[Federal Register Volume 88, Number 13 (Friday, January 20, 2023)]
[Proposed Rules]
[Pages 3786-3905]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2022-27614]
[[Page 3785]]
Vol. 88
Friday,
No. 13
January 20, 2023
Part II
Securities and Exchange Commission
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17 CFR Part 242
Disclosure of Order Execution Information; Proposed Rule
Federal Register / Vol. 88, No. 13 / Friday, January 20, 2023 /
Proposed Rules
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 242
[Release No. 34-96493; File No. S7-29-22]
RIN 3235-AN22
Disclosure of Order Execution Information
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule.
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SUMMARY: The Securities and Exchange Commission (``Commission'' or
``SEC'') is proposing to amend existing requirements under the
Securities Exchange Act of 1934 (``Exchange Act'') to update the
disclosure required for order executions in national market system
(``NMS'') stocks. First, the Commission is proposing to expand the
scope of reporting entities subject to the rule that requires market
centers to make available to the public monthly execution quality
reports to encompass broker-dealers with a larger number of customers.
Next, the Commission is proposing to modify the definition of ``covered
order'' to include certain orders submitted outside of regular trading
hours and certain orders submitted with stop prices. In addition, the
Commission is proposing modifications to the information required to be
reported under the rule, including changing how orders are categorized
by order size as well as how they are categorized by order type. As
part of the changes to these categories, the Commission is proposing to
capture execution quality information for fractional share orders, odd-
lot orders, and larger-sized orders. Additionally, the Commission is
proposing to modify reporting requirements for non-marketable limit
orders (``NMLOs'') in order to capture more relevant execution quality
information for these orders by requiring statistics to be reported
from the time such orders become executable. The Commission is also
proposing to eliminate time-to-execution categories in favor of average
time to execution, median time to execution, and 99th percentile time
to execution, each as measured in increments of a millisecond or finer
and calculated on a share-weighted basis. In order to better reflect
the speed of the marketplace, the Commission is proposing that the time
of order receipt and time of order execution be measured in increments
of a millisecond or finer, and that realized spread be calculated at
both 15 seconds and one minute. Finally, the Commission is proposing to
enhance the accessibility of the required reports by requiring all
reporting entities to make a summary report available.
DATES: Comments should be received on or before March 31, 2023.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's internet comment form (http://www.sec.gov/rules/submitcomments.htm); or
Send an email to [email protected]. Please include
File Number S7-29-22 on the subject line.
Paper Comments
Send paper comments to Secretary, Securities and Exchange
Commission, 100 F Street NE, Washington, DC 20549-1090.
All submissions should refer to File Number S7-29-22. This file number
should be included on the subject line if email is used. To help the
Commission process and review your comments more efficiently, please
use only one method of submission. The Commission will post all
comments on the Commission's website (http://www.sec.gov/rules/proposed.shtml). Comments are also available for website viewing and
printing in the Commission's Public Reference Room, 100 F Street NE,
Washington, DC 20549, on official business days between the hours of 10
a.m. and 3 p.m. Operating conditions may limit access to the
Commission's Public Reference Room. All comments received will be
posted without change. Persons submitting comments are cautioned that
we do not redact or edit personal identifying information from comment
submissions. You should submit only information that you wish to make
available publicly.
Studies, memoranda, or other substantive items may be added by the
Commission or staff to the comment file during this rulemaking. A
notification of the inclusion in the comment file of any materials will
be made available on the Commission's website. To ensure direct
electronic receipt of such notifications, sign up through the ``Stay
Connected'' option at www.sec.gov to receive notifications by email.
FOR FURTHER INFORMATION CONTACT: Kathleen Gross, Senior Special
Counsel, Lauren Yates, Senior Special Counsel, Christopher Chow,
Special Counsel, or David Michehl, Special Counsel, at (202) 551-5500,
Division of Trading and Markets, Commission, 100 F Street NE,
Washington, DC 20549.
SUPPLEMENTARY INFORMATION: The Commission is proposing amendments to 17
CFR 242.600 of Regulation National Market System (``Regulation NMS'')
under the Exchange Act (``Rule 600'') to add new defined terms to and
modify certain existing defined terms in Rule 600 that are used in 17
CFR 242.605 of Regulation NMS under the Exchange Act (``Rule 605'' or
``Rule'') as proposed to be amended; as well as amendments to Rule 605.
Table of Contents
I. Introduction
II. Current Reporting of Execution Quality Statistics
A. Adoption of Rule 11Ac1-5
B. Scope and Content of Rule 605
1. Scope
2. Required Information
3. Procedures for Making Reports Available to the Public
C. Other Relevant Rules
D. Overview of Need for Modernization
E. EMSAC Recommendations, Petition for Rulemaking, and Other
Comments
III. Proposed Modifications to Reporting Entities
A. Larger Broker-Dealers
B. Qualified Auction Mechanisms
C. ATSs and Single-Dealer Platforms
IV. Proposed Modifications to Scope of Orders Covered and Required
Information
A. Covered Order
1. Orders Submitted Pre-Opening/Post-Closing
2. Stop Orders
3. Non-Exempt Short Sale Orders
B. Required Information
1. Categorization by Order Size
2. Categorization by Order Type
3. Timestamp Conventions
4. Changes to Information Required for All Types of Orders
5. Additional Required Information for Market, Marketable Limit,
Marketable IOC, and Beyond-the-Midpoint Limit Orders
6. Additional Required Information for Executable NMLOs,
Executable Stop Orders, and Beyond-the-Midpoint Limit Orders
V. Proposed Summary Execution Quality Reports
VI. Paperwork Reduction Act
A. Summary of Collection of Information
B. Proposed Use of Information
C. Respondents
D. Total PRA Burdens
E. Request for Comment
VII. Economic Analysis
A. Introduction
B. Market Failure
C. Baseline
1. Regulatory Baseline
2. Current Rule 605 Disclosure Requirements
3. Markets for Brokerage and Trading Services for NMS Stocks
Under Current Rule 605 Disclosure Requirements
D. Economic Effects
1. Benefits
2. Costs
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3. Economic Effects on Efficiency, Competition, and Capital
Formation
E. Reasonable Alternatives
1. Reasonable Alternative Modifications to Reporting Entities
2. Reasonable Alternative Modifications to Scope of Covered
Orders
3. Reasonable Alternative Modifications to Required Information
4. Reasonable Alternative Modifications to Accessibility
5. Other Reasonable Alternatives
F. Request for Comment
VIII. Consideration of Impact on the Economy
IX. Initial Regulatory Flexibility Analysis
Statutory Authority and Text of Proposed Rule
I. Introduction
The Commission is proposing to update the requirements to disclose
order execution information under Rule 605. Currently, market centers
that execute investor orders are required to make monthly disclosures
of basic information concerning their quality of executions. The
required disclosures have provided significant insight into execution
quality at different market centers; however, both the scope and the
content of Rule 605 reports have not kept pace with technological and
market developments. The proposal would require broker-dealers with a
larger number of customers (``larger broker-dealers'') \1\ to prepare
execution quality reports, would capture execution quality information
for more order types and sizes, and would require time-based metrics to
be recorded at a more granular level that reflects current market
speed. By providing more relevant and accessible metrics, the proposal
would better promote competition among market centers and broker-
dealers on the basis of execution quality and ultimately improve the
efficiency of securities transactions, consistent with the national
market system objectives.\2\
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\1\ Throughout the release, the term ``larger broker-dealer''
refers to a broker-dealer that meets or exceeds the ``customer
account threshold,'' as defined in proposed Rule 605(a)(7). See also
infra section III.A (discussing proposed Rule 605(a)(7)).
\2\ 15 U.S.C. 78k-1.
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The national market system objectives of section 11A of the
Exchange Act include the economically efficient executions of
securities transactions; fair competition among brokers and dealers,
among exchange markets, and between exchange markets and markets other
than exchange markets; the availability of information on securities
quotations and transactions; and the practicability of brokers
executing investor orders in the best market.\3\ These objectives guide
the Commission as it seeks to ensure market structure rules keep pace
with continually changing economic conditions and technological
advancements. However, these objectives, in particular the goal of
promoting opportunities for the most willing seller to meet the most
willing buyer (i.e., order interaction) and the goal of promoting
competition among markets, can be difficult to reconcile.\4\ The Rule,
along with 17 CFR 242.606 (``Rule 606'') of Regulation NMS, was adopted
in 2000 and together these rules required the public disclosure of
execution quality and order routing practices.\5\ In adopting these
rules, the Commission recognized the importance of vigorous competition
among buyers and sellers in an individual security.\6\ However, the
Commission also recognized the importance of competition among market
centers, which entails some fragmentation of order flow.\7\ Such
competition has benefits to investors including the development of
innovative trading services, lower fees, and faster executions.\8\ The
Commission characterized the rules as a ``minimum step necessary to
address fragmentation'' \9\ and stated that by making visible the
execution quality of the securities markets, the rules are intended to
spur more vigorous competition among market participants to provide the
best possible prices for investor orders.\10\
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\3\ See 15 U.S.C. 78k-1(a)(1)(C).
\4\ See Securities Exchange Act Release No. 61358 (Jan. 14,
2010), 75 FR 3594, 3597 (Jan. 21, 2010) (``Concept Release on Equity
Market Structure'').
\5\ See Securities Exchange Act Release No. 43590 (Nov. 17,
2000), 65 FR 75414, 75416 (Dec. 1, 2000) (Disclosure of Order
Execution and Routing Practices) (``Adopting Release'').
\6\ See id. at 75415.
\7\ See id. at 75416.
\8\ See id.
\9\ Id.
\10\ See id. at 75414.
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Although the Rule has provided visibility into execution quality at
different market centers, the content of the disclosures required by
the Rule has not been substantively updated since the Rule was adopted
in 2000.\11\ Changed equity market conditions and technological
advancements have eroded the utility of the Rule. The speed and nature
of trading have changed dramatically as a result of technological
improvements and the markets' response to the changing regulatory
landscape.\12\ Trading has moved from being concentrated on a given
security's listing exchange \13\ to being spread across a highly
fragmented market where national securities exchanges, alternative
trading systems (``ATSs''), single-dealer platforms (``SDPs''), off-
exchange market makers, and others compete for order flow. Orders may
be matched, routed, or cancelled in microseconds and market information
is transmitted nearly instantaneously. At the same time, individual
investor \14\ participation in the equity markets has increased.\15\
Further, the average share prices of certain stocks have continued to
increase over time.\16\
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\11\ In 2018, the Commission amended Rule 600, 605, and 606 of
Regulation NMS (``the 2018 Rule 606 Amendments''). The 2018 Rule 606
Amendments modified Rule 605 to require that the public order
execution quality reports be kept publicly available for a period of
three years. See Securities Exchange Act Release No. 84528 (Nov. 2,
2018), 83 FR 58338 (Nov. 19, 2018) (``2018 Rule 606 Amendments
Release'').
\12\ For example, since the adoption of the Rule in 2000, the
Commission has periodically revised certain of its NMS rules,
including the adoption of Regulation NMS in 2005. See, e.g.,
Securities Exchange Act Release Nos. 51808 (June 9, 2005), 70 FR
37496 (June 29, 2005) (``Regulation NMS Adopting Release''); and
90610 (Dec. 9, 2020), 86 FR 18596 (Apr. 9, 2021) (``MDI Adopting
Release'').
\13\ For example, in January 2005, the New York Stock Exchange
Inc. (``NYSE'') executed approximately 79.1% of the consolidated
share volume in its listed stocks, compared to 25.1% in October
2009. See Concept Release on Equity Market Structure, 75 FR 3594
(Jan. 21, 2010) at 3595.
\14\ As used in this release, the term ``individual investor''
will refer to natural persons that trade relatively infrequently for
their own or closely related accounts.
\15\ See, e.g., Caitlin McCabe, ``New Army of Individual
Investors Flexes Its Muscle,'' The Wall Street Journal (Dec. 30,
2020), available at https://www.wsj.com/articles/new-army-of-individual-investors-flexes-its-muscle-11609329600.
\16\ See MDI Adopting Release, 86 FR at 18606-07 (citing
Securities Exchange Act Release No. 88216 (Feb. 14, 2020), 85 FR
16726, 16739 (Mar. 24, 2020) (``MDI Proposing Release'') (stating
that ``between 2004 and 2019, the average price of a stock in the
Dow Jones Industrial Average nearly quadrupled'')).
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The Commission continues to believe that facilitating the ability
of the public to compare and evaluate execution quality among different
market centers is an effective means of reconciling the need to promote
both vigorous price competition and fair competition among market
centers. Providing increased visibility into the execution quality of
larger broker-dealers would similarly encourage competition among
market participants. It is the Commission's task continually to monitor
market conditions and competitive forces and to evaluate whether the
structure of the national market system as it evolves is achieving its
Exchange Act objectives.\17\ Section 11A of the Exchange Act \18\
grants the Commission authority to promulgate rules necessary or
appropriate to assure the fairness and usefulness of information on
securities
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transactions \19\ and to assure that broker-dealers transmit and direct
orders for the purchase or sale of qualified securities in a manner
consistent with the establishment and operation of a national market
system.\20\ Through the proposed updates to Rule 605, the Commission
seeks to promote increased transparency of order execution quality,
increase the information available to investors, and help to promote
competition among market centers and broker-dealers, while ameliorating
the potentially adverse effects of fragmentation on efficiency, price
transparency, best execution of investor orders, and order
interaction.\21\
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\17\ See Securities Exchange Act Release No. 42450 (Feb. 23,
2000), 65 FR 10577, 10585 (Feb. 28, 2000) (``Fragmentation
Release'').
\18\ 15 U.S.C. 78k-1.
\19\ 15 U.S.C. 78k-1(c)(1)(B).
\20\ 15 U.S.C. 78k-1(c)(1)(E).
\21\ See Concept Release on Equity Market Structure, 75 FR 3594
(Jan. 20, 2010) at 3597.
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II. Current Reporting of Execution Quality Statistics
A. Adoption of Rule 11Ac1-5
When the Commission adopted Rule 11Ac1-5, which was later re-
designated as Rule 605, in 2000, there was little publicly available
information to enable investors to compare and evaluate execution
quality among different market centers.\22\ The Commission proposed and
adopted Rule 11Ac1-5 together with Rule 11Ac1-6, which was later re-
designated as Rule 606, requiring broker-dealers to disclose the
identity of market centers to which they route orders on behalf of
customers. When adopting these rules, the Commission stated that, taken
together, they should significantly improve the opportunity for
investors to evaluate what happens to their orders after they submit
them to a broker-dealer for execution.\23\ The Commission reasoned that
competitive forces could then be brought to bear on broker-dealers both
with respect to the explicit trading costs associated with brokerage
commissions and the implicit trading costs associated with execution
quality.\24\ Rule 11Ac1-5 was intended to remedy an absence of public
information about how broker-dealers responded to trade-offs between
price and other factors, such as speed or reliability, and establish a
baseline level of disclosure in order to facilitate cross-market
comparisons of execution quality.\25\
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\22\ See Adopting Release, 65 FR 75414 (Dec. 1, 2000) at 75416.
For clarity, when this release discusses the adoption of Rule 605,
it is referring to the Adopting Release, supra note 5.
\23\ See id. at 75414.
\24\ See id. at 75419. Although it is difficult to isolate the
effects of the Rule given the evolution of the equity markets over
time, one academic study examining the introduction of Rule 605
found that the routing of marketable order flow by broker-dealers
became more sensitive to changes in execution quality across market
centers after Rule 605 reports became available. See Ekkehart
Boehmer, Robert Jennings & Li Wei, Public Disclosure and Private
Decisions: Equity Market Execution Quality and Order Routing, 20
Rev. Fin. Stud. 315 (2007) (``Boehmer et al.''). Another study
attributed a significant decline in effective and quoted spreads
following the implementation of Rule 605 to an increase in
competition between market centers, who improved the execution
quality that they offered in order to attract more order flow. See
Xin Zhao & Kee H. Chung, Information Disclosure and Market Quality:
The Effect of SEC Rule 605 on Trading Costs, 42 J. Fin. Quantitative
Analysis, 657 (Sept. 2007) (``Zhao & Chung'').
\25\ See Adopting Release, 65 FR 75414 (Dec. 1, 2000) at 75418,
75419. Data obtained from Rule 605 reports are used by the third
parties including academics and the financial press to study a
variety of topics related to execution quality, including liquidity
measurement, exchange competition, zero commission trading, and
broker-dealer execution quality. See infra notes 545-547 and
accompanying text.
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B. Scope and Content of Rule 605
1. Scope
Currently, Rule 605 requires market centers to make available, on a
monthly basis, standardized information concerning execution quality
for covered orders in NMS stocks that they received for execution.
Market centers must provide specified measures of execution quality,
including effective spread, average amount of price improvement, number
of shares executed, and speed of execution.\26\
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\26\ See 17 CFR 242.605.
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(a) Market Centers
Regulation NMS defines the term ``market center'' to mean any
exchange market maker,\27\ OTC market maker,\28\ ATS,\29\ national
securities exchange,\30\ or national securities association.\31\ This
definition was intended to cover entities that hold themselves out as
willing to accept and execute orders in NMS securities.\32\ Further, a
market center must report on orders that it ``received for execution
from any person,'' which was intended to assign the disclosure
obligation to an entity that controls whether and when an order will be
executed.\33\
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\27\ ``Exchange market maker'' means any member of a national
securities exchange that is registered as a specialist or market
maker pursuant to the rules of such exchange. See 17 CFR
242.600(b)(32).
\28\ ``OTC market maker'' means any dealer that holds itself out
as being willing to buy from and sell to its customers, or others,
in the United States, an NMS stock for its own account on a regular
or continuous basis otherwise than on a national securities exchange
in amounts of less than a block size. See 17 CFR 242.600(b)(64).
\29\ ``Alternative trading system'' or ``ATS'' means any
organization, association, person, group of persons, or system: (1)
That constitutes, maintains, or provides a market place or
facilities for bringing together purchasers and sellers of
securities or for otherwise performing with respect to securities
the functions commonly performed by a stock exchange within the
meaning of 17 CFR 240.3b-16; and (2) That does not: (i) Set rules
governing the conduct of subscribers other than the conduct of such
subscribers' trading on such organization, association, person,
group of persons, or system; or (ii) Discipline subscribers other
than by exclusion from trading. See 17 CFR 242.300(a). See also 17
CFR 242.600(b)(4) (stating that ``alternative trading system'' has
the meaning provided in 17 CFR 242.300(a)).
\30\ ``National securities exchange'' means any exchange
registered pursuant to section 6 of the Exchange Act. See 17 CFR
242.600(b)(53).
\31\ See 17 CFR 242.600(b)(46). ``National securities
association'' means any association of brokers and dealers
registered pursuant to section 15A of the Exchange Act. See 17 CFR
242.600(b)(52).
\32\ See Adopting Release, 65 FR 75414 (Dec. 1, 2000) at 75421.
\33\ See id.
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In many instances, broker-dealers accept orders from customers for
execution and then route these customer orders to various execution
venues, but do not execute customer orders directly. These broker-
dealers generally do not fall within the definition of ``market
center'' and therefore fall outside of the scope of Rule 605's
reporting requirements.\34\
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\34\ See, e.g., 17 CFR 242.605(a) (monthly electronic reports by
market centers). In some instances, broker-dealers accept orders
from customers for execution and execute a small portion of their
order flow internally (e.g., fractional share orders), and therefore
would fall within the definition of ``market center'' in Rule
600(b)(46) with respect to the portion of their order flow for which
they hold themselves out as being willing to buy or sell for their
own account on a regular or continuous basis. However, if, for
example, they only act as a market center for orders smaller than
100 shares, then these market centers would not be required to
prepare Rule 605 reports currently because the portion of their
order flow for which they act as a market center would include only
orders that fall below the smallest order size category (i.e., 100
to 499 shares). See 17 CFR 242.600(b)(defining ``categorized by
order size''); 17 CFR 242.605)(a)(1) (stating that a market center's
monthly report ``shall be categorized by security, order type, and
order size'').
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(b) Covered Orders
The covered order definition is limited by several conditions and
exclusions in order to include those orders that provide a basis for
meaningful and comparable statistical measures of execution quality. A
``covered order'' is defined to include any market order or any limit
order (including immediate-or-cancel orders) received by a market
center during regular trading hours at a time when the national best
bid and national best offer is being disseminated, and, if executed, is
executed during regular trading hours.\35\ This definition serves two
purposes: (1) because the nature and execution quality for regular and
after-hours trading differs, it avoids blending statistics for orders
executed after-hours with those executed during the regular
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trading day; and (2) because many of the statistical measures included
in the rule rely on the availability of the national best bid and offer
(``NBBO'') at the time of order receipt, it excludes orders for which
execution quality metrics could not be calculated.
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\35\ See 17 CFR 242.600(b)(22).
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Covered orders do not include any orders for which the customer
requests special handling, which include, but are not limited to,
market on open and market on close orders, stop orders, all or none
orders, and ``not held'' orders.\36\ The Commission reasoned that
special handling instructions could skew general execution quality
measures.\37\
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\36\ See id. Generally, a ``not held'' order provides the
broker-dealer with price and time discretion in handling the order,
whereas a broker-dealer must attempt to execute a ``held'' order
immediately. See 2018 Rule 606 Amendments Release, 83 FR 58338 (Nov.
19, 2018) at 58340. As a general matter, if a customer submits an
order for an NMS stock to its broker-dealer, whether it be for a
fractional share, whole shares, or whole shares with a fractional
share component, and the customer reasonably expects its broker-
dealer to attempt to execute such order immediately, then the
broker-dealer generally should categorize the order as a held order.
