surprised by the regulatory agency’s interpretation, they were hoping for a narrower definition which would generate far less angst, particularly for executing brokers.
Postponed until October, the new Rule 606 calls for information on trade execution to be regrouped into two reports. The first Report 606(a)1 will be for held-only orders, typically affecting retail investors. The second report 606(b)3, focused on not-held orders typically executed for institutional investors, will for the first time flash a spotlight on the fees paid and rebates received.
The SEC’s goal is for fund managers to weed out bad brokers who have conflicts of interest. Therefore, the new report must include information on where an order was filled, fill rates, whether the order was executed at the mid-point of bid or offer, took or provided liquidity and any fees and rebates.
The SEC says that the introducing broker interfacing the client is responsible for providing all of the new information to its end client if it has discretion over its trading strategy. Taken at face value, trade compliance experts tell FinOps Report, the word discretion implies that the introducing broker-dealer has a say in where the order was routed and executed. Practically speaking, that’s not the case when it comes to orders routed to another broker dealer or using a third-party algorithm. When that occurs, the first broker doesn’t know when or at what price the order will be executed.
However, that’s not the SEC’s interpretation. “Based on the responses the SEC provides in its FAQs, it would appear that virtually any time, with extremely limited exception, an introducing broker using another’s algorithm or smart order router, the SEC says the introducing broker has discretion,” says Chris Montagnino, managing director of compliance services at Jordan & Jordan, a New York-based financial services consultancy. “The FAQs define a very broad application of discretion for 606(b) purposes that is a departure from how the securities industry has historically defined discretion.”
The SEC suggests that executing brokers won’t have any choice, but to fork over all the information required under the new Rule 606. The introducing broker can always find another executing broker willing to comply with the letter of the new rule.
However, executing brokers can’t afford to be too transparent. Executing brokers create algorithms and trading strategies designed to give them a competitive edge. “Release too much information and reverse engineering could occur,” says Mark Davies, chief executive of S3, a trade execution reporting firm in Austin, Texas. That means that an executing broker’s rival might be able to determine how and why they made certain decisions. This, in turn, might allow the rival to create either similar algos or trading strategies, thereby undermining the original executing broker. Therefore, for executing brokers, less is more.
An introducing broker’s end client is also worried about data leakage to proprietary trading firms or high frequency firms. If those firms detect a big move in or out of a position, they could trade ahead of the big trade.
Now what? “Executing brokers and their clients — introducing brokers– will need to figure out just how to reveal information in a way that doesn’t jeopardize the executing broker’s strategy or the trading pattern of the ultimate client,” says Davies. “It will also be critical for the introducing broker to mitigate data leakage, because the client won’t want anyone else to know about its strategy. ”
Because many of the statistics required for the new reporting is based on averages, such as average fee, rebate, order size, and fill size the executing broker can compile the information based on a particular order ID or even client ID, says Montagnino. The introducing broker can then incorporate the data for reporting.
A bit of technology and some solid negotiation can go a long way to solving the data leakage quagmire. “The data delivery system can be created to grant access to customer specific data only to those who request it or are authorized to receive the data,” says Venu Palaparthi, chief compliance officer of Dash Financial Technologies, a New York-based executing broker offering real-time order routing and trade analytics. “In addition, on a case-by-case basis executing brokers can address any perceived risk of releasing confidential trading strategy by providing aggregated data instead of raw data.”
However, such a solution may not work in every case. “An introducing broker using several executing brokers may want the raw data to produce their reports or in some cases they may use vendors, who will likely want raw data,” says Palaparthi.
Davies recommends that one way to communicate only the bare essentials is for introducing brokers and executing brokers is to use an independent non-trading firm, such as S3, which would link critical confidential data in the backround. The name of the client wouldn’t have to be disclosed to the executing broker and the executing broker wouldnt disclose the granular details of each order. However, that scenario still calls for both sides to release information to a third party.
Yet another solution, says Davies, would be for a particular data set to be transmitted between the executing broker and introducing broker that would reduce the amount of information released. Davies says he has presented this idea to his clients and the Financial Information Forum. The New York-based industry group focused on regulatory compliance, had asked the SEC to clarify the fuzzy terminologies the agency used in drafting the new Rule 606.
Given all the extra work and potential expense brokers must incur to comply with the new Rule 606, one can only hope that fund managers will find the information valuable. “Supporting the data needs of new Rule 606 adds incremental expense to the executing brokers,” says Palaparthi. “Executing brokers may be willing to absorb the cost associated with processing the data that is provided to the customer facing broker depending on the amount of data, existing capabilities, as well as other relationship-specific factors.”
Introducing brokers required to comply with Rule 606 could also end up with additional costs related to the production of their own reports or the use of reporting services such as those of S3, Abel Noser, BestXStats and Jordan & Jordan. Introducing brokers must then decide whether to pass along those costs to their ultimate clients.
“The largest fund managers likely already have enough market intelligence on their own to understand the trading decisions and conflicts of interest,” says Palaparthi. “It is the small to mid-sized managers which will likely benefit from having new information they would otherwise not have.”
However, not all fund managers will understand what they are reading. The largest fund managers typically rely on best execution committees comprised of trading and compliance specialists to evaluate the total cost of trade execution, broker performance metrics and broker-selection. The small-to-mid sized fund managers might need to rely more heavily on account management executives at their introducing brokers to translate the complicated data into user friendly information. Those customer interfacing managers, in turn, must turn to their in-house trade execution and market structure specialists and executing brokers for more help. Davies says that S3 will be offering fund managers an out-of-the-box easy to understand analysis of the Rule 606 reports.
In crafting the new Rule 606, the SEC certainly had investors’ best interests in mind. At the very least it has ignited critical discussions among all parties in the trade execution chain to shed light on the decision-making process. They were certainly long overdue.