Kartik Arthanat, product manager for Trading Analytics at S&P Global Market Intelligence, explores the intricate implications of the recent SEC market structure reforms in the form of the Rule 605 and 606 updates: why they are significant, what will change, and how the industry is likely to react.
What is the significance of the 605 and 606 rule change?
The updates to Rule 606 (in 2018 and 2023) and Rule 605 (in 2024) are significant because these are the first set of changes to the rules since they were initially adopted in 2000. In the years following the rule change, the market structure evolved both in response to REG NMS and rapidly changing technology. The number of venues that are available for trading has changed. Back in 2000, according to the SEC’s accounts, there were only nine registered exchanges and one NASDAQ. As of early 2023 we had 16 exchanges, 33 automated trading systems and 220 other venues where orders can be executed. Separately, the number of orders covered under 605 has declined over the years as trading shifted more towards odd lots and fractional shares.
These updated rules aim to better capture routing and execution quality statistics that define today’s highly fragmented markets and changing order flow.
What has been the journey to arrive at the rule change and what were the biggest obstacles?
Over the last decade, the SEC has conducted studies, formed advisory committees (the EMSAC in 2015) and sought feedback from industry participants regarding the effectiveness of Rule 606 and 605 to make informed decisions on future amendments.
One of the things that came out of the tick pilot study, which they did for small cap stocks, is that a lot of orders went unreported. Over 51% of the orders went unreported because of certain order type exclusions, and almost 11% went unreported because of order size exclusions. The SEC now requires those orders to be captured and evaluated for best execution. That is how we are here right now.
A notable challenge was regulatory adaptation to technology changes and how market participants respond to existing rules. One key change since the original rule has been the proliferation of different types of trading venues and the move to off exchange trading. It is difficult to come up with rules that ensure investor protection in what seems like an ever-evolving trading landscape.
How will the rule change impact/encourage retail investor inclusion?
One way Rule 605 will positively impact retail investors is through the measurement of odd lot trades. Both trading volume and rate have almost doubled in the last 5 years, fuelled by more individual investors trading fractional shares.
Since these orders were not previously captured in Rule 605 they went unreported. It is unable to tell how firms were performing on these orders. With the new amendments they will be, and individual investors will be able to measure execution quality on such transactions.
Retail investors do not typically have the time to go through these reports, but the SEC’s intention is to make it easier for them to evaluate and choose the brokers that provide them the best balance of execution quality and fill rates.
How is 605 going to interact with the other market structure proposal pillars?
At this time, it is unclear how Rule 605 will interact with the other market structure proposals from December 2022. We have heard both sides from industry members, but most believe Rule 605 should go into effect before decisions are made on the other proposals to better assess the impact of the other changes are on execution quality and to assess whether any other amendments are needed to those rules.
Is a gap between the finalisation of different rules necessary for them to be effective?
Yes, a gap will be necessary. General feedback from the industry would be to implement 605 now, along with other rules with little regulatory overlap. For rules that have a greater overlap, wait for 605 so market participants can measure execution quality as it exists today, especially for order types and sizes that are currently uncovered and then evaluate if the new rules are still needed or require amending. Some of these rules will take time to implement. So, do we want firms to implement them without proper understanding of their effectiveness? That is the big question.
How will the rule change improve best execution?
The amendment in 2023 to extend Rule 606 from NMS Stocks and Options to OTC (Over-the-Counter) Equities will greatly improve transparency to the routing practices in OTC Markets.
With Rule 605 SEC is:
- Expanding the scope of institutions to large broker dealers that introduce or carry at least 100,000 customer accounts need to report on execution quality.
- Significantly expanding the scope of orders covered by the rule to include odd lots, fractional shares, non-marketable orders submitted outside regular trading hours that become executable during trading hours, and stop orders.
How will the rule change impact the visibility of order execution and routing practices?
Rule 606 amendments introduced reporting venues to which orders are “routed for execution”. It meant that all venues in the final 606 report were venues where an execution could take place. Rule 605 reports execution quality for such execution venues. This, along with the fact that the SEC has expanded the scope of 605 to large broker-dealers ensures that an investor can:
Analyse execution quality from the perspective of when a broker-dealer received their orders through the broker-dealer’s 605 reports.
Take 606 reports from a broker-dealer and 605 reports from venues to assess if the broker-dealer they are using is routing to venues with the best execution quality. With the 606 reports now disclosing payment for order flow information, the 606 and 605 reports are expected to shed light on whether firms are trading execution quality in exchange for payment for order flow.
What should firms be doing to prepare and meet the new compliance requirements?
To effectively prepare for the new requirements, it is crucial to evaluate whether your firm trades OTC Equities instruments for 606 or is impacted by the large broker-dealer threshold outlined in Rule 605. Firms should begin working with their vendors to fully understand the regulatory impacts and identify actions to be taken to ensure compliance.
In many cases, this will involve providing and sourcing additional data points to provide to your vendors. At S&P Global Market Intelligence, we offer a comprehensive suite of products that includes 606, 605, and Transaction Cost Analytics to support firms navigate these regulatory changes effectively.
*Market Viewpoints comprise sponsored content and do not necessarily reflect the views of the editor.
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