\37\ See Adopting Release, 65 FR 75414 (Dec. 1, 2000) at 75421.
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2. Required Information
Rule 605 reports contain a number of execution quality metrics for
covered orders, including statistics for all NMLOs with limit prices
within ten cents of the NBBO at the time of order receipt as well as
separate statistics for market orders and marketable limit orders.
Under the Rule, the information is categorized by (1) individual
security,\38\ (2) one of five order types,\39\ and (3) one of four
order sizes.\40\ These categories provide users flexibility in
determining how to summarize and analyze the information.\41\
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\38\ See 17 CFR 242.605(a)(1).
\39\ See id. ``Categorized by order type'' refers to
categorization by whether an order is a market order, a marketable
limit order, an inside-the-quote limit order, an at-the-quote limit
order, or a near-the-quote limit order. See 17 CFR 242.600(b)(14).
\40\ See 17 CFR 242.605(a)(1). The current size categories are:
100 to 499 shares; 500 to 1999 shares; 2000 to 4999 shares, and 5000
or greater shares. See 17 CFR 242.600(b)(11). On June 22, 2001, the
Commission granted exemptive relief to any order with a size of
10,000 shares or greater, reasoning that the exclusion of very large
orders would help assure greater comparability of statistics in the
largest size category of 5,000 or greater shares. See Letter from
Annette L. Nazareth, Director, Division of Market Regulation to
Darla C. Stuckey, Assistant Secretary, NYSE, dated June 22, 2001
(``Large Order Exemptive Letter'').
\41\ See Adopting Release, 65 FR 75414 (Dec. 1, 2000) at 75417.
For instance, a user could analyze execution quality for a group of
securities and by size and order type.
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Within each of the three categories, the reports are required to
include statistics about the total number of orders submitted as well
as the total number of shares submitted, shares cancelled prior to
execution, shares executed at the receiving market center, shares
executed at another venue, shares executed within different time-to-
execution buckets, and average realized spread.\42\ For market and
marketable limit orders, the reports also must include average
effective spread; number of shares executed better than the quote, at
the quote, or outside the quote; average time to execution when
executed better than the quote, at the quote, or outside the quote; as
well as average dollar amount per share that orders were executed
better than the quote or outside the quote.\43\ In addition, time of
order execution and time of order receipt are required to be measured
to the nearest second.\44\
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\42\ See 17 CFR 242.605(a)(1)(i).
\43\ See 17 CFR 242.605(a)(1)(ii).
\44\ See 17 CFR 242.600(b)(91), (92).
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The categorization by order type does not currently include away-
from-the-quote NMLOs, i.e., those orders with a limit price more than
ten cents away from the NBBO. In proposing to exclude these orders in
2000, the Commission indicated that the execution quality statistics
for these types of orders may be less meaningful because execution of
these types of orders may be more dependent on the extent to which the
orders' limit prices were outside the consolidated best bid and offer
(``BBO'') and price movement in the market than on their handling by
the market center.\45\
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\45\ See Securities Exchange Act Release No. 43084 (July 28,
2000), 65 FR 48406, 48414 (Aug. 8, 2000) (File No. S7-16-00)
(Disclosure of Order Execution and Routing Practices) (``Proposing
Release'') (stating that the Commission preliminarily believed that
the rule's statistical measures (e.g., fill rates and speed of
execution) for this type of order may be less meaningful because
they would be more dependent on the extent to which the orders'
limit prices were outside the consolidated BBO (and movements in
market prices) than on their handling by a market center).
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3. Procedures for Making Reports Available to the Public
The Rule 605 NMS Plan establishes procedures for market centers to
make data available to the public in a uniform, readily accessible, and
usable electronic form.\46\ The Plan also requires market centers to
post their monthly reports on an internet website that is free of
charge and readily accessible to the public.\47\ Generally, reports are
posted on market centers' own websites; however, they may be posted on
a third-party vendor site if a market center uses a vendor to prepare
its reports.\48\ In addition, formatting for Rule 605 data is governed
by the Plan. Among other things, the Plan sets forth the file type and
structure of the reports and the order and format of fields, yielding
reports that are structured and machine-readable.\49\
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\46\ See 17 CFR 242.605(a)(2) and Securities and Exchange
Commission File No. 4-518 (National Market System Plan Establishing
Procedures Under Rule 605 of Regulation NMS) (``Rule 605 NMS Plan''
or ``Plan''). See also Securities Exchange Act Release No. 44177
(Apr. 12, 2001), 66 FR 19814 (Apr. 17, 2001) (order approving the
Plan).
\47\ Currently, the parties to the Plan are the 16 registered
national securities exchanges trading NMS stocks and 1 national
securities association (the ``Participants''). Although not all
market centers are Participants, the Participants are required to
enforce compliance with the terms of the Plan by their members and
person associated with their members. See 17 CFR 242.608(c). Market
centers that are not Participants must make arrangements with a
Participant to act as their ``Designated Participant.'' See Plan at
IV. Each market center must notify its Designated Participant of the
website where its reports may be downloaded, and each Designated
Participant must maintain a comprehensive list of links for all
market centers for which it functions as a Designated Participant.
See Plan at IV, VIII(c).
\48\ See Plan at n.3.
\49\ See id. at 2 (``Section V . . . provides that market center
files must be in standard, pipe-delimited ASCII format'').
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C. Other Relevant Rules
Rule 606 reports address order handling information and Rule 606's
reporting requirements differ for held orders versus not held orders.
With respect to held orders, Rule 606(a)(1) requires broker-dealers to
produce quarterly public reports regarding their routing of non-
directed orders \50\ in NMS stocks that are submitted on a held basis.
These reports must identify certain regularly-used venues to which the
broker-dealer routed non-directed orders for execution and provide data
on the percentage of orders routed to each venue.\51\ These reports
also must provide information, for each venue identified, about the
payment relationship between the broker-dealer and the venue, including
any payments made by a venue to a broker-dealer for the right to trade
with its customer order flow (i.e., payment for order flow or ``PFOF'')
or rebates,\52\ and a description of the material aspects of the
broker-dealer's relationship with the venue and the terms of
arrangements that may influence a broker-dealer's order routing
[[Page 3790]]
decision.\53\ In addition, Rule 606(b)(1) requires broker-dealers to
provide to their customers, upon request, reports that include high-
level customer-specific order routing information, such as the identity
of the venues to which the customer orders were routed for execution in
the prior six months and the time of the transactions, if any, that
resulted from such orders.\54\ For orders submitted on a held basis,
the reports required by Rule 606 do not contain any execution quality
information. However, a customer of a reporting broker-dealer may
access the execution quality reports produced pursuant to Rule 605 by
each venue identified as a routing destination in the broker-dealer's
Rule 606 reports, to the extent that venue is a market center.\55\
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\50\ A ``non-directed order'' means any order from a customer
other than a directed order. See 17 CFR 242.600(b)(56). A ``directed
order'' means an order from a customer that the customer
specifically instructed the broker or dealer to route to a
particular venue for execution. See 17 CFR 242.600(b)(27).
\51\ See 17 CFR 242.606(a)(1)(ii) (stating that each section in
the required report shall include the identity of the ten venues to
which the largest number of total non-directed orders for the
section were routed for execution and of any venue to which five
percent or more of non-directed orders were routed).
\52\ See 17 CFR 242.606(a)(1)(iii).
\53\ See 17 CFR 242.606(a)(1)(iv).
\54\ See 17 CFR 242.606(b)(1).
\55\ See supra note 23 and accompanying text.
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In contrast, Rule 606 requires broker-dealers to produce reports
that provide detail regarding execution quality in connection with not
held orders, which are typically used by institutional investors.\56\
Specifically, Rule 606(b)(3) requires broker-dealers to produce reports
pertaining to order routing upon the request of a customer that places,
directly or indirectly, one or more orders in NMS stocks that are
submitted on a not held basis.\57\ These customer-specific reports
generally must include detailed information, by venue, including
metrics pertaining to the broker-dealer's routing of the customer's
orders and the execution of such orders.\58\ In particular, the venue-
by-venue order execution information must include aggregated metrics
such as fill rate, percentage of shares executed at the midpoint, and
percentages of total shares executed that were priced on the side of
the spread more favorable to the order and on the side of the spread
less favorable to the order.\59\
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\56\ See 2018 Rule 606 Amendments Release, 83 FR 58338 (Nov. 19,
2018) at 58345 (stating that by using the not held order
distinction, Rule 606(b)(3) as adopted will likely result in more
Rule 606(b)(3) disclosures for order flow that is typically
characteristic of institutional customers--not retail customers--and
will likely cover all or nearly all of the institutional order
flow). In contrast, held orders are typically used by individual
investors. See, e.g., id. at 58372 (stating that retail investors'
orders are typically submitted on a held basis and are typically
smaller in size).
\57\ See 17 CFR 240.606(b)(3).
\58\ See 17 CFR 240.606(b)(3).
\59\ See 17 CFR 240.606(b)(3)(ii).
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Current Rule 606 reflects significant changes that were made in the
2018 Rule 606 Amendments.\60\ When adopting the 2018 Rule 606
Amendments, the Commission identified intensified competition for
customer orders, the rise in the number of trading centers, and the
introduction of new fee models for execution services as the main
concerns with held orders for NMS stocks that it sought to address with
the proposal.\61\ The Commission stated that the more prevalent use of
financial inducements to attract order flow from broker-dealers that
handle retail investor orders created new, and in many cases
significant, potential conflicts of interests for these broker-
dealers.\62\ Further, the Commission stated that enhanced public
disclosures for held orders should focus on providing more detailed
information regarding these financial inducements, as opposed to the
different information geared towards not held orders from customers
that is set forth in Rule 606(b)(3).\63\ Therefore, the Commission
adopted enhanced public disclosures pursuant to Rule 606(a)(1) that
focused on increased transparency for the financial inducements that
broker-dealers face when determining where to route held order
flow.\64\ The Commission stated that this enhancement would allow
customers to better assess the nature and quality of broker-dealers'
order handling services, including the potential for broker-dealer
conflicts of interest, and would also benefit customers to the extent
that broker-dealers were spurred to compete further by providing
enhanced order routing services and better execution quality.\65\
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\60\ See generally 2018 Rule 606 Amendments Release.
\61\ See 2018 Rule 606 Amendments Release, 83 FR 58338 (Nov. 19,
2018) at 58372.
\62\ See id.
\63\ See id. The Commission also considered but did not adopt an
aspect of the proposal that would have required broker-dealers to
make publicly available a report that would have aggregated Rule
606(b)(3) order handling information pertaining to not held orders.
See id. at 58369-70. The Commission stated that its decision stemmed
from fundamental differences between held order flow and not held
order flow, because held orders are typically non-directed orders
with no specific order-handling instructions for the broker-dealer.
See id. at 58371 (stating that held order flow is handled similarly
by broker-dealers--held orders are generally small orders that are
internalized or sent to OTC market makers if marketable or fully
executed on a single trading center if not marketable). The
Commission further stated that, by contrast, not held order flow is
diverse and customers may provide specific order handling
instructions to their broker-dealers, limit the order handling
discretion of their broker-dealers, or have specific needs that
impact the broker-dealers' handling of these orders. See id.
Therefore, the Commission concluded that the disparate behavior of
customers when using not held orders limited the potential ability
for customers and broker-dealers to use aggregated Rule 606(b)(3)
order handling information to better understand broker-dealers'
routing behavior or compare broker-dealers' order routing
performance. See id.
\64\ See 2018 Rule 606 Amendments Release, 83 FR 58338 (Nov. 19,
2018) at 58373.
\65\ See id. In comparison, with respect to the addition of
customer-specific order-handling disclosures in Rule 606(b)(3), the
Commission stated that these disclosures are particularly suited to
customers that submit not held NMS stock orders because the
disclosures set forth detailed order handling information that is
useful in evaluating how broker-dealers exercise the discretion
attendant to not held orders and, in the process, carry out their
best execution obligations and manage the potential for information
leakage and conflicts of interest. See id. at 58344. As part of the
2018 Rule 606 Amendments, the Commission added Rule 606(b)(3) to
require broker-dealers to make detailed, customer-specific order
handling disclosures available to institutional customers, in
particular, who previously were not entitled to disclosures under
the rule for their order flow, or were entitled to disclosures that
had become inadequate in a highly automated and more complex market.
See id.
---------------------------------------------------------------------------
At the time of the 2018 Rule 606 Amendments, the Commission
considered suggestions from the Equity Market Structure Advisory
Committee (``EMSAC'') and other commenters that the Commission include
more or different execution quality statistics in the required
disclosures.\66\ But the Commission stated that the limited
modifications to Rule 606(a) that it was adopting were reasonably
designed to further the goal of enhancing transparency regarding
broker-dealers' order routing practices and customers' ability to
assess the quality of those practices, and that the suggested execution
quality statistics were not necessary to achieve that goal.\67\
However, the Commission noted that its determination not to adopt the
additional specific disclosures was not an indication that the
Commission had formed a decision on the validity or usefulness of the
suggested execution quality statistics.\68\
---------------------------------------------------------------------------
\66\ See id. at 58379. See also EMSAC III at 2-3 (suggesting
that the Commission modify the enhancements to Rule 606 to include,
among other things, execution quality statistics by routing
destination).
\67\ See 2018 Rule 606 Amendments Release, 83 FR 58338 (Nov. 19,
2018) at 58379.
\68\ See id.
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Separately, each broker-dealer has a legal duty to seek to obtain
best execution of customer orders.\69\ The
[[Page 3791]]
duty of best execution requires broker-dealers to execute customers'
trades at the most favorable terms reasonably available under the
circumstances.\70\ When adopting Rule 605 and Rule 606, the Commission
stated that these rules do not address and therefore do not change the
existing legal standards that govern a broker-dealer's duty of best
execution.\71\ The Commission recognized that the information contained
in the Rule 605 reports (and Rule 606 reports) will not, by itself, be
sufficient to support conclusions regarding a broker-dealer's
compliance with its legal responsibility to obtain the best execution
of customer orders.\72\ As the Commission stated, any such conclusions
would require a more in-depth analysis of the broker-dealer's order
routing practices than will be available from the disclosures required
by the rules.\73\
---------------------------------------------------------------------------
\69\ See, e.g., Regulation NMS Adopting Release, 70 FR at 37537;
Newton v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 135 F.3d
266, 269-70, 274 (3d Cir.), cert. denied, 525 U.S. 811 (1998);
Certain Market Making Activities on Nasdaq, Securities Exchange Act
Release No. 40900, 53 SEC 1150, 1162 (1999) (settled case) (citing
Sinclair v. SEC, 444 F.2d 399 (2d Cir. 1971); Arleen Hughes, 27 SEC
629, 636 (1948), aff'd sub nom. Hughes v. SEC, 174 F.2d 969 (D.C.
Cir. 1949)). In addition, the Commission is separately proposing a
rule concerning broker-dealers' duty of best execution. See
Securities Exchange Act Release No. 96496 (Dec. 14, 2022) (File No.
S7-32-22) (Regulation Best Execution). The Commission encourages
commenters to review that proposal to determine whether it might
affect their comments on this proposing release.
\70\ See Regulation NMS Adopting Release, 70 FR 37496 (Jun. 29,
2005) at 37538 (referring to the best reasonably available price and
citing Newton, 135 F.3d at 266, 269-70, 274). Newton also specified
certain other factors relevant to best execution--order size,
trading characteristics of the security, speed of execution,
clearing costs, and the cost and difficulty of executing an order in
a particular market. See Newton, 135 F.3d at 270 n.2.
\71\ See Adopting Release, 65 FR 75414 (Dec. 1, 2000) at 75420.
\72\ See id.
\73\ See id. For example, the execution quality statistics
included in Rule 605 do not encompass every factor that may be
relevant in determining whether a broker-dealer has obtained best
execution, and the statistics in a market center's reports typically
will reflect orders received from a number of different routing
broker-dealers. See id. See also infra notes 564-565 and
accompanying text for discussion of an investment adviser's
fiduciary duty, including the duty to seek best execution of a
client's transactions where the investment adviser has the
responsibility to select broker-dealers to execute client trades.
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D. Overview of Need for Modernization
The U.S. equity markets have evolved significantly since the
Commission adopted the Rule in 2000. For instance, the equities markets
have become increasingly fragmented, as both the market shares of
individual national securities exchanges became less concentrated and
an increased percentage of order flow moved off-exchange. In 2000,
there were 9 registered national securities exchanges and one
registered national securities association.\74\ A large proportion of
the order flow in listed equity securities was routed to a few, mostly
manual, trading centers,\75\ and the primary listing exchanges retained
a high percentage of the order flow for exchange-listed equities.\76\
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\74\ See Securities and Exchange Commission, Annual Report for
fiscal year 2000, at 38 available at https://www.sec.gov/pdf/annrep00/ar00full.pdf.
\75\ See Securities Exchange Act Release No. 78309 (July 13,
2016), 81 FR 49432, 49436 (July 27, 2016) (``Rule 606 Proposing
Release''); Fragmentation Release, 65 FR 10577 (Feb. 28, 2000) at
10579-80.
\76\ See Adopting Release, 65 FR 75414 (Dec. 1, 2000) at 75415
(stating that in September 2000, for example, NYSE accounted for
83.3% of the share volume in NYSE equities and that the American
Stock Exchange, LLC (``Amex'') accounted for 69.9% of share volume
in Amex equities). See also Concept Release on Equity Market
Structure, 75 FR 3594 (Jan. 21, 2010) at 3595 (stating that in
January 2005, NYSE executed approximately 79.1% of the consolidated
share volume in its listed stocks, as compared to 25.1% in October
2009). In addition, NYSE-listed stocks were traded primarily on the
floor of the NYSE in a manual fashion until October 2006, at which
time NYSE began to offer fully automated access to its displayed
quotations. See Concept Release on Equity Market Structure, 75 FR
3594 (Jan. 21, 2010) at 3594-95. However, stocks traded on the
NASDAQ Stock Market LLC (``NASDAQ''), which in 2000 was owned and
operated by a national securities association, were already trading
in a highly automated fashion at many different trading centers. See
id. at 3595; Fragmentation Release, 65 FR 10577 (Feb. 28, 2000) at
10580.
---------------------------------------------------------------------------
In contrast, trading in the U.S. equity markets today is highly
automated and spread among different types of trading centers, allowing
even more choices about where orders may be routed. The types of
trading centers that currently trade NMS stocks are: (1) national
securities exchanges operating SRO trading facilities; \77\ (2) ATSs
that trade NMS stocks (``NMS Stock ATSs''); \78\ (3) exchange market
makers; (4) wholesalers; \79\ and (5) any other broker-dealer that
executes orders internally by trading as principal or crossing orders
as agent.\80\ In the first quarter of 2022, NMS stocks were traded on
16 national securities exchanges, and off-exchange at 32 NMS Stock ATSs
and at over 230 other FINRA members.\81\ National securities exchanges
executed approximately 60% of NMS share volume.\82\ The majority of
off-exchange volume was executed by wholesalers, who executed almost
one quarter of total volume (23.9%) and about 60% of off-exchange
volume.\83\ Some OTC market makers, such as wholesalers, operate SDPs
through which they execute institutional orders in NMS stocks against
their own inventory.\84\
---------------------------------------------------------------------------
\77\ See 17 CFR 242.600(b)(89) (defining ``SRO trading
facility'' as, among other things, a facility operated by a national
securities exchange that executes orders in a security).
\78\ An ``NMS Stock ATS'' as used in this release is an ATS that
has filed an effective Form ATS-N with the Commission.
\79\ The term ``wholesaler'' is not defined in Regulation NMS,
but is commonly used to refer to an OTC market maker that seeks to
attract orders from broker-dealers that service the accounts of a
large number of individual investors.
\80\ See 15 U.S.C. 78c(a)(4)(A) (defining ``broker'' generally
as any person engaged in the business of effecting transactions in
securities for the account of others); 15 U.S.C. 78c(a)(5)(A)
(defining ``dealer'' generally as any person engaged in the business
of buying and selling securities for such person's own account
through a broker or otherwise). The term ``broker-dealer'' is used
in this release to encompass all brokers, all dealers, and firms
that are both brokers and dealers. See also 17 CFR 242.600(b)(95)
(defining ``trading center'').
\81\ See infra note 766 and accompanying text; Table 7.
\82\ See infra note 767 and accompanying text; Table 7.
\83\ See infra Table 7.
\84\ See infra note 768 and accompanying text.
---------------------------------------------------------------------------
Broker-dealers that primarily service the accounts of individual
investors (referred to in this release as ``retail brokers'') often
route the marketable orders of individual investors in NMS stocks to
wholesalers.\85\ The primary business model of wholesalers is to trade
internally as principal with individual investor orders. They do not
publicly display or otherwise reveal the prices at which they are
willing to trade internally as a means to attract individual investor
orders from broker-dealers. Moreover, it is generally more profitable
for liquidity providers such as wholesalers to execute against orders
with lower adverse selection risk because of the reduced risk that
prices will move against the liquidity provider.\86\ Wholesalers may
provide different execution quality to different broker-dealers,
depending on factors including the level of adverse selection risk of
their order flow.\87\
---------------------------------------------------------------------------
\85\ There are six wholesalers that internalize the majority of
individual investors' marketable orders. See infra note 766 and
accompanying text.
\86\ See infra note 608 and accompanying text.
\87\ Analysis of Consolidated Audit Trail (``CAT'') data from
the first five months of 2022 found that wholesalers provide
different execution quality to different retail brokers, and in
particular that broker-dealers with higher adverse selection risk
systematically receive higher effective spreads and lower price
improvement than broker-dealers with lower adverse selection risk.
See infra notes 609-613 and accompanying text; Table 3. For further
discussion of differences in execution quality across broker-
dealers, see infra section VII.C.1.a).
---------------------------------------------------------------------------
Some retail brokers may face conflicts of interest when making
order routing decisions, including whether to route to a particular
wholesaler.\88\ For example, broker-dealers could face conflicts of
interest when making routing decisions due to their own affiliation
with market centers (e.g., if the broker-dealer operates its own ATS),
from the presence of liquidity fees and rebates on some market centers,
or from payments that some retail brokers receive from wholesalers to
attract the order flow of
[[Page 3792]]
their individual investor customers (PFOF).\89\
---------------------------------------------------------------------------
\88\ See infra section VII.C.3.a)(2). See also 2018 Rule 606
Amendments Release, 83 FR 58338 (Nov. 19, 2018) at 58372 (stating
that financial inducements to attract order flow from broker-dealers
that handle retail investor orders have become more prevalent and
for some broker-dealers such inducements may be a significant source
of revenue); supra note 62 and accompanying text (stating that these
financial inducements have created new, and in many cases
significant, potential conflicts of interest for these broker-
dealers).
\89\ See infra notes 759-762 and accompanying text.
---------------------------------------------------------------------------
The Commission is concerned that variations in execution quality
across broker-dealers may be difficult to assess using current Rule 605
and Rule 606 reports. In particular, broker-dealers that route customer
orders externally, rather than executing customer orders internally,
are not required to prepare Rule 605 reports because they do not meet
the definition of market center. Customers of a broker-dealer can use
Rule 606 reports to identify market centers to which the broker-dealer
routes, and then access those market centers' Rule 605 reports to
review the execution quality that the market center provides to all
orders that the market center received for execution. However, to the
extent that the market center may provide different execution quality
to orders based on different order routing arrangements with different
broker-dealers, current Rule 605 and 606 do not require reports that
provide investors with a way to assess these differences.
In addition, developments in trading, including the increased speed
of trading, further necessitate proposing updates to the Rule. Average
stock prices have continued to increase over time,\90\ and odd-lots
\91\ and fractional shares \92\ continue to trade with increasing
frequency. Similarly, odd-lot quotes in higher-priced stocks continue
to offer prices that are frequently better than the round lot NBBO for
these stocks,\93\ and this better-priced odd-lot liquidity is
distributed across multiple price levels.\94\ In addition, odd-lot
rates have increased among lower priced stocks.\95\ Because current
Rule 605 size categories exclude orders smaller than 100 shares, a
significant proportion of market activity is currently excluded.\96\ An
analysis of Rule 605 data shows that Rule 605 coverage has likely
declined in the decades since the initial adoption of Rule 605.\97\
Further, because order size categories are tied to the number of
shares, the categories may group orders of very different notional
values, which may complicate comparisons of aggregate execution
quality. Finally, the speed of the market has increased exponentially
since 2000,\98\ rendering the Rule's current one-second timestamp
conventions less meaningful.
---------------------------------------------------------------------------
\90\ See supra note 16.
\91\ See MDI Adopting Release, 85 FR 18612 (Apr. 2, 2020) at
18616 (describing analyses included in the MDI Adopting Release
confirming observations made in the MDI Proposing Release that a
significant proportion of quotation and trading activity occurs in
odd-lots, particularly for frequently traded, high-priced stocks).
Analysis using the NYSE Trade and Quote database (obtained via
Wharton Research Data Services (WRDS) (``TAQ data'' or ``NYSE TAQ
data'') found that odd-lots increased from around 15% of trades in
January 2014 to more than 55% of trades in March 2022. An analysis
of data from the SEC's MIDAS analytics tool available at https://www.sec.gov/marketstructure/datavis.html#.YoPskqjMKUk shows that, in
Q1 2022, odd-lots made up 81.2% of on-exchange trades (40% of
volume) for stocks in the highest price decile and 25% of on-
exchange trades (2.72% of volume) for stocks in the lowest price
decile. See dataset ``Summary Metrics by Decile and Quartile''
available at https://www.sec.gov/marketstructure/downloads.html.
\92\ Analysis using CAT data for executed orders in March 2022
found that an estimated 46.63 million originating orders with a
fractional share component were eventually executed on- or off-
exchange. This represents approximately 2% of all executed orders
and 14% of executed orders from individual accounts. Generally,
accounts classified as ``individual'' in CAT are attributed to
natural persons. See also infra note 647 and accompanying text.
\93\ See MDI Adopting Release, 86 FR 18596 (Apr. 9, 2021) at
18729. In addition, a recent academic working paper shows that odd-
lots offer better prices than the NBBO 18% of the time for bids and
16% of the time for offers. This percentage increases monotonically
in the stock price, for example, for bid prices, increasing from 5%
for the group of lowest-price stocks in their sample, to 42% for the
group of highest-priced stocks. See Robert P. Bartlett, Justin
McCrary, and Maureen O'Hara, The Market Inside the Market: Odd-Lot
Quotes (Feb. 1, 2022), available at SSRN: https://ssrn.com/abstract=4027099 (``Bartlett, et al.''). See also Elliot Banks, BMLL
Technologies, Inside the SIP and the Microstructure of Odd-Lot
Quotes (observing an upward trend in odd-lot trading inside the NBBO
from January 2019 to January 2022).
\94\ See MDI Adopting Release, 86 FR 18596 (Apr. 9, 2021) at
18613 n.202 (describing analysis included in the MDI Adopting
Release that examined quotation data for the week of May 22-29, 2020
for stocks priced from $250.01 to $1000.00 and found that there is
odd-lot interest priced better than the new round lot NBBO 28.49% of
the time, and, in 48.49% of those cases, there are better priced
odd-lots at multiple price levels).
\95\ For example, odd-lot rates for corporate stock price
deciles 1-3 (the lowest priced corporate stocks comprising 30% of
all corporate stocks) have been higher on average in 2021 and June
2022 (34%, 39%) as compared to 2019 and 2020 (26%, 29%). Similarly,
exchange-traded products (``ETPs'') also exhibit higher average odd-
lot rates in price quartiles 1 and 2 (the lowest priced ETPs
comprising 50% of all ETPs) on average in 2021 and June 2022 (26%,
29%) compared to 2019 and 2020 (20%, 23%). See SEC market structure
analytics data, available at https://www.sec.gov/marketstructure/midas.html.
\96\ See supra notes 91-92. See also infra notes 619-622 and
accompanying text (estimating, based on analysis of Tick Size Pilot
data, coverage of current Rule 605 reporting requirements).
\97\ Analysis comparing one market center's volume (NYSE) to TAQ
data shows that an estimated 50% of shares executed during regular
market hours were included in Rule 605 reports as of February 2021,
and shows that this number has been on a slightly downward trend
since around mid-2012. See infra section VII.C.2.b) and infra Figure
3.
\98\ Analysis of data from the SEC's MIDAS analytics tool shows
that the percent of on-exchange NMLOs that are fully executed within
one millisecond (as a percentage of all fully executed on-exchange
NMLOs) has increased from 2.1% in Q1 2012 to 10.3% in Q1 2022 for
small cap stocks, and from 5.9% in Q1 2012 to 15.7% in Q1 2022 for
large cap stocks. Further, in Q1 2022 more than half (51.6%) of
NMLOs executed in less than one second in large market cap stocks.
See dataset ``Conditional Cancel and Trade Distribution,'' available
at https://www.sec.gov/marketstructure/downloads.html. See also
infra note 692 and accompanying text.
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E. EMSAC Recommendations, Petition for Rulemaking, and Other Comments
The EMSAC \99\ as well as commenters responding to the Commission's
Concept Release on Equity Market Structure \100\ and to the 2018 Rule
606 Amendments,\101\ have recommended
[[Page 3793]]
that the Commission amend Rule 605 to modernize the Rule and increase
the usefulness of available execution quality disclosures. In addition,
one broker-dealer petitioned the Commission to make ``modest rule
amendments'' to Rule 605 and further stated that ``[i]mproving these
metrics is essential for a market participant to quantitatively and
qualitatively assess whether any particular broker-dealer obtained the
most favorable terms under the circumstances for customer orders.''
\102\
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\99\ See Transcript from EMSAC Meeting (Aug. 2, 2016), available
at https://www.sec.gov/spotlight/emsac/emsac-080216-transcript.txt
(``EMSAC I''); Transcript from EMSAC Meeting (Nov. 29, 2016),
available at https://www.sec.gov/spotlight/equity-market-structure/emsac-transcript-112916.txt (``EMSAC II''); EMSAC Recommendations
Regarding Modifying Rule 605 and Rule 606 (``EMSAC III''), Nov. 29,
2016, available at https://www.sec.gov/spotlight/emsac/emsac-recommendations-rules-605-606.pdf.
\100\ See, e.g., Letter from Christopher Nagy, CEO, and Dave
Lauer, President, KOR Group LLC (Apr. 4, 2014) (``KOR Group I'');
Letter from Citigroup Global Markets Inc. and its affiliates re
Concept Release on Equity Market Structure (Release No. 34-61358;
File No. S7-02-10) (Aug. 7, 2014) (``Citigroup Letter''); Letter
from Consumer Federation of America re File Number S7-02-10,
Comments on Concept Release on Equity Market Structure (Sept. 9,
2014) (``Consumer Federation I''); Letter from BlackRock, Inc. re
Equity Market Structure Recommendations; Concept Release on Equity
Market Structure, File No. S7-02-10; Regulation Systems Compliance
and Integrity, File No. S7-01-13; and Equity Market Structure Review
(Sept. 12, 2014) (``BlackRock Letter''); Letter from Financial
Information Forum re Rule 605/606 Enhancements from a Retail
Perspective (Oct. 22, 2014) (``FIF I''); Letter from Securities
Industry and Financial Markets Association re Recommendations for
Equity Market Structure Reforms (Oct. 24, 2014) (``SIFMA Letter'');
Healthy Markets Proposal re SEC Rule 605/606 Reform (referenced in
Aug. 2, 2016 statement of Christopher Nagy before the EMSAC)
(``Healthy Markets II'') at 2; Letter from Healthy Markets re Notice
of Meeting of Equity Market Structure Advisory Committee Meeting
(File No. 265-29); List of Rules to be Reviewed Pursuant to the
Regulatory Flexibility Act (File No. S7-21-16); Concept Release on
Equity Market Structure (File No. S7-02-10) (Apr. 3, 2017)
(``Healthy Markets III''); Letter from Healthy Markets re Potential
Reforms Regarding the Provision of Market Data, Concept Release on
Equity Market Structure (Rel. No. 34-61358; File No. S7-02-10), and
Market Data and Market Access Roundtable (Rel. No. 4-729) (Jan. 3,
2020) (``Healthy Markets IV''). Comments on the Commission's 2010
Concept Release on Equity Market Structure are available at https://www.sec.gov/comments/s7-02-10/s70210.shtml. As with various other
comments referenced herein, including, without limitation, comments
received in connection with the Concept Release, the comments were
not provided with reference to the proposals discussed in this
release.
\101\ See, e.g., Letter from James J. Angel, Ph.D., CFA,
Georgetown University re Disclosure of Order Handling Information,
File S7-14-16 (Aug. 26, 2016) (``Angel Letter''); Letter from
Consumer Federation of America re File Number S7-14-16, Disclosure
of Order Handling Information (Sept. 26, 2016) (``Consumer
Federation II''); Letter from Fidelity Investments re Disclosure of
Order Handling Information; File No. S7-14-16 (Sept. 26, 2016)
(``Fidelity Letter''); Letter from Financial Information Forum re
Release No. 34-78309; File No. S7-14-16; Disclosure of Order
Handling Information (Sept. 26, 2016) (``FIF II''); Letter from
Financial Services Roundtable re Disclosure of Order Handling
Information Proposal [File No. S7-14-16] (Sept. 26, 2016)
(``Financial Services Roundtable Letter''); Letter from Healthy
Markets Association re Disclosure of Order Handling Information (S7-
14-16) (Sept. 26, 2016) (``Healthy Markets I''); Letter from IHS
Markit re Disclosure of Order Handling Information; Proposed Rule,
Release No. 34-78309; File No. S7-14-16 (Sept. 26, 2016) (``IHS
Markit Letter''). Comments receiving in connection with the 2018
Rule 606 Amendments are available at https://www.sec.gov/comments/s7-14-16/s71416.htm.
\102\ Letter from Virtu Financial re Petition for Rulemaking to
Amend SEC Rule 605 (Sept. 20, 2021) (``Virtu Petition'') at 2,
available at https://www.sec.gov/rules/petitions/2021/petn4-775.pdf.
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The EMSAC and commenters generally support expanding the Rule's
scope beyond market centers.\103\ In particular, in November 2016, the
EMSAC recommended that the Commission ``[e]xpand the scope of Rule 605
by requiring every broker-dealer to report with an exemption for
broker[-]dealers with de minimis order flow, aligning the scope of Rule
605 reporting with Rule 606.'' \104\ The EMSAC's recommendation
acknowledged that there would be compliance and implementation costs
associated with this expansion, but stated that the use of third-party
vendors may mitigate some of these concerns.\105\ Further, the EMSAC's
recommendation stated that having all broker-dealers provide Rule 605
data would create an opportunity for market participants, academics,
and the press to evaluate these statistics in a consistent manner.\106\
---------------------------------------------------------------------------
\103\ See EMSAC III at 2; IHS Markit Letter at 2; Healthy
Markets II at 2.
\104\ EMSAC III at 2 (adopting recommendations of the Customer
Issues Subcommittee).
\105\ See id.
\106\ See id.
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When the EMSAC met to consider this recommendation, panelists
provided some explanation of the gaps in current execution quality
disclosures. One panelist stated that the current reporting regime
``miss[es] important information about the overall execution quality of
a covered order'' because Rule 605 reports only pertain to order
routing handled by market centers.\107\ This panelist explained that
orders are handled by smart order routers that may not be located
within a market center, and the Rule 605 data does not capture price
slippage or delays that may occur as these orders are received by
multiple non-executing market centers or broker-dealers.\108\ Another
panelist described the difficulties that he encountered when trying to
compare the execution quality of brokers using data available under the
existing rules.\109\ According to the panelist, he ``had to make very
rough inferences about the brokers' executions because of the gaps in
the disclosure requirements.'' \110\ Moreover, this panelist stated
that one fundamental problem with making these inferences was that a
market maker's average execution quality across all of its orders
received from brokers may be better or worse than its execution quality
with respect to a particular broker's order flow.\111\
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\107\ See EMSAC I at 0103:23-0104:7 (Frank Hatheway, NASDAQ).
\108\ See id. at 0104:7-12 (Frank Hatheway, NASDAQ).
\109\ See id. at 0094:6-0100:12 (Bill Alpert, Barron's).
\110\ Id. at 0096:12-15 (Bill Alpert, Barron's). See also id. at
0097:3-8 (Bill Alpert, Barron's) (stating that ``the only effective,
objective way to use the available disclosures was to score each
broker with a weighted sum of their order flow fractions from the
routing reports and then weight those with the effective over quoted
measures of the market makers that they were sending their orders
to''); 0096:25-0097:3 (stating that some brokers voluntarily
disclose execution quality information, but they use different
information and so the information is not comparable).
\111\ See EMSAC I at 0097:14-22 (Bill Alpert, Barron's). See
also id. at 0096:18-22 (Bill Alpert, Barron's) (stating that
``almost every broker'' claimed that the execution quality that it
received at a particular market maker was above average). This
panelist also argued, based on the introduction of voluntary
disclosures regarding price improvement for odd-lot orders by a few
brokers and market makers, that disclosure improves behavior. See
id. at 0098:6-0099:9 (Bill Alpert, Barron's) (stating the price
improvement on odd-lot orders improved within a year after voluntary
disclosures started). See also id. at 0132:6-11 (Brad Katsuyama,
IEX) (stating that improving disclosures leads to improved
performance).
---------------------------------------------------------------------------
One EMSAC committee member acknowledged that retail brokerage firms
did not favor the recommendation to expand Rule 605 reporting to
broker-dealers, and stated that these firms would argue that aggregate
statistics are more important for retail investors, who they claim are
not going to look at the Rule 605 reports.\112\ This committee member
stated that the counter-argument to this position is that if everyone
is preparing Rule 605 reports, it would be possible to do various types
of aggregation using that data.\113\ When the EMSAC met later to
approve the recommendation, one committee member stated that the goal
is to make data publicly available so that ``experts can help people
make better decisions'' and that different groups would turn the data
into usable reports, so it is not necessary to scale back the
disclosures for the consumer.\114\
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\112\ See id. at 0136:24-0137:7 (Manisha Kimmel, Thomson
Reuters). But see id. at 0102:22-0103:2) (Frank Hatheway, NASDAQ)
(``While individual retail investors generally don't review 605
statistics themselves, . . . the existence of the reports appears to
provide precisely the form of discipline that the Commission
envisioned when it adopted Rule 605 and 606.'').
\113\ See EMSAC I at 0137:7-10 (Manisha Kimmel, Thomson
Reuters). See also Statement of Christopher Nagy, Healthy Markets
Association, at 6 (suggesting that the Commission mandate reporting
of some execution quality statistics for retail orders); Healthy
Markets I at 5-6 (recommending that the Commission modify Rule 606
to include select execution quality statistics from Rule 605 for
each identified routing destination).
\114\ EMSAC II at 0065:1-16 (Brad Katsuyama, IEX). But see id.
at 0064:18-24 (Jamil Nazarali, Citadel) (stating that his firm's
retail broker clients expressed concerns with the recommendation
that Rule 606 include the execution quality of the market makers
that they route to, because there is a lot of important criteria
that goes into routing and the reports could be misleading).
---------------------------------------------------------------------------
When the Commission solicited comment on the 2018 Rule 606
Amendments, several commenters recommended that the Commission expand
the required reporting of execution quality statistics to better cover
retail investors.\115\ One commenter stated that the type of
standardized execution statistics that several firms voluntarily
publish on a quarterly basis measure the quality of trade executions on
retail investor orders in exchange-listed stocks and help investors
evaluate their particular retail brokerage firm.\116\ Another commenter
stated that there is a ``fundamental flaw'' in the logic of Rule 605
and Rule 606 because ``[t]he structure of the rules implicitly assumes
[[Page 3794]]
that execution quality is solely a function of the market center and
that the brokerage firm has no impact on execution quality.'' \117\
According to this commenter, execution quality is a product of both the
broker's skill and the quality of the market center's execution, and
therefore requiring brokers to show where they route orders does not
provide retail investors with useful information about the actual
execution quality that their orders receive.\118\ Another commenter
stated that even though most retail investors may not use the
disclosures directly, disclosures provide indirect benefits by
promoting competition and by facilitating use by third-party analysts
and academic researchers that provide an in-depth review of the
disclosures.\119\
---------------------------------------------------------------------------
\115\ See Angel Letter at 3 (recommending that brokers should be
required to provide execution quality statistics by providing
information on individual trade confirmations and displaying summary
statistics on their websites); Fidelity Letter at 7-8 (recommending
that the Commission require brokers to make publicly available
certain execution quality statistics); Healthy Markets I at 7, 11
(recommending that execution quality metrics should be provided to
retail customers); IHS Markit Letter at 2 (recommending that all
brokers that receive client orders and subsequently route orders on
behalf of the client should provide information on the execution
quality received at each venue). See also Consumer Federation II at
10; Financial Services Roundtable Letter at 4-5.
\116\ See Fidelity Letter at 7-8. For additional discussion
about this voluntary effort to provide aggregated execution quality
statistics, see infra notes 450-451 and accompanying text. See also
Consumer Federation II at 10 (stating that voluntary disclosures by
several market participants show that such disclosures are possible,
and undercut arguments that doing so is too costly or burdensome).
\117\ Angel Letter at 3.
\118\ See id. However, this commenter also stated that the Rule
605 data on execution quality is too raw for most investors to
interpret. See id. at 2. See also Consumer Federation II at 10
(stating that the only way to assess whether customers are being
best served by their broker-dealer's routing decisions is by
requiring execution quality statistics); Financial Services
Roundtable Letter at 4-5 (stating that currently Rule 605 reports
require investors to draw an inference that they will achieve the
same performance as the average order sent to that venue, and
additional data would help an investor compare the execution quality
that various broker-dealers obtain at a particular execution venue).
\119\ See Consumer Federation II at 10. See also IHS Markit
Letter at 29-30 (stating that large retail routing brokers use
private, internal versions of Rule 605 reports to calculate
execution quality metrics for different market centers, leading to
significant improvement in execution quality statistics for covered
orders, and that voluntary reporting of execution quality metrics
has also improved execution quality).
---------------------------------------------------------------------------
One market participant, in a letter recommending that the
Commission require broker-dealers to publish monthly cost of execution
statistics, stated that Rule 605 and Rule 606 statistics published by
market centers and broker-dealers do not provide a means for customers
to judge how their brokers have performed with respect to keeping
commissions low without adversely affecting execution quality.\120\
This commenter further remarked that matching a broker's routing
statistics up with a receiving market center's execution quality
statistics is ``essentially impossible.'' \121\
---------------------------------------------------------------------------
\120\ See Letter from Thomas Peterffy, Chairman, Interactive
Brokers Group (Aug. 1, 2014), at 3 (``Interactive Brokers Letter''),
available at https://www.interactivebrokers.com/download/execution_stats_comment_letter.pdf (``Payment for order flow has
often been justified by its advocates based on the claim that the
receipt of such payments allows brokers to keep commissions low and
does not affect execution quality (or if it does, such costs are
passed back to customers in the form of lower commissions). . . .
[T]he current Rule 605 and 606 statistics published by market
centers and brokers . . . do not provide a basis for regulators to
judge these claims, or for customers to judge their broker's
performance.'').
\121\ Interactive Brokers Letter at 3.
---------------------------------------------------------------------------
Commenters have also suggested various ways to expand or modify the
definition of covered order, including broadening its scope to capture
additional order types.\122\ In particular, the petitioner for
rulemaking recommended including short sales, stop orders, and pre-
market orders in Rule 605 reports.\123\ The petitioner stated that
these order types are ``critical to a complete assessment of execution
quality,'' and stated that many retail brokers include these orders
when measuring the execution quality provided by market centers.\124\ A
commenter to the 2018 Rule 606 Amendments also recommended including
orders submitted prior to the market open in Rule 605 reports and
stated that the marketable or non-marketable characteristics of such
orders cannot be determined under the current framework.\125\
---------------------------------------------------------------------------
\122\ See Letter from Financial Information Forum re Request for
Comment--FIF Rule 605 Modernization Recommendations (Jan. 30, 2019)
(``FIF III''), available at https://www.sec.gov/comments/s7-02-10/s70210-5002077-182848.pdf; EMSAC III; IHS Markit Letter; Healthy
Markets II; FIF Letter I; KOR Group I.
\123\ See Virtu Petition at 5.
\124\ Id.
\125\ See FIF II at 11-12.
---------------------------------------------------------------------------
The EMSAC and commenters have also suggested bringing smaller and
larger order sizes within scope.\126\ The petitioner stated that
bucketing orders solely by numbers of shares is skewing
comparisons.\127\ Another commenter, responding to the Commission's
Concept Release on Equity Market Structure, recommended the following
order size buckets: one share to 99 shares; 100 shares up to 9,999
shares, divided into 100 share increments; 10,000 shares to 24,999
shares; greater than 25,000 shares.\128\ One commenter that offered
recommendations to modify Rule 605 suggested including a $500,000
notional cap on all share size buckets.\129\ Another market participant
expressed support for that cap or a different one.\130\ The market
participant suggested that a cap of $200,000, consistent with the
definition of ``block size'' in 17 CFR 242.600(b)(12)(ii), would make
sense, but noted that benchmark has not changed with inflation.\131\
The market participant also stated that the use of notional buckets in
the ``categorized by order size'' definition would account for
fractional share and odd-lot orders.\132\
---------------------------------------------------------------------------
\126\ See EMSAC III at 2; FIF III at 4; Healthy Markets II at 3;
IHS Markit Letter at 9-10, 34.
\127\ See Virtu Petition at 5.
\128\ See Healthy Markets II at 4.
\129\ See FIF III at 4.
\130\ See ``Would 605 Work Better in Dollars?'', Phil
Mackintosh, Chief Economist and Senior Vice President, Nasdaq (Sept.
16, 2021), available at: https://www.nasdaq.com/articles/would-605-work-better-in-dollars-2021-09-16.
\131\ See id. The market participant stated that ``a lower [than
$500,000] notional cap makes sense too, given the small sizes of
retail orders, especially when we consider the limits of the typical
depth of book to fill covered orders.'' Id.
\132\ See id.
---------------------------------------------------------------------------
Commenters have also raised concerns about the current provisions
in the Rule for timestamps, especially given the speed of today's
marketplace.\133\ Others have also suggested modifications to improve
the accessibility and standardizations of reports, including
centralizing report creation and requiring summary statistics.\134\ In
several contexts in which the Commission has received general feedback
on equity market structure, commenters have suggested that the
Commission require a simplified execution quality report, particularly
for retail investors.\135\ One commenter on the Concept Release on
Equity Market Structure stated that if the Commission's goal was for
execution quality statistics to make the markets more transparent for
retail investors, the commenter did not believe that was occurring, and
the average retail investor might benefit more from a simplified
version of the report.\136\ One EMSAC committee member stated that some
retail firms have argued that aggregate statistics are more important
for the retail investor, and that retail investors are not going to
look at Rule 605 reports.\137\ This EMSAC committee member further
stated that an issue with aggregation is what to include in the
aggregate statistics, and depending on a firm's business model, the
firm may want to
[[Page 3795]]
put in different things.\138\ Separately, the EMSAC, as well as a
commenter to the 2018 Rule 606 Amendments, recommended that the
Commission incorporate Rule 605 and 606 data into the Commission's data
visualization tool.\139\
---------------------------------------------------------------------------
\133\ See KOR Group I at 2, FIF I at 2.
\134\ See EMSAC I at 0099:25-0100:3, 0106:14-25; EMSAC III at 2;
Healthy Markets II at 3; BlackRock Letter at 3; Citi Letter at 8;
Consumer Federation II at 6.
\135\ See, e.g., Citigroup Letter at 8 (suggesting in connection
with the Concept Release on Equity Market Structure that a
simplified execution quality report geared towards retail investors
should contain a simple chart or graph showing how often a
customer's trades are executed at the NBBO or better, how fast the
trade is done, and whether the customer received enhanced
liquidity); SIFMA Letter at 12 (stating in providing recommendations
for equity market structure reforms that regulators should direct
broker-dealers to provide public reports of order routing and
execution quality metrics that are geared towards retail investors,
and these reports should include relevant information in a uniform
format that is easy to understand).
\136\ See Citigroup Letter at 8.
\137\ See EMSAC I at 0137:4-7 (Manisha Kimmel, Thomson Reuters).
See also id. at 0137:7-10 (``The counter argument to that is, if
everybody is doing the 605 [reports], then you could have all sorts
of aggregation based on that . . .'').
\138\ See id. at 0137:11-16 (Manisha Kimmel, Thomson Reuters).
\139\ See EMSAC III at 2; FIF II at 13. See also EMSAC I at
0139:20-0140:11 (Gary Stone) (stating that individual investors need
the Commission to provide the data, because they cannot rely on
vendors that will charge for that service); EMSAC I at 0105:20-
0106:7 (Frank Hatheway, NASDAQ) (stating that before replacing these
existing offerings by data vendors of data visualization tools for
Rule 605 and 606 data, the Commission may want to consider
alternatives for making the data widely available and accessible);
EMSAC I at 0140:12-15 (Bill Alpert, Barron's) (stating that it would
be salutary to have competition between vendors, the Commission, and
the press to develop easier to use tools and better presentations).
---------------------------------------------------------------------------
III. Proposed Modifications to Reporting Entities
A. Larger Broker-Dealers
Rule 605 of Regulation NMS requires market centers, such as
national securities exchanges, OTC market makers, and ATSs, to produce
publicly available, monthly execution quality reports. However, broker-
dealers are not included within the scope of Rule 605's reporting
requirements unless they are market centers. Although Rule 606 requires
broker-dealers to identify the venues, including market centers, to
which they route customer orders for execution, customers of those
broker-dealers do not have access to comprehensive information about
execution quality. For example, to the extent that a market center's
execution quality differs for orders received from one broker-dealer
versus another broker-dealer, that difference would not be apparent
from currently available execution quality statistics.
The Commission is proposing to expand the scope of entities that
must prepare Rule 605 reports to include larger broker-dealers, which
have a customer-facing line of business. As proposed, Rule 605 would
include broker-dealers as reporting entities, in addition to market
centers, but exclude from that expanded requirement broker-dealers that
do not introduce or carry at least 100,000 customer \140\ accounts.
This expansion of the scope of Rule 605 would improve the usefulness of
execution quality statistics, promote fair competition, and enhance
transparency by providing investors with information that they could
use to compare the execution quality provided by customer-facing
broker-dealers. Further, limiting these reporting obligations to
broker-dealers that have a larger number of customers would focus the
associated implementation costs on those broker-dealers for which the
availability of more specific execution quality statistics would
provide a greater benefit.
---------------------------------------------------------------------------
\140\ ``Customer'' means any person that is not a broker or
dealer. See 17 CFR 242.600(b)(23).
---------------------------------------------------------------------------
Rule 605 and Rule 606 operate together to allow investors to
evaluate what happens to their orders after investors submit their
orders to a broker-dealer for execution.\141\ In the current regulatory
environment, customers that submit held orders (in many cases,
individual investors) have a limited ability to assess the execution
quality that their broker-dealers are providing. A customer of a
broker-dealer can use a broker-dealer's Rule 606 reports to identify
certain regularly-used venues to which the broker-dealer routes orders
for execution. However, with respect to held orders, these Rule 606
reports are not required to include any detailed execution quality
information.\142\ Moreover, Rule 605 reports prepared by market centers
commingle orders from all broker-dealers that send covered order flow
to the reporting market center. Yet a market center may provide
different execution quality to customers of different broker-dealers,
and in some cases this difference may be substantial.\143\ Therefore, a
customer of that broker-dealer must make an inference about the
execution quality achieved by that particular broker-dealer at a market
center based on a Rule 605 report that covers all orders received by
the market center, even though that inference may not be accurate.\144\
---------------------------------------------------------------------------
\141\ See Adopting Release, 65 FR 75414 (Dec. 1, 2000) at 75414.
\142\ See supra notes 50-55 and accompanying text.
\143\ See supra notes 108-110 and accompanying text (discussing
an EMSAC panelist's observations after trying to infer execution
quality based on available data that one ``fundamental problem''
with making these inferences was that a market maker's execution
quality may vary according to each broker's order flow). See also
supra note 87 and accompanying text.
\144\ See supra notes 107-111, 115-118, and 120-121 and
accompanying text.
---------------------------------------------------------------------------
Due to this gap in the reporting requirements, variations in
execution quality provided by a market center to a particular broker-
dealer submitting the order are not observable by market participants
and other interested parties using publicly available execution quality
reports.\145\ When requiring each market center to report on all orders
that it received for execution, the Commission intended to assign the
disclosure obligation to the entity that would control whether and when
the order would be executed.\146\ The Commission required market
centers to include in their Rule 605 reports those orders that they
routed to another venue for execution, thereby recognizing that market
centers' decisions about whether and how to route orders can affect
execution quality.\147\ Likewise, broker-dealers that route customer
orders make decisions that affect the execution quality that their
customers' orders receive.
---------------------------------------------------------------------------
\145\ The Commission preliminarily believes that many
institutional customers regularly conduct, directly or through a
third-party vendor, transaction cost analysis of their orders to
assess execution quality against various benchmarks, but this
information is not publicly available. The Commission believes that
some institutional investors may currently use aggregated statistics
or summaries of Rule 605 reports prepared by third parties, who make
these reports available for a fee. See infra section VII.C.1.(c)(2).
\146\ See supra note 33 and accompanying text (citing Adopting
Release, 65 FR 75414 (Dec. 1, 2000) at 75421).
\147\ When adopting Rule 605, the Commission stated that from
the perspective of the customer who submitted the order, the fact
that a market center chooses to route the order away ``does not
reduce the customer's interest in a fast execution that reflects the
consolidated BBO'' that is ``as close to the time of order
submission as possible,'' and that, consequently, in evaluating the
quality of order routing and execution, it is important for
customers to know how the market center handles ``all orders that it
receives, not just those it chooses to execute.'' Adopting Release,
65 FR 75414 (Dec. 1, 2000) at 75423.
---------------------------------------------------------------------------
In addition, while the Commission adopted Rule 605 in 2000 as a
``minimum step necessary to address fragmentation,'' \148\ the equities
markets have grown even more fragmented since that time.\149\ Broker-
dealers have many choices about where to route customer orders for
execution. But broker-dealers may face conflicts of interest when
discussing arrangements regarding the outsourcing of customer order
flow, including those that involve PFOF, and making routing
decisions.\150\ With respect to orders submitted on a held basis,
broker-dealers must include information about their payment
relationships with execution venues in quarterly reports prepared
pursuant to Rule 606(a)(1).\151\ Without information
[[Page 3796]]
about the execution quality that broker-dealers in the business of
routing customer orders obtain for those orders, market participants
and other interested parties lack key information that would facilitate
their ability to evaluate how these payment relationships may affect
execution quality. Recognizing these and other concerns, the EMSAC and
other commenters in multiple contexts have suggested that the
Commission expand the scope of Rule 605 to require reporting by broker-
dealers.\152\
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\148\ See supra note 9 and accompanying text.
\149\ See supra notes 74-84 and accompanying text.
\150\ See supra notes 88-89 and accompanying text.
\151\ See supra notes 50-52 and accompanying text. As discussed
above (supra section II.D), Rule 606 requires broker-dealers to
identify and report data according to execution venue, rather than
by market center. Not all execution venues reflected on Rule 606
reports will necessarily fall within Regulation NMS's definition of
``market center.'' See, e.g., 2018 Rule 606 Amendments Release, 83
FR 58338 (Nov. 19, 2018) at 58365 (stating that the Commission's
reference to ``venues'' for purposes of Rule 606(b)(3) is meant to
refer to external liquidity providers to which the broker-dealer may
send actionable indications of interest (``IOIs''), and that this
category of market participants likely would include market centers
as defined in Rule 600(b)(38), but may not be limited to such market
centers).
\152\ See generally supra section II.E.
---------------------------------------------------------------------------
Consequently, the Commission is now proposing to require larger
broker-dealers to prepare and publish execution quality reports
pursuant to Rule 605, through the proposed revisions to Rule 605 and
the addition of proposed Rule 605(a)(7). This expansion of the scope of
reporting entities would increase transparency into the differences in
execution quality achieved by broker-dealers when they route customer
orders to execution venues, and thereby would make the execution
quality statistics more useful to market participants and other
interested parties.\153\ This change would increase competition among
broker-dealers that accept customer orders for execution by providing
information that market participants can use to evaluate and compare
broker-dealers' execution quality. This could lead to faster
executions, better price improvement, and a shift in order flow to
those broker-dealers offering the best execution quality for their
customers. This would further the national market system objectives set
forth in section 11A(a)(1) of the Exchange Act, including the efficient
execution of securities transactions, fair competition among market
participants, the public availability of information on securities
transactions, and the best execution of investor orders.\154\
---------------------------------------------------------------------------
\153\ Among the commenters that raised concerns about the lack
of available information regarding the execution broker-dealers
provide to their customers' orders, one commenter stated that there
is a ``fundamental flaw'' in the logic of Rule 605 and Rule 606
because these rules assume that execution quality is solely the
function of the market center, but instead execution quality is a
product of a combination of the broker's skill and the quality of
the market center's execution. See supra notes 117-118 and
accompanying text. The proposal would address this concern by
requiring larger broker-dealers to produce execution quality
reports, rather than leaving market participants and other
interested parties to rely solely on the execution quality reports
produced by the market centers to which a particular broker-dealer
routes orders.
\154\ See Adopting Release, 65 FR 75414 (Dec. 1, 2000) at 75414
n.1, 75417 (citing 15 U.S.C. 78k-1).
---------------------------------------------------------------------------
Specifically, the Commission is proposing to amend Rule 605 to
apply the reporting requirements contained therein to brokers and
dealers, in addition to market centers. Where current Rule 605 refers
to ``market centers,'' the Commission is proposing to insert references
to ``brokers'' and ``dealers.'' \155\ The proposed expansion of Rule
605's reporting requirements to cover broker-dealers would also affect
Rule 600 of Regulation NMS. Specifically, the definition of ``covered
order'' in Rule 600(b)(22) refers to ``any market order or any limit
order (including immediate-or-cancel orders) received by a market
center.'' \156\ The Commission is proposing to amend this provision to
refer to orders ``received by a market center, broker, or dealer.''
\157\ Further, as noted above, the Plan establishes procedures for
market centers to follow in making available to the public the monthly
reports required by the Rule.\158\ Because of the proposed amendments
to the Rule, the existing Plan would no longer comply with proposed
Rule 605(a)(3) and thus would need to be updated in order to
incorporate references to broker-dealers subject to the Rule.\159\ As
is currently the case for market centers that are not Participants, the
Participants would be required to enforce compliance with the terms of
the Plan by their members and person associated with their
members.\160\
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\155\ See proposed Rules 605 (introductory paragraph), 605(a)
(caption), 605(a)(1), 605(a)(1)(i)(D), 605(a)(3), 605(a)(4),
605(a)(5), and 605(a)(6).
\156\ 17 CFR 242.600(b)(22). The Commission is proposing to
renumber the definition of ``covered order'' as proposed Rule
600(b)(30).
\157\ See proposed Rule 600(b)(30).
\158\ See supra section II.B.3.
\159\ The Plan details procedures for market centers to follow
and, among other things, specifies the order and format of fields in
a manner that aligns with current Rule 605(a)(1). See Plan generally
and section VI(a) of the Plan. Under current Rule 605(a)(2), every
national securities exchange trading NMS stocks and each national
securities association is required to act jointly in establishing
procedures for market centers to follow in making the reports
required by Rule 605(a)(1) available to the public in a uniform,
readily accessible, and usable electronic form. See 17 CFR
242.605(a)(2). The proposal would add brokers and dealers to the
scope of entities to be covered by the Plan's procedures and
renumber Rule 605(a)(2) as Rule 605(a)(3). See proposed Rule
605(a)(3). The Plan would also need to be updated to accommodate any
new data elements in the order and format of fields.
\160\ See 17 CFR 242.608(c). See also supra note 47 (describing
Participants and Designated Participants under the Plan).
---------------------------------------------------------------------------
The Commission is mindful that Rule 605's execution quality reports
contain a large volume of statistical data, and as a result it may be
difficult for individual investors to review and digest the reports.
The Commission considered the volume of execution quality statistics
that would be produced when adopting Rule 605, and stated that the
large volume of statistics reflects a deliberate decision by the
Commission to avoid the dangers of overly general statistics that could
hide significant differences in execution quality.\161\ By requiring
brokers-dealers to report stock-by-stock order execution information in
a uniform manner, the proposal would make it possible for market
participants and other interested parties to make their own
determinations about how to group stocks or orders when comparing
execution quality across broker-dealers.\162\ Further, to the extent
that certain market participants may not have the means to directly
analyze the detailed statistics,\163\ the Commission expects that
independent analysts, consultants, broker-dealers, the financial press,
and market centers will respond to the needs of investors by analyzing
the disclosures and producing more digestible information using the
data, as the Commission anticipated when approving the predecessor to
Rule 605 and has observed since that time.\164\ As discussed further
below, the Commission also is proposing to require all market centers
and broker-dealers that would be subject to Rule 605's reporting
requirements to produce summary reports with aggregated execution
quality information.\165\ Requiring broker-dealers to produce more
detailed execution quality data would help ameliorate potential
concerns about overly general statistics, or about the specific
categorization of orders and selection of metrics in the summary
reports, by allowing market participants and other interested parties
to conduct their own analysis based on
[[Page 3797]]
alternative categorizations of the underlying data.
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\161\ See Adopting Release, 65 FR 75414 (Dec. 1, 2000) at 75419.
See also id. (stating that after this basic information is disclosed
by all market centers in a uniform manner, market participants and
other interested parties will be able to determine the most
appropriate classes of stocks and orders to use in comparing
execution quality across market centers).
\162\ See, e.g., supra note 113 and accompanying text.
\163\ See Adopting Release, 65 FR 75414 (Dec. 1, 2000) at 75419,
text accompanying n.27 (stating that most individual investors
likely would not obtain and digest the reports themselves). See also
supra note 112 and accompanying text (EMSAC committee member stating
that retail investors will not look at the Rule 605 reports); note
118 (commenter stating that Rule 605 data is too raw for most
investors to interpret); note 119 and accompanying text (commenter
stating that most retail investors may not use the disclosures
directly).
\164\ See Adopting Release, 65 FR 75414 (Dec. 1, 2000) at 75419.
See also supra notes 106, 114, 116 and accompanying text; infra
notes 544-546 and accompanying text.
\165\ See infra section V.
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Proposed Rule 605(a)(7) states that a broker or dealer that is not
a market center shall not be subject to the requirements of Rule 605
unless that broker or dealer introduces or carries 100,000 or more
customer accounts through which transactions are effected for the
purchase or sale of NMS stocks (the ``customer account
threshold'').\166\ The Commission is mindful of the additional costs
that broad expansion of the rule to broker-dealers would entail. The
relative benefit of having a broker-dealer prepare Rule 605 reports
increases when the broker-dealer has more customers. The Commission is
proposing a minimum reporting threshold of 100,000 customers to balance
the benefits of having broker-dealers produce execution quality
statistics with the costs of implementation and continued
reporting.\167\
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\166\ In addition, as discussed further below, proposed Rule
605(a)(7) states that any broker or dealer that meets or exceeds
this customer account threshold and is also a market center shall
produce separate reports pertaining to each function.
\167\ See infra section VII.D.2 for a discussion of the costs of
the proposed amendments to Rule 605. As discussed further below,
broker-dealers that were previously not required to publish Rule 605
reports would incur initial costs to develop the policies and
procedures to post Rule 605 reports for the first time, and all
broker-dealers would face ongoing costs to continue to prepare them
each month. Other potential costs include a potential for less
transparency or lower execution quality, and the costs to update
best execution methodology. See also infra section VII.E.1.(a) for a
discussion about the potential costs of imposing Rule 605's
reporting requirements on broker-dealers with a smaller number of
customer accounts.
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Analysis indicates that approximately 85 broker-dealers (or
approximately 6.7% of customer-carrying broker-dealers) introduce or
carry more than 100,000 customer accounts and these broker-dealers
together handle over 98% of customer accounts.\168\ Utilizing a 100,000
customer account threshold would allow the Rule 605 reporting
requirements to capture those broker-dealers that introduce or carry
the vast majority of customer accounts, while subjecting only a
relatively small percentage of broker-dealers that accept customer
orders for execution to the reporting obligation and excluding those
broker-dealers that introduce or carry a smaller number of customer
accounts. Although utilizing a lower customer account threshold, such
as 10,000 customer accounts, would result in capturing substantially
more transactions, the lower customer account threshold would result in
capturing only marginally more customer accounts. This implies that the
additional customer coverage would result from a small number of
accounts that trade in large volumes. Therefore, the additional
coverage may not be as beneficial because many of the additional
customer accounts that would be included with a lower threshold likely
belong to institutional traders that have access to alternative
execution quality information and also are likely to use not held
orders, which are not included in Rule 605 reports.\169\
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\168\ See infra Table 13 for cost-benefit analysis of different
customer account thresholds defining ``larger broker-dealer'' and
infra note 1008 and accompanying text for methodology. For example,
approximately 45 broker-dealers introduce or carry more than 500,000
customer accounts and these broker-dealers together handle over 96%
of customer accounts. Further, approximately 235 broker-dealers
introduce or carry more than 10,000 customer accounts and these
broker-dealers together handle over 99% of customer accounts. See
infra Table 13.
\169\ See infra note 1011 and accompanying text; Table 13. See
also infra section VII.E.1.(a) for further discussion of alternative
customer account thresholds.
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The Commission considered using the volume of broker-dealers'
customer transactions, rather than the number of their customer
accounts, for purposes of establishing a reporting threshold. Although
establishing a reporting threshold using the number of customer
transactions would likely capture a larger number of customer orders
than the proposed customer account threshold, this approach would
likely exclude broker-dealers that have a larger number of relatively
inactive customer accounts and include broker-dealers that have a small
number of customer accounts associated with large amounts of trading
volume. In each respect, the reporting threshold would be less likely
to capture individual investor orders and more likely to capture
institutional investor orders, and therefore the threshold would be
less likely to target the types of orders that may be most useful for
consumers of Rule 605 reports. In addition, utilizing a threshold based
on the number of customer transactions may result in a less stable set
of broker-dealers that are subject to Rule 605's reporting
requirements, because transaction volume is more likely than customer
account numbers to vary significantly from month to month based on
market conditions. Further, the number of their customer accounts is
likely less costly for broker-dealers to calculate and track as
compared to the volume of transactions associated with their customer
accounts.\170\
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\170\ See infra section VII.E.1.(c) for further discussion about
using a threshold based on the number of customer transactions.
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The Commission also considered EMSAC's recommendation to expand the
scope of Rule 605 to cover all broker-dealers, which contemplated
excluding only broker-dealers with de minimis order flow.\171\ The
Commission is preliminarily concerned that subjecting a significantly
larger number of broker-dealers to Rule 605's reporting requirements
would substantially increase the costs of the proposal and that the
increase in cost that would accompany the use of a de minimis threshold
would not be justified by the corresponding benefit.\172\ This concern
about requiring smaller broker-dealers to prepare Rule 605 reports is
present with any de minimis threshold, whether based on order flow as
the EMSAC suggested or on some other measure such as number of customer
accounts.
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\171\ See supra notes 104-106 and accompanying text.
\172\ See infra note 1011 and accompanying text and Table 13
(showing that, for example, adjusting the customer account threshold
from 100,000 customer accounts to 10,000 customer accounts would
increase the estimated costs from approximately $5 million to
approximately $13.9 million).
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The proposed customer account threshold would require brokers-
dealers to include in their calculations the public customer accounts
that they introduce, as well as the customer accounts that they
carry.\173\ Rule 605 reports that reflect orders received from customer
accounts that a broker-dealer introduces or carries would provide
useful information to market participants because both introducing and
carrying broker-dealers make decisions about where to route those
orders and it would be helpful for customers to be able to evaluate the
execution quality received as a result of those decisions.\174\ An
introducing broker-dealer may choose to utilize an omnibus clearing
arrangement and not disclose certain information about its underlying
customer accounts to the clearing firm.\175\ In such circumstances,
[[Page 3798]]
because the clearing broker may not have access to information about
how many customer accounts a particular omnibus account represents, the
proposal specifies that when an omnibus clearing arrangement is used
the underlying customer accounts would be required to be counted as
accounts carried by the introducing broker-dealer rather than by the
clearing broker. Therefore, for purposes of Rule 605, a broker or
dealer that utilizes an omnibus clearing arrangement for any of its
underlying customer accounts would be considered to carry such
underlying customer accounts when calculating the number of customer
accounts that it introduces or carries.\176\
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\173\ See proposed Rule 605(a)(7).
\174\ An introducing broker-dealer is a broker-dealer that has a
contractual arrangement with another firm, known as the carrying or
clearing firm, under which the clearing/carrying firm agrees to
perform certain services for the introducing firm. Usually, the
introducing firm transmits its customer accounts and customer orders
to the clearing/carrying firm, which executes the orders and carries
the account. See Securities Exchange Act Release No. 31511 (Nov. 24,
1992), 57 FR 56973, 56978 (Dec. 2, 1992) (Net Capital Rule).
\175\ Some broker-dealers utilize an ``omnibus clearing
arrangement,'' where the clearing firm maintains one account for all
of customer transactions of the introducing firm, rather than a
``fully disclosed introducing relationship.'' In an omnibus
arrangement, the clearing firm does not know the identity of the
customers of the introducing firm, whereas in a fully-disclosed
arrangement, the clearing/carrying firm knows the names, addresses,
securities positions, and other relevant data as to each customer.
See id. at 56978 n.16.
\176\ See proposed Rule 605(a)(7). For example, an introducing
broker-dealer that utilizes an omnibus clearing arrangement for
100,000 customer accounts and separately carries 50,000 customer
accounts would be considered, for purposes of proposed Rule 605, to
carry 150,000 customer accounts. In contrast, a broker-dealer who
introduces, on a fully-disclosed basis, 125,000 customer accounts
would be considered, for purposes of proposed Rule 605, to introduce
125,000 customer accounts. In both cases, the introducing broker-
dealers would exceed the proposed customer account threshold.
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Requiring both introducing broker-dealers and carrying broker-
dealers to prepare Rule 605 reports might result, in some instances, in
the same underlying order being reflected on multiple broker-dealers'
Rule 605 reports. However, Rule 605 does not require reports that
reflect execution quality on an order-by-order basis and the separate
reports would provide different views of execution quality specific to
the group of orders handled by each broker-dealer. Moreover, the
current structure of Rule 605 already contemplates that certain orders
may be reflected on more than one report, in the case of orders that
are received by one market center and then routed to another market
center for execution.\177\
---------------------------------------------------------------------------
\177\ See 17 CFR 242.605(a)(1).
---------------------------------------------------------------------------
Proposed Rule 605(a)(7) states that any broker or dealer that meets
or exceeds the customer account threshold and is also a market center
shall produce separate reports pertaining to each function. Therefore,
a broker-dealer that meets or exceeds the customer account threshold
and is also a market center would be required to produce one report
that includes all of the covered orders in NMS stocks that it received
for execution when acting as a market center and a separate report that
includes all of the covered orders in NMS stocks that it received for
execution when acting as a broker-dealer. Requiring a firm to produce
separate reports pertaining to its market center function and its
broker-dealer function would allow market participants and other
interested parties to view the firm's execution quality from the
perspective of how it operates in each of these separate roles.
This aspect of the proposal would not change how a firm should
determine when it is acting as a market center, as that term is defined
in Rule 600(b)(46).\178\ In particular, some firms that are larger
broker-dealers also act as OTC market makers, which are a type of
market center. Currently, to the extent that a dealer holds itself out
as being willing to buy from and sell to its customers, or others, in
the United States, an NMS stock for its own account on a regular or
continuous basis otherwise than on a national securities exchange in
amounts of less than a block size, that dealer is defined as an OTC
market maker.\179\ For example, if a broker-dealer executes certain
types of orders internally (e.g., fractional share orders, small-sized
orders, or orders in particular symbols), that broker-dealer may be
acting as an OTC market maker, and thus a market center, for those
specific types of orders. Moreover, Rule 605 requires that any report
pertaining to a market center include all covered orders that it
received for execution from any person, whether executed at the market
center or at any other venue.\180\ As is the case under Rule 605
currently for market centers that route orders away, under the
proposal, the fact that a larger broker-dealer has routed certain
covered orders away for execution would not alone be the basis on which
to determine that it did not act as a market center with respect to
those orders.\181\
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\178\ See 17 CFR 242.600(b)(46). The Commission is proposing to
renumber the definition of ``market center'' as proposed Rule
600(b)(56).
\179\ See supra note 28. See also Securities Exchange Act
Release No. 37619A (Sept. 6, 1996), 61 FR 48290, 48318-19 (Sept. 12,
1996) (Order Execution Obligations) (stating that dealers that
internalize customer order flow in particular stocks by holding
themselves out to customers as willing to buy and sell on an ongoing
basis would fall within the definition of ``OTC market maker'' as
defined in the predecessor to Rule 602 of Regulation NMS, even
though they may not hold themselves out to all other market
participants, and that dealers that hold themselves out to
particular firms as willing to receive customer order flow, and
execute those orders on a regular or continuous basis, also would
fall within the definition of an OTC market maker); id. at 48319
(stating that broker-dealers will not be considered to be holding
themselves out as regularly or continuously willing to buy or sell a
security if they occasionally execute a trade as principal to
accommodate a customer's request, and that, in response to the
suggestion of some commenters, the Commission has modified the
proposed amendment to the definition of ``OTC market maker'' to make
clear that more than an isolated transaction is necessary before a
dealer is designated an OTC market maker).
\180\ See 17 CFR 242.605(a)(1). We note that the staff has
provided their views on a way that a firm might determine the scope
of covered orders for which it acts as a market center, see Division
of Market Regulation: Staff Legal Bulletin No. 12R (Revised),
Question 4 (June 22, 2001), available at https://www.sec.gov/interps/legal/slbim12a.htm (``The Rule applies to broker-dealers
insofar as they act as a `market center' with respect to orders
received from other persons. Consequently, for orders in securities
for which Firm X does not act as an OTC market maker, Firm X would
not be acting as a market center in those securities and therefore
need not report on orders in those securities that it receives as an
agent and routes elsewhere for execution. Conversely, the orders
that Firm X receives from any person in the 500 securities in which
it acts as an OTC market maker (and therefore is a market center)
generally must be included in Firm X's monthly reports, even if Firm
X ultimately routes some of the orders to other market centers for
execution.''). Staff reports, Investor Bulletins, and other staff
documents (including those cited herein) represent the views of
Commission staff and are not a rule, regulation, or statement of the
Commission. The Commission has neither approved nor disapproved the
content of these staff documents and, like all staff statements,
they have no legal force or effect, do not alter or amend applicable
law, and create no new or additional obligations for any person.
\181\ See supra notes 143-144 and accompanying text.
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For a larger broker-dealer that is also a market center, the report
pertaining to its broker-dealer function would cover all orders that
the broker-dealer received for execution as part of its customer-facing
line of business, whether executed internally or routed away. An order
would need to be reflected on both the report regarding the firm's
market center function and the report regarding its broker-dealer
function, if the broker-dealer received the order from a customer and
also acts as a market center for that type of order. Each report would
provide a different view of the firm's execution quality based on a
different aspect of its business, and because reports reflect orders
grouped by symbol, order type, and size, would reflect different
execution quality metrics to the extent that the group of orders
covered by the different reports did not overlap completely.\182\
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\182\ For certain firms regarding certain symbols, order types,
or order sizes, the group of orders for which the firm acts as a
larger broker-dealer may overlap completely with the group of orders
for which the firm acts as a market center. However, broker-dealer
firms are structured in myriad different ways, and the degree of
overlap among reports might not remain stable over time; therefore,
requiring firms to produce reports according to the orders for which
they act as a market center and the orders for which they act as a
broker-dealer would help keep the reports consistent with firms'
lines of business.
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As proposed, pursuant to Rule 605(a)(7), a broker-dealer would be
excluded from Rule 605's reporting requirements only with respect to
its customer-facing broker-dealer function (as opposed to its function
as market center, if applicable) as long as the
[[Page 3799]]
number of customer accounts that it introduces or carries continues to
be less than the customer account threshold. A broker-dealer would no
longer be excluded from Rule 605 once and as long as it meets or
exceeds the customer account threshold; however, a broker-dealer that
meets or exceeds the customer account threshold for the first time
would have a grace period before being required to comply with Rule
605's reporting requirements, as described further below.
Proposed Rule 605(a)(7) states that a broker or dealer that meets
or exceeds the customer account threshold shall be required to produce
reports pursuant to this section for at least three calendar months
(``Reporting Period''). The Reporting Period would begin the first
calendar day of the next calendar month after the broker or dealer met
or exceeded the customer account threshold, unless it is the first time
the broker-dealer has met or exceeded the customer account
threshold.\183\ Any time after a broker or dealer has been required to
produce reports pursuant to this proposed section for at least a
Reporting Period, if a broker or dealer falls below the customer
account threshold, the broker or dealer would not be required to
produce a report pursuant to this paragraph for the next calendar
month.\184\ The Reporting Period would start on the first day of the
next calendar month after the customer account threshold has been
crossed because this timing would align with Rule 605's monthly
reporting period and avoid requiring broker-dealers to produce a report
that covers a partial month, which would be less comparable with the
monthly reports of other broker-dealers. Moreover, brokers-dealers that
may at times fall below the customer account threshold would be
required to produce reports pursuant to Rule 605 for at least three
calendar months, because this minimum reporting period would help
ensure a period of continuity in reporting. If instead a broker-dealer
could fluctuate in and out of being required to comply with the
reporting requirements from month-to-month, it would potentially be
disruptive to the broker-dealer to have to coordinate compliance with
the Rule on some months but not others and could interfere with
customers' or market participants' ability to look at a broker-dealer's
execution quality over time by analyzing historical data.\185\
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\183\ See proposed Rule 605(a)(7).
\184\ See id.
\185\ When discussing the 2018 amendments to Rule 605(a)(2) that
required market centers to keep Rule 605(a) reports posted on a
public website for a period of three years, the Commission stated
that it expected customers and the public to use the historical
information to compare information from the same time period. See
2018 Rule 606 Amendments Release, 83 FR 58338 (Nov. 19, 2018) at
58380 (also stating that, with respect to market centers voluntarily
posting Rule 605(a) reports that were created prior to the amended
rule's effectiveness, making historical data available to customers
and the public could be useful to customers or market participants
seeking to analyze such data).
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The Commission is proposing that, the first time a broker or dealer
has met or exceeded the customer account threshold, there would be a
grace period of three calendar months before the Reporting Period
begins and the broker or dealer must comply with the reporting
requirements of Rule 605.\186\ A limited three-month grace period is
appropriate because it would provide a broker-dealer that crosses the
customer account threshold for the first time with a period of time in
which to come into compliance with Rule 605's reporting requirements.
The three-month grace period would afford a broker-dealer adequate time
to develop the systems and processes and organize the resources
necessary to generate the reports pursuant to Rule 605, while still
requiring the broker-dealer to begin reporting without an overly long
delay. At the same time, should a broker-dealer subsequently fall below
the customer reporting threshold, the Commission preliminarily believes
that the broker-dealer should already have the necessary systems and
processes in place and therefore a grace period would not be necessary
if that broker-dealer again meets or exceeds the customer account
threshold and becomes subject to Rule 605's requirements. The
Commission notes that Rule 606 similarly provides for a three-month
grace period for brokers or dealers subject to Rule 606(b)(3)'s
reporting requirements for the first time only.\187\
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\186\ See proposed Rule 605(a)(7). After the three calendar
month grace period, the Reporting Period would begin on the first
calendar day of the fourth calendar month after the broker or dealer
has met or exceeded the customer account threshold. See id. As
described above, a broker-dealer that meets or exceeds the customer
account threshold would be required to produce Rule 605 reports for
at least a Reporting Period. See supra notes 183-184 and
accompanying text. Therefore, a broker-dealer that crosses the
customer account threshold for the first time would be required to
comply with the reporting requirements of Rule 605 for at least a
Reporting Period, even if that broker-dealer falls below the
customer account threshold during the grace period.
\187\ See 17 CFR 242.606(b)(4).
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Rule 605 requires that reporting entities calculate certain
statistics based on the time of order receipt.\188\ Moreover,
Regulation NMS defines ``time of order receipt'' based on the time an
order was received by a market center for execution.\189\ In
conjunction with the proposed expansion of Rule 605 to cover larger
broker-dealers, it is necessary to modify this definition to specify
how broker-dealers that are not acting as market centers would be
required to calculate ``time of order receipt.'' The Commission has
considered requiring broker-dealers to calculate the ``time of order
receipt'' based on the time that the broker-dealer received the order
or on the time that the broker-dealer transmitted the order to a market
center for execution. Measuring ``time of order receipt'' based on when
a broker-dealer received the order would provide a view of how that
broker-dealer handled that order from the time the order was within its
control, rather than limiting that view to what happened after the
broker-dealer sent the order to a particular market center for
execution. In this way, calculating execution quality statistics based
on the time that a broker-dealer received the order could provide
information about whether a broker-dealer's delay in sending the order
to a market center for execution may have affected the execution
quality obtained for that order, because the execution quality
statistics would be measured based on the prevailing market prices at
that time.\190\ Accordingly, the Commission is proposing to modify the
definition of ``time of order receipt'' to specify that, in the case of
a broker or dealer that is not acting as a market
[[Page 3800]]
center, the time of order receipt is the time that the order was
received by the broker or dealer for execution.\191\
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\188\ See, e.g., 17 CFR 242.605(a)(1)(ii)(D) (measuring, for
shares executed with price improvement, the share-weighted average
period from the time of order receipt to the time of order
execution).
\189\ See 17 CFR 242.600(b)(92). See also Adopting Release, 65
FR 75414 (Dec. 1, 2000) at 75423 (``The definition [of `time of
order receipt'] is intended to identify the time that an order
reaches the control of the market center that is expected, at least
initially, to execute the order.''). The Commission is proposing to
renumber the definition of ``time of order receipt'' as proposed
Rule 600(b)(109).
\190\ When adopting Rule 605, the Commission stated that a
market center will use the time and consolidated BBO at the time it
received the order, rather than the time and consolidated BBO when
the venue to which an order was forwarded received the order, to
calculate the required statistics. See Adopting Release, 65 FR 75414
(Dec. 1, 2000) at 75423. The Commission stated that a market center
should be held accountable for all orders that it receives for
execution and should not be given an opportunity to exclude
difficult orders by routing them to other venues, and that from the
customer's perspective the fact that a market center chooses to
route the order elsewhere does not reduce the customer's interest in
a fast execution that reflects the consolidated BBO as close to the
time of order submission as possible. See id. This same reasoning
applies to orders that a broker-dealer receives and then routes to
another venue for execution, and supports measuring the time of
order receipt from the time that the broker-dealer receives the
order.
\191\ See proposed Rule 600(b)(109). The time that the order is
received by the market center for execution should be the same as
the time that the order is received by the broker-dealer for
execution when the broker-dealer also acts as a market center for
that order.
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The Commission is mindful that some of Rule 605's execution quality
statistics may as a general matter differ for the larger broker-
dealers, as compared to market centers, to the extent that some of
these larger broker-dealers generally or exclusively route orders away.
However, it is appropriate for broker-dealers to report on the same
execution quality statistics as market centers because the reported
statistics can be understood in the context of the specific reporting
entity, and the detailed execution quality statistics would allow
customers and other market participants to parse the differences among
the statistics for each reporting entity. For example, Rule 605
requires statistics for the number of shares executed at the receiving
market center and the number of shares executed at any other
venue.\192\ As discussed above, broker-dealers that generally route the
orders that they receive to other venues for execution, and thereby
would report these shares as being executed at another venue, may
execute certain portions of their order flow internally (e.g.,
fractional shares).\193\ While the Commission considered whether or not
broker-dealers should be required to provide execution quality
statistics for both shares executed at the receiving broker-dealer and
shares executed at any other venue, the Commission decided to propose
to keep both of these statistics in the Rule 605 reporting requirements
for broker-dealers so as to capture all orders that broker-dealers
receive for execution as part of their customer-facing broker-dealer
function.\194\ Further, differences in certain statistics for broker-
dealers as compared to market centers may be more reflective of
differences in business models rather than effectiveness in achieving
execution quality for covered orders because of differences in order
handling practices. The Commission understands that these differences
are well-known and are taken into account by market participants when
evaluating execution quality statistics. For example, broker-dealers
that route customer orders may have consistently longer time to
executions as compared to market centers for similar orders, because of
the time it takes to route these orders, but this difference is well
understood by market participants.
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\192\ See 17 CFR 242.605(a)(1)(i)(D) and (E). As discussed
herein, the Commission is proposing to modify Rule 605(a)(1)(i)(D)
to also cover the number of shares executed at the receiving broker
or dealer. See supra note 155 and accompanying text.
\193\ See supra note 34 and accompanying text.
\194\ If a broker-dealer does not execute any covered orders
internally, then that broker-dealer's Rule 605 report would not
reflect any shares executed at the receiving broker-dealer. For
discussion of what orders broker-dealers that are market centers
would include in their reports pertaining to their market center
function, see supra notes 178-180 and accompanying text.
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The Commission is also mindful that, for orders routed to other
venues for execution, broker-dealers may not have all of the
information needed to calculate the proposed statistics at the time of
order execution. However, these broker-dealers should be able to obtain
the needed information in time to prepare the required reports. Broker-
dealers would need to calculate their execution quality statistics, or
engage a vendor to calculate the statistics on their behalf, on a
monthly basis. At the time that the broker-dealer or its vendor would
need to calculate the execution quality statistics, the broker-dealer
would have received any needed information about the order's execution
from the execution venue and be able to obtain any needed historical
price information from publicly available data sources, such as the
exclusive plan processors (``exclusive SIPs'').\195\ For example, a
broker-dealer that routed an order away for execution would receive
time of order execution and execution price as part of the trade
confirmation provided by the execution venue. The broker-dealer could
then use historical price information available via the exclusive SIPs
to determine the NBBO at the time of order receipt and at the time of
order execution, the number of shares displayed at the NBBO, and the
best available displayed price, if such price is being disseminated,
and use this data to calculate the required execution quality
statistics.\196\
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\195\ See MDI Adopting Release, 86 FR 18596 (Apr. 9, 2021) at
18598-99 (describing that the exclusive SIPS, among other things,
disseminate core data, which currently consists of: (1) the price,
size, and exchange of the last sale; (2) each exchange's current
highest bid and lowest offer and the shares available at those
prices; and (3) the NBBO). A securities information processor
(``SIP'') is defined in section 3(a)(22)(A) of the Exchange Act. See
15 U.S.C. 78c(a)(22)(A). Further, an ``exclusive processor'' (also
known as an exclusive SIP) is defined in section 3(a)(22)(B) of the
Exchange Act. See 15 U.S.C. 78c(a)(22)(B).
\196\ With respect to NMLOs, the broker-dealer could also use
this historical price information available via the exclusive SIPs
to determine when the order became executable, based on when the
NBBO first reached the order's limit price.
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Request for Comment
The Commission seeks comment generally on the proposed expansion of
Rule 605 reporting requirements to include larger broker-dealers that
meet or exceed the customer account threshold, as well as the other
proposed changes to Rule 605 and Rule 600(b) discussed above. In
particular, the Commission solicits comment on the following:
1. Should Rule 605 be expanded to apply to broker-dealers? Why or
why not? Do commenters agree that it would be useful for customers of
certain broker-dealers to be able to access execution quality
statistics that are specific to those broker-dealers, rather than
needing to rely on the execution quality statistics reported by the
market centers to which the broker-dealers route? Do commenters agree
that market centers may provide different execution quality to orders
based on the routing broker-dealer? Please explain and provide data.
2. Do commenters agree that it would be useful for broker-dealers
that are also market centers to produce separate reports pertaining to
each function? Why or why not? Do commenters agree that broker-dealers
that are also market centers should be required to include in the
report pertaining to their market center function all covered orders
for which they act as a market center, including as an OTC market
maker, rather than only those covered orders executed at the market
center? Do commenters agree that broker-dealers that are also market
centers should be required to include in the report pertaining to their
broker-dealer function all of the covered orders in NMS stocks that
they received for execution from any customer, rather than only those
orders that do not pertain to their market center function (i.e., those
orders for which they do not act as a market center)? Would broker-
dealers that are also market centers encounter any specific
difficulties when determining which orders to include in each report?
Please explain.
3. Is a numerical customer account threshold the proper criterion
for determining whether a broker-dealer should be subject to the Rule
605 reporting requirements? If so, is 100,000 or more customer accounts
the appropriate amount? Why or why not? If not, should be it higher or
lower (e.g., 500,000 or more customer accounts or 10,000 or more
customer accounts)? If so, by what amount? Is it appropriate to
consider both the number of customer accounts that the broker-dealer
carries and the number of customer accounts
[[Page 3801]]
that the broker-dealer introduces? Why or why not? Do commenters
believe that it would be more useful to consider the trading volume,
either based on share volume or notional volume, or both, of a broker-
dealer's customers when setting the reporting threshold? Why are why
not? Please explain and provide data to support your argument. Are
there alternative approaches that the Commission should adopt in
expanding Rule 605's reporting requirements to broker-dealers? If so,
please explain the approach in detail, including the benefits and costs
of the approach.
4. Should the Commission require all broker-dealers to report
pursuant to Rule 605 irrespective of the number of customer accounts
that the broker-dealer carries or introduces? Or should such a
requirement be subject to a de minimis exclusion? Why or why not? If
so, what would be an appropriate de minimis exclusion? Please explain
and provide data, if possible.
5. Is three months an appropriate timeframe to use for the
Reporting Period, i.e., the minimum length of time for which a broker-
dealer would need to comply with Rule 605's reporting requirements once
its number of customer accounts meets or exceeds the customer account
threshold? Would a shorter or longer time period (e.g., one, two or six
months) be more appropriate? If so, by what amount? Does whether or not
a broker-dealer uses or could use an outside vendor to prepare reports
pursuant to Rule 605 affect this answer? Please explain.
6. Is three months an appropriate grace period from Rule 605's
reporting requirements for a broker-dealer that has met or exceeded the
customer account threshold for the first time? Would a shorter or
longer time period be more appropriate (e.g., one month, two months, or
six months)? Do commenters agree that a grace period would not be
necessary for broker-dealers that have previously equaled or exceeded
the customer account threshold, but subsequently have fallen below the
threshold and stopped reporting and then need to restart reporting? If
not, what grace period do commenters think would be appropriate? Would
one month be sufficient in this context? Are there any other
circumstances in which a broker-dealer that has met or exceeded the
customer account threshold would need an additional grace period from
Rule 605's reporting requirements? Please explain.
7. Should a broker-dealer that is not a market center be required
to calculate time of order receipt based on when that broker-dealer
received the order? Why or why not? Would it be more useful to
customers or other market participants for a broker-dealer that
generally routes customer orders to calculate time of order receipt
based on when that broker-dealer sent the order to a market center for
execution? Please explain and provide data, if possible.
8. Should broker-dealers be required to produce all of the detailed
execution quality statistics set forth in Rule 605? Why or why not? Do
commenters agree that broker-dealers' customers and other market
participants would be able to interpret differences in these execution
quality statistics among reporting entities that may be attributable to
the context of their different types of business? Do commenters believe
that there are any additional execution quality statistics that would
be useful to require of broker-dealers? Please explain and provide
data, if possible.
9. Would it be difficult for broker-dealers to obtain any of the
information needed to calculate the Rule 605 statistics? Why or why
not? If so, which statistics in particular? Would broker-dealers have
some or all of the information needed to calculate their Rule 605
statistics already, including to meet their obligations to assess
whether they are providing best execution for these orders? Do
commenters agree that broker-dealers would be able to obtain needed
information from the execution venues to which they routed the orders
or publicly available sources? Should the Commission exclude certain
proposed execution quality statistics that are specific to certain
order types, such as executable NMLOs? Why or why not? Please explain.
B. Qualified Auction Mechanisms
Separately, the Commission is proposing rules that generally would
require that individual investor orders be exposed to order-by-order
competition in fair and open auctions designed to obtain the best
prices before such orders could be internalized by wholesalers or any
other type of trading center that restricts order-by-order
competition.\197\ Under those proposed rules, a restricted competition
trading center would not be allowed to execute internally a segmented
order for an NMS stock until after a broker or dealer has exposed such
order to competition at a specified limit price in a qualified auction
that meets certain requirements and is operated by an open competition
trading center.\198\ An ``open competition trading center'' would be a
national securities exchange or NMS Stock ATS that meets certain
requirements, including being transparent and having a substantial
trading volume in NMS stocks independent of qualified auctions.\199\ A
``qualified auction'' would be an auction operated by an open
competition trading center pursuant to specified requirements that are
designed to achieve competition.\200\
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\197\ For a full description and discussion of the order
competition rule proposal, see Securities Exchange Act Release No.
96495 (Dec. 14, 2022) (File No. S7-31-22) (Order Competition Rule)
(``Order Competition Rule Proposal''); proposed Rule 615.
\198\ See Order Competition Rule Proposal; proposed Rule
600(b)(87) (defining ``restricted competition trading center'');
proposed Rule 600(b)(91) (defining ``segmented order''); proposed
Rule 615(a) (describing the order competition requirement).
\199\ See Order Competition Rule Proposal; proposed Rule
600(b)(64) (defining ``open competition trading center'').
\200\ See Order Competition Rule Proposal; proposed Rule
600(b)(81) (defining ``qualified auction''); proposed Rule 615(c)
(setting forth requirements for operation of a qualified auction).
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If the Commission adopts the Order Competition Rule Proposal and a
national securities exchange or NMS Stock ATS that serves as an open
competition trading center is required to prepare execution quality
reports under current Rule 605, that national securities exchange or
NMS Stock ATS would be required to include covered orders that it
received for execution in a qualified auction within its blended
executing quality statistics, which also would include trading activity
outside of the qualified auctions.\201\
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\201\ As discussed further below, the Commission is proposing to
eliminate the separate reporting categories for inside-the-quote
limit orders, at-the-quote limit orders, and near-the-quote limit
orders, and create new reporting categories for executable NMLOs and
beyond-the-midpoint limit orders. See infra sections IV.B.2.(a) and
IV.B.2.(b). While, as proposed, orders submitted to qualified
auctions may in many instances be classified as beyond-the-midpoint
limit orders, this reclassification would not resolve the
Commission's concern about blending execution quality statistics for
orders executed in qualified auctions with orders executed outside
of these auctions.
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The Commission is concerned that there may be differences in
execution quality for orders executed within proposed qualified
auctions, as compared to other orders executed by market centers
outside of these qualified auctions, that would not be apparent in
blended execution quality statistics. For example, orders submitted to
a qualified auction may be more or less likely to receive price
improvement, and may have systematically different fill rates, as
compared to similar orders executed in other trading mechanisms. In
addition, the Order Competition Rule Proposal would propose both a
minimum and maximum time period for
[[Page 3802]]
the qualified auction.\202\ Therefore, the time to execution statistics
for orders submitted to a qualified auction may be systematically
different from the time to execution statistics of other orders
executed at a market center. Further, if a market center receives
covered orders for execution in a qualified auction, then that market
center would not have discretion about whether to submit these orders
into a qualified auction and therefore the distinction between orders
executed by the market center within and outside of a qualified auction
would not reflect any decision-making on the part of the market center.
Thus, it would be more useful for market participants to be able to
review execution quality statistics that are specific to covered orders
submitted to a qualified auction.
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\202\ See Order Competition Rule Proposal; proposed Rule
615(c)(2).
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Accordingly, the Commission is proposing to amend Rule 605(a)(1) to
state that market centers that operate a qualified auction must prepare
a separate report pursuant to Rule 605 pertaining only to covered
orders that the market center receives for execution in a qualified
auction.\203\ This proposed requirement for separate reports is limited
to market centers that operate proposed qualified auctions, and would
not extend to market centers or broker-dealers that route orders away
for execution in a qualified auction. Therefore, a market center or
broker-dealer that routes covered orders to an open competition trading
center for execution within a proposed qualified auction would not be
required to separately report on or otherwise distinguish orders routed
to qualified auctions from other types of orders routed away for
execution in its Rule 605 reports.\204\ In this way, the proposal would
follow current Rule 605's focus on the overall execution quality that
the reporting entity provided to all covered orders that it received
for execution.\205\ Having market centers and broker-dealers report on
the execution quality provided to orders, regardless of where they are
executed, would inform market participants and other observers about
overall execution quality that the market center or broker-dealer is
able to obtain, including when the market center or broker-dealer
decides whether and where to route orders to receive such executions.
Further, distinctions between whether an order was routed to a
qualified auction or not may depend on the characteristics of the
order, such as whether it is a segmented order, rather than the
performance of the market center or broker-dealer that routed the
order. As such, it would be of more limited utility to have a market
center or broker-dealer that routes orders to a qualified auction to
produce a separate Rule 605 report specific to such orders.
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\203\ See proposed Rule 605(a)(1).
\204\ If a larger broker-dealer is also a market center and its
market center operates a qualified auction mechanism, that aspect of
the market center would be subject to the separate reporting
requirement.
\205\ For example, currently Rule 605 does not require market
centers to distinguish among covered orders routed to particular
types of away market centers. Instead, a market center's execution
quality statistics are blended statistics pertaining to all covered
orders that the market center received for execution, with the
limited exception of the statistics for cumulative number of shares
of covered orders executed at the receiving market center and at any
other venue. See 17 CFR 242.605(a)(1).
---------------------------------------------------------------------------
Although market centers and broker-dealers would not be required to
produce a separate Rule 605 report pertaining to orders that they route
to a qualified auction, Rule 606 requires routing broker-dealers to
disclose certain regularly-used execution venues to which they route
orders, and a report prepared by a broker-dealer pursuant to Rule 606
would be required to indicate that orders were routed to a particular
qualified auction.\206\ A customer of a broker-dealer could then
analyze whether and to what extent the broker-dealer routes to a
particular market center's qualified auctions (using reports prepared
pursuant to Rule 606), and evaluate the execution quality provided by
that market center's qualified auctions (using reports prepared
pursuant to Rule 605).
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\206\ See 17 CFR 242.606(a)(1). For example, if a broker-dealer
operates an ATS and that ATS has qualified auctions and a continuous
order book, the broker-dealer's Rule 606 report would be required to
disclose information about orders that were routed to the ATS's
qualified auctions separately from orders that were sent directly to
the ATS's continuous order book.
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The Commission considered extending the proposed requirement for
separate Rule 605 reports beyond proposed qualified auctions to include
orders submitted to any trading mechanism that seeks to provide
liquidity to the orders of individual investors. For example, several
national securities exchanges operate retail liquidity programs.\207\
However, in the Order Competition Rule Proposal the Commission is
proposing a prohibition on certain facilities that are limited, in
whole or in part, to the execution of segmented orders and this
prohibition would apply to many of the retail liquidity programs
currently operated by national securities exchanges.\208\
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\207\ Retail liquidity programs are programs for retail orders
seeking liquidity that allow market participants to supply liquidity
to such retail orders by submitting undisplayed orders priced at
least $0.001 better than the exchange's protected best bid or offer.
Each program results from a Commission approval of a proposed rule
change made on Form 19b-4 combined with a conditional exemption,
pursuant to section 36 of the Exchange Act, from 17 CFR 242.612 (the
``Sub-Penny Rule'') to enable the exchange to accept and rank (but
not display) the sub-penny orders. See, e.g., Securities Exchange
Act Release Nos. 85160 (Feb. 15, 2019), 84 FR 5754 (Feb. 22, 2019)
(SR-NYSE-2018-28) (approving the NYSE retail liquidity program on a
permanent basis and granting the exchange a limited exemption from
the Sub-Penny Rule to operate the program); 86194 (June 25, 2019),
84 FR 31385 (July 1, 2019) (SR-BX-2019-011) (approving Nasdaq BX,
Inc.'s retail price improvement program on a permanent basis and
granting the exchange a limited exemption from the Sub-Penny Rule to
operate the program).
\208\ See Order Competition Rule Proposal. The Commission
discusses a number of alternatives in the Order Competition Rule
Proposal. See id. To the extent that any retail liquidity program is
retained, separate execution quality statistics specific to orders
submitted to those programs may be useful to investors.
---------------------------------------------------------------------------
Request for Comment
The Commission seeks comment on the proposal to require a market
center that operates a qualified auction to prepare a separate report
under Rule 605 for covered orders that were submitted to a qualified
auction if the Order Competition Rule Proposal is adopted. In
particular, the Commission solicits comment on the following:
10. Should market centers that operate a proposed qualified auction
be required to prepare a separate Rule 605 report for covered orders
that are submitted to their qualified auctions? Why or why not? Do
commenters agree with limiting this separate reporting requirement to
market centers that operate a proposed qualified auction, and not to
either broker-dealers that are not market centers or market centers
that do not operate a qualified auction? Please explain.
11. Should this separate reporting requirement be limited to a
trading mechanism that meets the proposed requirements for a
``qualified auction''? Would it be more useful if a market center
prepared a separate report for covered orders submitted to any trading
mechanism that seeks to provide liquidity to the orders of individual
investors (e.g., a national securities exchange's retail liquidity
program), whether or not that trading mechanism operates a ``qualified
auction''?
12. Do commenters believe that there are any additional execution
quality statistics that would be useful to require of a market center
that operates a proposed qualified auction to facilitate comparison
among different qualified auctions? For example, would it be useful for
a market center that operates a proposed qualified auction to provide
data on any price improvement provided in the qualified auction as
[[Page 3803]]
measured in relation to any additional price matching offered by the
wholesaler that routed the order to the qualified auction? Please
explain and provide data, if possible.
C. ATSs and Single-Dealer Platforms
Currently under Rule 605, firms that operate two separate markets
must prepare separate reports for each market center.\209\ For example,
for a firm that acts both as an exchange market maker and as an OTC
market maker, each function would be considered a separate market
center and Rule 605 requires the firm to prepare separate reports. The
requirement to produce separate Rule 605 reports for separate markets
allows market participants to assess the execution quality of each
market individually, and prevents differences in the nature of each
market from obscuring information about execution quality.
---------------------------------------------------------------------------
\209\ See 17 CFR 242.605(a)(1) (requiring ``every'' market
center to produce a report). See also Plan, at n.1 (``An entity that
acts as a market maker in different trading venues (e.g., as
specialist on an exchange and as an OTC market maker) would be
considered as a separate market center under the Rule for each of
those trading venues. Consequently, the entity should arrange for a
Designated Participant for each market center/trading venue (e.g.,
an exchange for its specialist trading and an association for its
OTC trading).''). For a description of ``Designated Participant'' as
defined in the Plan, see supra note 47.
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Regulation ATS requires each ATS to register as a broker-
dealer.\210\ Many broker-dealers that operate NMS Stock ATSs have
separate lines of business that are distinct from their ATSs, yet also
relate to the trading of NMS stocks.\211\ In addition, one EMSAC
panelist suggested that the Commission require all ATSs and dark pools
(i.e., ATSs that do not publish quotations) to report separately from
their affiliated broker-dealers under Rule 605.\212\ The Commission
believes there is a need to address directly what Rule 605 requires
with respect to reporting by firms that operate ATSs. By specifying
that a broker-dealer that operates an ATS must produce Rule 605 reports
that are specific to the ATS and separate from the broker-dealer
operator's other trading activity, the Commission intends to increase
transparency and regulatory compliance. Accordingly, the Commission
proposes to specify in Rule 605(a)(1) that ATSs (as defined in
Regulation ATS \213\) shall prepare reports separately from their
broker-dealer operators, to the extent such entities are required to
prepare reports.\214\
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\210\ See 17 CFR 242.301(b)(1). 17 CFR 242.301 through 17 CFR
242.304 is generally known as ``Regulation ATS.''
\211\ See, e.g., Securities Exchange Act Release No. 83663 (July
18, 2018), 83 FR 38768, 38771 (Aug. 7, 2018) (Regulation of NMS
Stock Alternative Trading Systems) (stating that ATSs that trade NMS
stocks are increasingly operated by multi-service broker-dealers
that engage in significant brokerage and dealing activities in
addition to operation of their ATS, and that, for instance, the
broker-dealer operator of an NMS Stock ATS may also operate an OTC
market making desk or principal trading desk, or may have other
business units that actively trade NMS stocks on a principal or
agency basis in the ATS or at other trading centers).
\212\ See Healthy Markets II at 2. See also Healthy Markets III
at 4 (recommending that the Commission modernize and mandate Rule
605 disclosure for all NMS ATS operators separate and distinct from
any affiliated broker-dealer). Additionally, a commenter to the
Concept Release on Equity Market Structure recommended that the
Commission require all ATSs and dark pools to report under Rule 605.
See KOR Group I at 3.
\213\ 17 CFR 242.300 et seq.
\214\ See proposed Rule 605(a)(1).
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Some OTC market makers, such as wholesalers, operate SDPs through
which they execute institutional orders in NMS stocks against their own
inventory.\215\ Institutional customers often communicate their trading
interest using immediate-or-cancel orders (``IOCs'') or IOIs on
SDPs.\216\ SDPs account for a nontrivial amount of trading volume
overall (for example, SDPs accounted for approximately 4% of total
trading volume in Q1 2022) and a significant portion of trading volume
executed by wholesalers.\217\ Co-mingling SDP activity with other
market center activity in Rule 605 reports may obscure differences in
execution quality or distort the general execution quality metrics for
the market center.\218\ It would be useful if SDPs reported execution
quality statistics separately from those of their associated broker-
dealer under Rule 605, so that their customers and other market
participants would be able to distinguish SDP activity from more
traditional dealer activity. Separate statistics may be particularly
useful if a dealer provides an SDP (i.e., a separate routing
destination for the execution of orders) for a particular group of
customers or type of orders. Therefore, the Commission is proposing to
require in Rule 605(a)(1) that any market center that provides a
separate routing destination that allows persons to enter orders for
execution against the bids and offers of a single dealer shall produce
a separate report pertaining only to covered orders submitted to such
routing destination.\219\
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\215\ Wholesalers and other OTC market makers either execute
orders themselves or instead further route the orders to other
venues. An SDP always acts as the counterparty to any trade that
occurs on the SDP. See, e.g., Where Do Stocks Trade?, FINRA.org
(Dec. 3, 2021), available at https://www.finra.org/investors/insights/where_do_stocks_trade for further discussion.
\216\ See infra note 615 and accompanying text.
\217\ See infra notes 618 and 769 and accompanying text.
\218\ For example, IOC orders typically have different execution
profiles than other types of orders, including lower fill rates, and
therefore including orders submitted to a market center's SDP with
its other orders will effect a downwards skew on the market center's
fill rates. See infra note 723 and accompanying text; Table 6.
\219\ See proposed Rule 605(a)(1). To the extent that a
reporting firm produces more than one Rule 605 report, the firm
could label each report with the type of business reflected on the
report. As discussed above, the Commission proposes to expand the
scope of Rule 605 to include larger broker-dealers. See supra
section III.A. It is possible that firms would need to prepare
several Rule 605 reports if they are both a larger broker-dealer and
a market center and need to prepare more than one report as a market
center, pursuant to proposed Rule 605(a)(1).
---------------------------------------------------------------------------
Request for Comment
The Commission seeks comment on the proposal to specify that an ATS
must produce reports separately from its broker-dealer operator, and to
require that any market center that provides a separate routing
destination that allows persons to enter orders against the bids and
offers of a single dealer must produce separate reports pertaining to
orders submitted to that routing destination. In particular, the
Commission solicits comment on the following:
13. Is it useful for an ATS to produce reports pursuant to Rule 605
that are specific to covered orders submitted to the ATS and separate
from orders submitted in connection with other trading activity of its
broker-dealer operator? Why or why not?
14. Should a broker-dealer operating an SDP be required to produce
reports pursuant to Rule 605 that are specific to orders sent to that
routing destination and separate from other trading activity by that
dealer, as proposed? Why or why not? Do commenters agree that the
description of ``a market center that provides a separate routing
destination that allows persons to enter orders for execution against
the bids and offers of a single dealer'' accurately describes SDPs? If
not, what is a more accurate description of an SDP? Please explain.
IV. Proposed Modifications to Scope of Orders Covered and Required
Information
Rule 605 reports group orders by both order size and order type,
and require certain standardized information for all types of orders
and additional information for market orders and marketable limit
orders. The Commission is proposing to modify the order size and order
type groupings, and is proposing to make changes to the required
information for: all types of orders; market and marketable limit
[[Page 3804]]
order types; and nonmarketable order types. The modifications described
below would apply to Rule 605 reports produced by all reporting
entities, including larger broker-dealers.
A. Covered Order
The Commission proposes to expand the definition of ``covered
order'' in a number of ways.\220\ The Commission proposes to include
certain orders received outside of regular trading hours and orders
submitted with stop prices. Additionally, the Commission is addressing
whether Rule 605 requires non-exempt short sale orders to be
incorporated into Rule 605 reporting when a price test restriction is
in effect for the security.
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\220\ See proposed Rule 600(b)(30).
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1. Orders Submitted Pre-Opening/Post-Closing
Currently, Rule 605 reports are required to include only orders
received during regular trading hours \221\ at a time when an NBBO is
being disseminated. The Commission excluded orders submitted during the
pre-opening or after the close, among other order types, from the scope
of reporting because nearly all of Rule 605's statistical measures
required the availability of the NBBO at the time of order receipt as a
benchmark.\222\ At the time of adoption, the Commission stated that
there are substantial differences in the nature of the market between
regular trading hours and after-hours, and orders executed at these
times should not be blended together in the same statistics.\223\
Similarly, orders for which customers requested special handling,
including orders to be executed at a market opening price, are excluded
from Rule 605 reports because their inclusion would skew the general
statistics.\224\
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\221\ ``Regular trading hours'' is defined as the time between
9:30 a.m. and 4:00 p.m. Eastern Time, or such other time as is set
forth in the procedures established pursuant to 17 CFR
242.605(a)(2). See 17 CFR 242.600(b)(77). The Commission is
proposing to renumber the definition of ``regular trading hours'' as
proposed Rule 600(b)(91).
\222\ See Adopting Release, 65 FR 75414 (Dec. 1, 2000) at 75421.
\223\ See id., text accompanying note 39. Specifically, the
Commission stated that the average quoted spread, average effective
spread, and trade price volatility increased significantly for
certain securities after the close of regular trading hours. See id.
at n.39.
\224\ See id. at 75421.
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Market participants submit limit orders prior to market open, and
these orders are not captured in current Rule 605 reports.\225\
Although NMLOs submitted outside of regular trading hours may represent
a relatively small percentage of NMLO orders overall, pre-open NMLO
submission volume includes a higher concentration of individual
investor orders.\226\ In order to provide increased visibility into
execution quality for individual investor orders, including those
submitted outside of regular trading hours, the Commission proposes to
expand the scope of Rule 605 reporting to include certain NMLOs
submitted outside of regular trading hours if they become executable
after the opening or reopening of trading during regular trading
hours.\227\ The Commission is proposing to expand the definition of
``covered order'' to include any NMLO received by a market center,
broker, or dealer outside of regular trading hours or at a time when a
national best bid and national best offer is not being disseminated
and, if executed, is executed during regular trading hours.\228\ As
discussed below, the Commission is proposing that NMLOs would be
benchmarked from the time they become executable rather than the time
of order receipt.\229\ The executability of limit orders that are
received while an NBBO is not being disseminated would be determined
with reference to the opening or re-opening price of the security. This
would allow market participants to evaluate execution performance for
NMLOs submitted outside of regular trading hours if they become
executable during regular trading hours.
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\225\ See supra notes 123-125 and accompanying text (commenter
to 2018 Rule 606 Amendments and petitioner for rulemaking
recommending inclusion of orders submitted prior to market open).
\226\ Analysis of CAT data found that NMLOs submitted prior to
open and designated as only able to execute during regular hours
make up only a small percentage of order flow when compared to a
sample 10-minute window of NMLOs submitted during regular hours.
However, the analysis shows that individual investor orders are
relatively concentrated in order flow submitted outside of regular
market hours. Specifically, pre-open submission volume contains a
larger percentage of individual investor shares than the sample time
window during regular trading hours, at least for off-exchange
market centers. See infra notes 672-673 and accompanying text.
\227\ See proposed Rule 600(b)(20) (defining ``categorized by
order type'' to include executable NMLOs and executable orders
submitted with stop prices).
\228\ See proposed Rule 600(b)(30).
\229\ See infra section IV.B.2.(a).
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The Commission proposes to amend the definition of ``marketable
limit order'' to specify that the marketability of an order received
when the NBBO is not being disseminated would be determined using the
NBBO that is first disseminated after the time of order receipt.
Specifically, the Commission proposes that an order received at a time
when a national best bid and national best offer is not being
disseminated would be a marketable limit order if it is a buy order
with a limit price equal to or greater than the national best offer at
the time that the national best offer is first disseminated during
regular trading hours after the time of order receipt, or if it is a
sell order with a limit price equal to or less than the national best
bid time at the time that the national best bid is first disseminated
during regular trading hours after the time of order receipt.\230\
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\230\ See proposed Rule 600(b)(57).
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Any limit order received outside of regular trading hours or during
a trading halt that is marketable based on the first disseminated NBBO
during regular trading hours after the time of order receipt would not
be a covered order for purposes of Rule 605.\231\ The Commission's
proposed definition excludes market orders and marketable limit orders
submitted prior to open or during a trading halt because such orders
would generally execute at the opening or re-opening price. Therefore,
their inclusion in general market and marketable limit order statistics
would skew both time to execution statistics and other measures of
execution quality if aggregated with market and marketable limit orders
received during regular trading hours. While including market and
marketable limit orders submitted prior to open or during a trading
halt within the definition of covered order and requiring that the
execution statistics for these types of orders be reported as a
separate order type category would avoid the concern about skewed
statistics, it would add to the complexity of the report.
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\231\ For example, a market or marketable limit order that is
not received by a market center or broker-dealer during regular
trading hours at a time when the NBBO is being disseminated would
not be a covered order under proposed Rule 600(b)(30). In addition,
the covered order definition would continue to exclude any order for
which the customer requests special handling for execution,
including orders to be executed at a market opening price, see
proposed Rule 600(b)(30), and therefore market-on-open (``MOO'')
orders and limit-on-open (``LOO'') orders would be excluded.
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The current definition of covered order includes orders received
during regular trading hours while an NBBO is being disseminated but
before the primary listing market has disseminated its first quotations
in the security. Prior to a primary listing market disseminating its
first quotations in a security, disseminated quotations often reflect
spreads that vary significantly from the norm.\232\ To prevent such
quotations from skewing the execution quality statistics, the
Commission exempted orders from inclusion in Rule
[[Page 3805]]
605 reports that are received prior to the dissemination of the primary
listing market's first firm, uncrossed quotations for a trading day
(``Opening Exemption'').\233\ With respect to orders received during
regular trading hours but before the primary listing market has
disseminated its first firm, uncrossed quotation, the Commission
continues to believe, for the same reasons it granted this exemption,
that including such orders could distort execution quality statistics.
Therefore, the Commission is proposing to incorporate this exemptive
relief into the proposed definition of covered order with respect to
market or limit orders received during regular trading hours at a time
when an NBBO is being disseminated.\234\ However, pursuant to the
proposed amendments to Rule 605, NMLOs (including orders submitted with
stop prices) received outside of regular trading hours or at a time
when an NBBO is not being disseminated could be considered covered
orders, provided the NMLOs were not executed outside of regular trading
hours.\235\ Inclusion of these orders in Rule 605 reports would be
useful to market participants, even though such orders necessarily
would be received before the primary listing market has disseminated
its first firm, uncrossed quotation and thus fall within the scope of
the Opening Exemption. Because the Commission is proposing to
incorporate the exemptive relief reflected in the Opening Exemption
into the Rule with respect to market or limit orders received during
regular trading hours, but believes it would be useful to include the
NMLOs described above in Rule 605 reports, the Commission is also
proposing to rescind the Opening Exemption.\236\
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\232\ See Letter from Annette L. Nazareth, Director, Division of
Market Regulation to Theodore Karn, President, Market Systems, Inc.,
dated June 22, 2001 (``Market Systems Exemptive Letter'') at 2.
\233\ See id. (exemption from reporting under Rule 11Ac1-5, the
predecessor to Rule 605). In addition to the Opening Exemption, the
Market Systems Exemptive Letter included a separate exemption from
the Rule for orders received during a time when the consolidated BBO
reflects a spread that exceeds $1 plus 5% of the midpoint of the
consolidated BBO (``Spread Width Exemption'').
\234\ See proposed Rule 600(b)(30).
\235\ See id.
\236\ Because the Spread Width Exemption is not inconsistent
with the proposed amendments to Rule 605, the Commission would not
rescind the Spread Width Exemption. The Commission continues to
believe that orders received during a time when the consolidated BBO
reflects a spread that exceeds $1 plus 5% of the midpoint of the
consolidated BBO ``could be the result of potentially erroneous
quotes or of abnormal trading conditions'' and their inclusion
``could significantly affect the comparability and reliability of
the execution quality measures in market center monthly reports.''
Market Systems Exemptive Letter at 2. The Commission may adopt an
updated or modified exemption under Rule 605(b) to further refine
the exemption if, for example, additional factors could be
considered reliable indicators of orders that could be the result of
erroneous quotes or abnormal trading conditions. See 17 CFR
242.605(b).
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As a result of the proposed inclusion of limit orders submitted
after closing and the proposed changes to the categorization of NMLOs
described in section IV.B.2, limit orders could be received for
execution and fall within the scope of Rule 605 on a day other than the
day of order receipt. Under current Rule 605(a)(1), a reporter must
prepare a monthly report on the covered orders in NMS stocks that it
received for execution from any person. In order to address this
scenario, the Commission proposes that a covered order would be
required to be included in the report for the month in which it becomes
executable if the day of receipt and the day it initially becomes
executable occur in different calendar months. Therefore, the
Commission proposes to amend Rule 605(a)(1) to require a market center,
broker, or dealer to include in its monthly report, in addition to the
covered orders in NMS stocks that it received for execution from any
person, those covered orders in NMS stocks that it received for
execution in a prior calendar month but which remained open.\237\
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\237\ See proposed Rule 605(a)(1).
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2. Stop Orders
The definition of ``covered order'' excludes orders with special
handling instructions, including orders submitted with stop
prices.\238\ Therefore, orders submitted with stop prices are excluded
from Rule 605 reports.
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\238\ See 17 CFR 242.600(b)(22). Generally, a limit order
submitted with a stop price becomes a market order when the stop
price is reached. A stop order to buy becomes a market order when
the security is bid or trades at or above the specified stop price;
a stop order to sell becomes a market order when the security is
offered or trades at or below the specified stop price.
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The Commission preliminarily understands that market centers and
broker-dealers may differ in how they handle stop orders, and the
current lack of consistent information regarding executions of such
orders may prevent investors from comparing the execution quality of
such orders. Further, stop orders are likely to hit their stop prices,
and are often executed, during periods of price volatility or downwards
market momentum, which may entail less than favorable execution
conditions. Given the potential for variation across market centers and
broker-dealers, as well as the market conditions under which stop
orders may execute, the Commission believes including stop orders
within the scope of the Rule would benefit market participants by
allowing them to analyze these variations in execution quality.
Further, as stated by the petitioner, including stop orders within the
Rule's scope would provide a more complete view of the orders certain
broker-dealers may use when assessing the execution quality market
centers provide.\239\
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\239\ See supra note 123 and accompanying text.
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Orders submitted with stop prices are often submitted well before
their stop prices are reached. In order to provide an ``apples-to-
apples'' comparison of stop orders, the Commission is proposing to
measure the execution quality of orders submitted with stop prices from
the time their stop prices are reached, i.e., when such orders become
executable. As part of the proposed definition of ``executable,'' the
Commission is proposing to specify that executable means, for any buy
order submitted with a stop price, that the stop price is equal to or
greater than the national best bid during regular trading hours, and,
for any sell orders submitted with a stop price, that the stop price is
equal to or less than the national best offer during regular trading
hours.\240\ Incorporation of the ``executable'' concept would have two
effects. First, stop orders would be reported as part of a Rule 605
report only if they become executable.\241\ Second, the point that a
stop order first becomes executable would be used as a benchmark for
several execution quality metrics, including average effective spread,
average effective over quoted spread, average realized spread, and
average time to execution statistics.\242\ The Commission is proposing
to use the time an order becomes executable rather than the time of
order receipt based on the understanding that customers, at least for
purposes of evaluating execution quality of stop orders, would
generally expect such orders to be executed close in time to when their
stop prices are triggered. Including executable orders submitted with
stop prices within the scope of the Rule would help investors compare
the performance of market centers and broker-dealers from a point in
time when such orders could reasonably be expected to execute.
Accordingly, the Commission proposes to rescind the exclusion of orders
submitted with stop prices within the definition of covered
[[Page 3806]]
order.\243\ As proposed, these orders would comprise a separate order
type category to help ensure comparability of execution quality
statistics since, as stated above, stop orders more often may execute
under volatile or downward-trending market conditions.\244\
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\240\ See proposed Rule 600(b)(42). See also infra note 303 and
accompanying text (discussing the definition of ``executable'' as it
relates to other non-marketable order types).
\241\ See proposed Rule 600(b)(20) (defining ``categorized by
order type'' to include a category for ``executable orders submitted
with stop prices'') (emphasis added).
\242\ For further discussion of these metrics, see infra
sections IV.B.3, IV.B.4.(a), IV.B.4.(b), IV.B.4.(d), and IV.B.6.
\243\ See proposed Rule 600(b)(30) (eliminating the express
carve out of orders submitted with stop prices from the definition
of ``covered order'').
\244\ See also infra section IV.B.2.a below for more detailed
description of the changes to categorization by order type,
including a new category for executable orders with stop prices.
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3. Non-Exempt Short Sale Orders
Commission staff has taken the position that staff would view all
short sale orders that are not marked ``short exempt'' (``non-exempt
short sale orders'') as special handling orders and, in the staff's
view, these orders may be excluded from the definition of ``covered
order'' in Rule 600(b)(15).\245\ Non-exempt short sale orders are
subject to a price test under Rule 201 of Regulation SHO (``Rule 201'')
that sets forth a short sale circuit breaker that is triggered in
certain circumstances, after which time a price restriction will apply
to short sale orders in that security for that day and the following
day.\246\ In 2013, Commission staff stated that because in certain
circumstances non-exempt short sale orders are subject to a price test
under Rule 201, and the circumstances could vary for different
securities and different days throughout the month, staff would view
all non-exempt short sale orders as subject to special handling.\247\
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\245\ 17 CFR 242.600(b)(15). See ``Responses to Frequently Asked
Questions Concerning Rule 605 of Regulation NMS'' (Feb. 22, 2013)
(``2013 FAQs'').
\246\ 17 CFR 242.201. Rule 201 generally requires trading
centers to establish, maintain, and enforce written policies and
procedures that are reasonably designed to prevent the execution or
display of a short sale at an impermissible price when a stock has
triggered a circuit breaker by experiencing a price decline of at
least ten percent in one day. Once the circuit breaker in Rule 201
has been triggered, the price test restriction will apply to short
sale orders in that security for the remainder of the day and the
following day, unless an exception applies. See 17 CFR
242.201(b)(1). One exception is for the execution or display of a
short sale order marked ``short exempt.'' See 17 CFR
242.201(b)(1)(iii)(B); 17 CFR 242.201(c).
\247\ See 2013 FAQs.
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The Commission preliminarily believes that for purposes of this
proposal, not all non-exempt short sale orders should be excluded from
the scope of Rule 605 reporting. When a non-exempt short sale order is
subject to a price test restriction under Rule 201 of Regulation SHO, a
trade may only take place at least one tick above the national best
bid.\248\ These tick-sensitive orders could be ``orders to be executed
only on a particular type of tick or bid,'' which is one of the types
of special handling orders specified in the definition of covered
order.\249\ However, excluding all non-exempt short sale orders from
Rule 605 reporting, regardless of whether or not a Rule 201 price test
restriction is in effect, excludes a significant portion of short sale
orders that are not tick-sensitive. Non-exempt short sale orders do not
appear to be tick-sensitive the majority of the time because they are
infrequently subject to a price test restriction. Analysis shows that,
between April 2015 and March 2022, an event that triggered the Rule 201
circuit breaker only occurred on 1.7% of trading days for an average
stock.\250\ The analysis also found that around 18% of trigger events
occurred the day after a previous trigger event, and around 46% of
trigger events occurred within a week after a previous trigger event,
implying that these trigger events tend to be relatively infrequent and
clustered around a small number of isolated events. Moreover, because
non-exempt short sale orders are not tick sensitive when a short sale
price test is not in effect, the inclusion of these orders would not
skew execution quality statistics.\251\
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\248\ See 17 CFR 242.201(b)(1)(i).
\249\ See 17 CFR 242.600(b)(22).
\250\ See infra note 662 and accompanying text.
\251\ In adopting Rule 605, the Commission stated that the
definition of covered order excludes orders (including short sales
that must be executed on a particular tick or bid) for which the
customer requested special handling for execution and that, if not
excluded, would skew general statistical measures of execution
quality. See Adopting Release, 65 FR 75414 (Dec. 1, 2000) at 75421.
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In addition, including non-exempt short sale orders for which a
price test restriction is not in effect for the security within Rule
605 statistics would lead to a more complete picture of reporting
entities' execution quality, because there is evidence that short sales
compose a large segment of trades, and likely also order flow. Analysis
of short volume data shows that, between August 2009 and February 2021,
short selling constituted an average of 47.3% of trading volume for
non-financial common stocks.\252\ As discussed further below, evidence
suggests that hedge funds make up the majority of the short selling
market, while an academic working paper found that, between January
2010 and December 2016, around 10.92% of retail trading was made up of
short sales.\253\
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\252\ See infra note 820 and accompanying text.
\253\ See infra notes 821-827 and accompanying text. See also
supra note 123 and accompanying text (petitioner recommending
inclusion of short sales in Rule 605).
---------------------------------------------------------------------------
Therefore, under the proposal, non-exempt short sale orders would
not be considered special handling orders unless a price test
restriction is in effect for the security. Unless another exclusion
applies, non-exempt short sale orders would fall within the definition
of covered order and thus within the scope of Rule 605 reporting.\254\
Conversely, during a short sale price test, a short sale order not
marked ``exempt'' would be subject to special handling and would be
excluded from the definition of covered order and thus from Rule 605
reporting.
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\254\ If an order is otherwise subject to special handling it
would not be a covered order. See proposed Rule 600(b)(30).
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Request for Comment
The Commission seeks comment generally on the proposed expansion of
Rule 605 reporting requirements to include certain orders received
outside of regular trading hours and orders submitted with stop prices,
as well as the proposal to incorporate non-exempt short sale orders
into Rule 605 unless a price test restriction is in effect for the
security. In particular, the Commission solicits comment on the
following:
15. Should the security's opening or re-opening price be required
to be used as a benchmark to determine whether a limit order submitted
outside of regular trading hours is marketable or non-marketable? If
not, what would be an alternative benchmark? Please explain.
16. Should the definition of ``covered order'' include NMLOs
submitted outside of regular trading hours or when the NBBO is not
being disseminated (i.e., limit orders that are not marketable based on
the security's opening or re-opening price)? Should market orders and
marketable limit orders submitted outside of regular trading hours or
when the NBBO is not being disseminated be included within the
definition of ``covered order''? Why or why not? Should these orders be
grouped with other market or marketable limit orders or as new order
type categories?
17. Do commenters agree that requiring orders submitted with stop
prices to be included in Rule 605 reports, and segregating them into
their own order type category, would avoid distorting execution quality
statistics? If not, why not?
18. Do commenters agree that periods when a short sale price test
is in effect are relatively infrequent and clustered around a small
number of isolated events? Why or why not?
19. Should other types of orders be included within the scope of
covered orders? For example, currently intermarket sweep orders
(``ISOs'') with a limit price inferior to the NBBO may
[[Page 3807]]
be viewed to be subject to special handling and are excluded from Rule
605 reports. Should these or other orders types be included within the
scope of covered orders? If so, please explain any additional
requirements or conditions that would help ensure comparability of
order execution quality statistics across reporting entities. For
example, if a new order type should be within the scope of covered
orders, should it be a new order type category or be added to an
existing or proposed order type category (as described in part IV.B.2
below)?
B. Required Information
The categories in Rule 605 reports are intended to strike a balance
between sufficient aggregation of orders to produce statistics that are
meaningful on the one hand, and sufficient differentiation of orders to
facilitate fair comparisons of execution quality across market centers
on the other hand.\255\ When adopting the Rule, the Commission stated
that its experience with the categories prescribed by the Rule may
indicate ways in which they could be improved in the future.\256\
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\255\ See Adopting Release, 65 FR 75414 (Dec. 1, 2000) at 75423.
\256\ See id.
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1. Categorization by Order Size
Rule 600(b)(13) defines ``categorized by order size'' as dividing
orders into separate categories based on the number of shares composing
an order.\257\ For the purposes of Rule 605 reports, the largest size
category has been limited to include only orders greater than 5,000
shares and less than 10,000 shares.\258\ The Commission proposes to
amend the definition of ``categorized by order size'' to provide the
following categories for order sizes: (i) less than 1 share; (ii) odd-
lot; (iii) 1 round lot to less than 5 round lots; (iv) 5 round lots to
less than 20 round lots; (v) 20 round lots to less than 50 round lots;
(vi) 50 round lots to less than 100 round lots; and (vii) 100 round
lots or greater.\259\
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\257\ 17 CFR 242.600(b)(13). See supra note 40.
\258\ See infra note 281 and accompanying text.
\259\ See proposed Rule 600(b)(19).
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The reasons for these changes are discussed below.
(a) Round Lot Multiple Characterization
Currently, Rule 605 reports utilize order size categories based on
the numbers of shares in the order (e.g., 100-499 shares and 500-1,999
shares). Historically, round lots generally have been viewed as groups
of 100 shares, and current Rule 605 reflects this.
In recent years, the prices of some of the most widely held stocks
have increased significantly,\260\ and differences in price affect how
stocks trade. For example, a 100-share order of a $1,200 stock would
likely have very different execution quality statistics than a 100-
share order of a $10 stock because more capital is at risk in the
former. But under current Rule 605, these orders are reported in the
same order size category.
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\260\ See supra note 16.
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Further, many of Rule 605's execution quality measures rely on the
NBBO as a benchmark.\261\ In adopting the Market Data Infrastructure
rules (the ``MDI Rules''), the Commission stated that the new
definition of round lot will improve certain Rule 605 statistics. The
Commission stated that the definition of round lot would allow
additional orders of meaningful size to determine the NBBO, and,
therefore, the execution quality and price improvement statistics
required under Rule 605 would be based upon an NBBO that the Commission
believes is a more meaningful benchmark for these statistics.\262\ As a
result of the new round lot definition,\263\ the NBBO in higher-priced
NMS stocks is based on smaller, potentially better-priced orders.\264\
The newly adopted definition of round lot is tiered based on the NMS
stock's prior month closing price.\265\ Upon implementation, the NBBO
will be calculated based on the new definition of round lot.\266\
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\261\ See Adopting Release, 65 FR 75414 (Dec. 1, 2000) at 75421
(stating that nearly all of the statistical measures included in the
Rule depend on the availability of a consolidated BBO at the time of
order receipt).
\262\ See MDI Adopting Release, 86 FR 18596 (Apr. 9, 2021) at
18621.
\263\ Specifically, the Commission re-defined ``round lot'' as:
100 shares for stocks priced at $250 or less, 40 shares for stocks
priced at $250.01 to $1,000, ten shares for stocks priced at
$1,000.01 to $10,000, and one share for stocks priced at $10,000.01
or more. See 17 CFR 242.600(b)(82).
\264\ As described in the MDI Adopting Release, orders currently
defined as odd-lots often reflect superior pricing. See MDI Adopting
Release, 86 FR 18596 (Apr. 9, 2021) at 18616 (describing analysis
that made similar findings using data from May of 2020). A recent
working paper analyzed the effect of the new round lot definition
and found that for sample stocks in the 40-share round lot category
the incidence of better-priced odd-lot quotes fell by approximately
4.8% and for sample stocks in the 10-share round lot category the
incidence fell by approximately 22%. See Bartlett, et al. at 5.
\265\ The round lot definition, together with the increased
availability of better priced odd-lot information, was designed to
provide investors with valuable information about the best prices
available and help to facilitate more informed order routing
decisions and the best execution of investor orders. See MDI
Adopting Release, 86 FR 18596 (Apr. 9, 2021) at 18602.
\266\ See id. The Commission is separately proposing to
accelerate the implementation of the round lot definition. See
Securities Exchange Act Release No. 96494 (Dec. 14, 2022) (File No.
S7-30-22) (Regulation NMS: Minimum Pricing Increments, Access Fees,
and Transparency of Better Priced Orders) (``Minimum Pricing
Increments Proposal''). The Commission established a phased
transition plan for the implementation of the MDI Rules, which
provided for the implementation of the round lot definition as part
of the final phase of implementation. See MDI Adopting Release, 86
FR 18596 (Apr. 9, 2021) at 18698-18701. At a minimum, round lot
implementation will be two years after the Commission's approval of
the plan amendment(s) required by Rule 614(e). Until the round lot
definition adopted pursuant to the MDI Rules is implemented, round
lots continue to be defined in exchange rules. See id. at 16738. For
most NMS stocks, a round lot is defined as 100 shares. According to
TAQ Data, as of April 2022, eleven stocks had a round lot size other
than 100. Nine stocks had a round lot of ten and two stocks had a
round lot of one.
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The Commission proposes to modify the order size categories to
utilize the new definition of round lot and include odd-lots,
fractional shares, and larger order sizes. Because the new definition
of round lot incorporates the current market price of the security, the
Commission believes that notional buckets and caps suggested by
commenters are not necessary.\267\ The proposed order size categories
would correspond to the existing share-based order size categories to
reflect that round lots historically had been viewed as groups of 100
shares. For example, the category for 100 to 499 shares would instead
be 1 round lot to less than 5 round lots. Because the current exemptive
relief \268\ effectively caps the existing order size category of 5,000
or more shares to 9,999 shares, the second largest order size category
would be 50 round lots to less than 100 round lots. The Commission is
also proposing to add new order size categories for odd-lots,
fractional shares, and larger-sized orders as discussed below.\269\
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\267\ See supra notes 128-132 and accompanying text.
\268\ See Large Order Exemptive Letter.
\269\ See infra section IV.B.1.(b)(1) and (2). The largest order
size category would be 100 round lots or more. See proposed Rule
600(b)(19)(vii).
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Additionally, modifying the order size categories to reflect the
number of round lots would better allow Rule 605 reports to group
orders with similar characteristics and notional values, and thereby
provide more useful execution quality information. In particular, with
the NBBO to be calculated based on the new definition of round lot,
updating the order size categories to be based on round lots should
allow for better comparisons of statistics that rely on the NBBO as a
benchmark, including price improvement statistics. The NBBO is used as
a benchmark throughout Rule 605 to determine marketability of orders,
effective and realized spread, and price improvement/dis-improvement
statistics. If the order size category were not based on the round lot
size for that stock, Rule 605 statistics
[[Page 3808]]
would show, for example, larger amounts of price improvement for high-
priced stocks based on the presumably wider NBBO. However, the
statistics would still be comparable across market centers and broker-
dealers since they would all be utilizing the same benchmark.
(b) New Sizes Within Scope
(1) Odd-Lots and Orders Less Than a Share
Currently, Rule 605 does not require reporting for orders smaller
than 100 shares, including odd-lot orders or fractional share orders
(i.e., orders for less than one share).\270\ Commenters suggested
amending the scope of the Rule to include odd-lot orders.\271\ One
commenter offering suggestions regarding enhancements to Rule 605 and
Rule 606 from a retail perspective stated that, while ``odd lots may
not represent a high percentage of executed share volume, they do
represent a high percentage of incoming executed order volume.'' \272\
Market participants stated that odd-lots make up a majority of all
trades.\273\ Particularly as stock prices have risen,\274\ odd-lots
have come to represent an increased percentage of orders.\275\ Analysis
using TAQ data found that odd-lots increased from around 15% of trades
in January 2014 to more than 55% of trades in March 2022.\276\ An
analysis of data from the SEC's MIDAS analytics tool shows that, in Q1
2022, odd-lots made up 81.2% of on-exchange trades (40% of volume) for
stocks in the highest price decile and 25% of on-exchange trades (2.72%
of volume) for stocks in the lowest price decile.\277\ Based on changes
the Commission has observed in the market, the observations of
commenters and other market participants, as well as its analysis, the
Commission preliminarily believes the exclusion of order sizes smaller
than 100 shares excludes an important segment of order flow. Therefore,
the Commission is proposing a new order size category for odd-lots.
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\270\ There are a variety of circumstances in which an order for
an NMS stock submitted to a broker-dealer results in a fractional
share. Examples include customer orders to buy: (1) a fraction of a
share (e.g., order to buy 0.5 shares); (2) shares with a fractional
component (e.g., order to buy 10.5 shares); and (3) a dollar amount
that leads to the purchase of a fractional share (e.g., order to buy
$1,223 worth of XYZ stock at $50 per share or 24.46 shares).
\271\ See Healthy Markets IV (discussing recommended reforms to
Rule 605 and Rule 606) at 3; IHS Markit Letter (responding to the
2018 Rule 606 Amendments) at 5, text accompanying n.15; EMSAC III
(recommendations regarding modifications to Rule 605 and Rule 606)
at 2.
\272\ FIF I at 1. The commenter also stated that retail
investors account for a notable portion of odd-lot trades. See FIF I
at 1. Later, the commenter stated that odd-lots represent close to
50% of self-directed orders. See FIF III at 4.
\273\ See ``Effective Spreads, Payment for Order Flow, and Price
Improvement'', RBC Capital Markets (Mar. 2022) at 5. Cf., Virtu
Petition at 4, n.13 and accompanying text (odd-lots make up 70% of
all trades in high priced stocks).
\274\ See supra note 16.
\275\ See MDI Adopting Release, 86 FR 18596 (Apr. 9, 2021) at
18616 (describing analyses confirming observations made in the MDI
Proposing Release that a significant proportion of quotation and
trading activity occurs in odd-lots, particularly for frequently
traded, high-priced stocks).
\276\ See supra note 91.
\277\ See dataset ``Summary Metrics by Decile and Quartile''
available at https://www.sec.gov/marketstructure/downloads.html.
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Similarly, fractional share orders have become increasingly popular
with individual investors as certain stock prices have risen and
certain broker-dealers have made fractional shares available to their
customers.\278\ Analysis of CAT data from March 2022 found that
executed orders with a fractional share component originated from over
5 million unique accounts. Orders for less than a single share
represent a significant portion of fractional orders executions.\279\
In order to capture execution quality information for these orders, the
Commission is proposing a new size category for orders less than a
share. To the extent an order with a fractional share component is for
more than a single share, it would not be included in this size
category to help ensure comparability of order execution quality
statistics.\280\
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\278\ See infra note 642. Orders with a fractional share
component may be executed in a number of ways: a broker-dealer may
(i) internalize the entire order as principal using its own
inventory; (ii) create a representative order that rounds up the
order to the nearest whole number using its own inventory and route
it for execution, then fill the original customer's fractional order
after the representative order is executed; (iii) internalize the
fractional component of the order (e.g., 0.5 shares) and send the
whole share component (e.g., 2 shares) away for execution; or (iv)
aggregate different fractional orders to make one large
representative order and then route it for execution, and fill the
original fractional orders post-execution.
\279\ Analysis of CAT data from March 2022 found that almost 68%
percent (31.67 million) of the 46.63 million executed orders with a
fractional component were for less than a single share. See infra
note 644 and accompanying text.
\280\ For example, a covered order for 10.5 shares in a security
with a 100-share round lot would be categorized as an odd-lot. See
proposed Rule 600(b)(19).
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(2) Larger-Sized Orders
Currently, Rule 605 does not require reports that include orders
with a size of 10,000 shares or greater pursuant to exemptive relief
provided by the Commission in 2001.\281\ In granting the exemption, the
Commission stated that a primary objective of the Rule is to ``generate
statistical measures of execution quality that provide a fair and
useful basis for comparisons among different market centers,'' and
reasoned that the exclusion of such orders would help assure greater
comparability of statistics in the largest size category of 5,000 or
more shares.\282\
---------------------------------------------------------------------------
\281\ See Large Order Exemptive Letter.
\282\ Id. at 2.
---------------------------------------------------------------------------
Commenters have advocated for the Commission to include larger-
sized orders in Rule 605 reports. One commenter responding to the 2018
Rule 606 Amendments stated that the exclusion of certain types of
marketable limit orders, including those of 10,000 shares or more,
undermines the utility of Rule 605 reports.\283\ The entity that
petitioned for rulemaking in this area stated that because of the
variation in stock prices (e.g., a 5,000 share order with a notional
value of $17.3 million and a 5,000 share order with a notional value of
$76,000), categorizing orders by share size is no longer
effective.\284\ The petitioner recommended the Commission include both
odd-lots and orders of 10,000 or more shares, and add notional size
categories to the metrics, with a notional cap.\285\
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\283\ See IHS Markit Letter at 34. See also KOR Group I at 4
(responding to the Commission's Concept Release on Equity Market
Structure, suggesting elimination of a share size cap on Rule 605
reporting).
\284\ See Virtu Petition at 4-5.
\285\ See id. at 5.
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The Commission proposes to rescind the exemptive relief for orders
of 10,000 or more shares and include these orders within the scope of
Rule 605 reports. The Commission believes that including such larger-
sized orders would improve execution quality statistics in Rule 605
reports by including information about an important segment of order
flow. Analysis of TAQ data shows that the number of shares associated
with trades that were for 10,000 or more shares as a percent of total
executed shares was 11.3% in March 2022.\286\ In addition, analysis of
the distribution of NMLO sizes in order submission data from MIDAS for
the month of March 2022, shows that, while NMLOs of 10,000 or more
shares made up only 0.09% of order flow in terms of number of orders,
they made up nearly 7.8% of order flow in terms of share volume.\287\
Although
[[Page 3809]]
the Commission had concerns about the comparability of execution
quality statistics for larger-sized orders when adopting the Rule, the
Commission expects that the proposed inclusion of two additional
categories for larger order sizes \288\ (i.e., corresponding to 5,000-
9,999 shares and 10,000 or more shares in the case of a 100 share round
lot) would allow for better comparability of statistics. The proposed
amended definition of ``categorized by order size'' that aligns with
the new definition of round lot would enhance such comparability.
---------------------------------------------------------------------------
\286\ See infra note 649 and accompanying text. The percentage
of larger-sized trades has fluctuated over time, in part due to
broker-dealers' use of Smart Order Routers (``SORs'') to break up
their institutional investor customers' large parent orders into
smaller-sized child orders along with other market changes, such as
the overall increase in stock prices. The rate of larger-sized
trades has declined from a rate of more than 25% in late 2003, but
has increased from 6.7% in August 2011. See id.
\287\ See infra Figure 4. While larger-sized orders comprise a
non-negligible percent of order flow, some or possibly most of these
large orders may be not held to the market, in which case they would
not be included in Rule 605 reports even without the exemptive
relief.
\288\ See supra text following note 267, notes 268-269 and
accompanying text. The two largest buckets in proposed Rule
600(b)(19)(vi) and (vii) group together orders of between 50 round
lots to less than 100 round lots and orders of 100 round lots or
greater, respectively.
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Request for Comment
The Commission seeks comment on the proposed changes to the
definition of ``categorized by order size.'' In particular, the
Commission solicits comment on the following:
20. Should fractional share orders be required to be included in
Rule 605 reports? Why or why not?
21. Should odd-lot orders be required to be included in Rule 605
reports? Why or why not?
22. Should orders of 10,000 or more shares be required to be
included in Rule 605 reports? Why or why not? Do commenters believe
that including such orders would skew the statistics for the largest
order size category? Would commenters support one or more notional caps
for share size buckets (such as 10,000 shares or greater), and if so,
why? Please explain and provide data.
23. Do commenters agree with the proposed modification of order
size categories? If not, why not? Would categories based on number of
shares--or the following categories based exclusively on notional
value: $1 to less than $10,000.00, $10,000.01 to less than $25,000.00,
$25,000 to less than $100,000, and over $100,000--be more useful, less
burdensome, or more cost-effective as either a permanent or an
alternative measure until such time as the new definition of round lot
has been implemented? Do commenters recommend different size or
notional value categories? If so, please describe such categories.
2. Categorization by Order Type
Under Rule 605(a)(1), monthly reports are categorized by order
type. Currently, ``categorized by order type'' means dividing orders
into separate categories for market orders, marketable limit orders,
inside-the-quote limit orders, at-the-quote limit orders, and near-the-
quote limit orders.\289\ As discussed below, the Commission proposes to
modify this definition to mean dividing orders into separate categories
for market orders, marketable limit orders (excluding immediate-or-
cancel orders), marketable immediate-or-cancel orders, beyond-the-
midpoint limit orders, executable non-marketable limit orders
(excluding beyond-the midpoint limit orders and orders submitted with
stop prices), and executable orders submitted with stop prices.\290\
The following compares the order type categories under the current Rule
to the proposed new order type categories:
---------------------------------------------------------------------------
\289\ See 17 CFR 242.600(b)(14). The Commission is proposing to
renumber the definition of ``categorized by order type'' as proposed
Rule 600(b)(20).
\290\ See proposed Rule 600(b)(20). Market orders and marketable
limit orders are existing categories under the current definition of
``categorized by order type.'' See 17 CFR 242.600(b)(14).
------------------------------------------------------------------------
Existing order type category Order type category as proposed
------------------------------------------------------------------------
Market................................. Market, Marketable IOC.
Marketable Limit....................... Marketable Limit, Marketable
IOC.
Inside-the-Quote Limit................. Beyond-the-Midpoint Limit,
Executable NMLO.
At-the-Quote Limit..................... Executable NMLO.
Near-the-Quote Limit................... Executable NMLO.\291\
[Not Included] \292\................... Executable NMLO, Executable
Stop.
------------------------------------------------------------------------
The Commission believes that the proposed categories will improve
execution quality information within Rule 605 reports and better group
comparable orders.
---------------------------------------------------------------------------
\291\ Under the proposal, near-the-quote limit orders would fall
outside the scope of the order type categories if they do not become
executable. See infra section IV.B.2.(a) for discussion of the
definition of executable.
\292\ The following orders fall outside the scope of the current
order type categories: (1) non-marketable buy orders and non-
marketable sell orders with limit prices that are more than $0.10
lower than the national best bid or higher than the national best
offer, respectively, at the time of order receipt; and (2) stop
orders. Under the proposal, such orders, if they become executable,
would fall within the order types for executable NMLOs or executable
stop orders. However, these orders would fall outside the scope of
the order type categories as proposed if they do not become
executable.
---------------------------------------------------------------------------
(a) NMLOs and Orders Submitted With Stop Prices
The Commission proposes to eliminate the three separate categories
for types of NMLOs (i.e., inside-the-quote limit orders, at-the-quote
limit orders, and near-the-quote limit orders) and to replace them with
new categories: non-marketable limit orders that become executable
(excluding orders submitted with stop prices and beyond-the-midpoint
limit orders) and beyond-the-midpoint limit orders.\293\ Current Rule
605 reports group NMLOs as inside-the-quote, at-the-quote, and near-
the-quote, and exclude NMLOs that are more than ten cents away from the
quote at the time of order receipt.\294\ When proposing to exclude
NMLOs with a limit price more than ten cents away from the NBBO, the
Commission reasoned that the execution quality statistics for these
types of orders may be less meaningful because executions of these
types of orders depend more on the order's limit price and price
movement in the market than on handling by the market center.\295\
---------------------------------------------------------------------------
\293\ See supra text accompanying note 290. Beyond-the-midpoint
limit orders, discussed in more detail in section IV.B.2.(b) infra,
are a type of NMLO that is priced more aggressively than the
midpoint.
\294\ See 17 CFR 242.600(b)(14). Inside-the-quote limit order,
at-the-quote limit order, and near-the-quote limit order mean non-
marketable buy orders with limit prices that are, respectively,
higher than, equal to, and lower by $0.10 or less than the national
best bid at the time of order receipt, and non-marketable sell
orders with limit prices that are, respectively, lower than, equal
to, and higher by $0.10 or less than the national best offer at the
time of order receipt. See 17 CFR 242.600(b)(37). The Commission is
proposing to eliminate this definition of inside-the-quote limit
order, at-the-quote limit order, and near-the-quote limit order.
These defined terms would no longer be used with the changes to
order type categories proposed herein. The proposed new order type
categories for NMLOs would focus on whether a NMLO becomes
executable rather than on how a NMLO's limit price compares to the
quote, as discussed further below.
\295\ See Proposing Release, 65 FR 48406 (Aug. 8, 2000) at
48414.
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Commenters supported including NMLOs further away from the quote in
[[Page 3810]]
Rule 605 reports but noted the difficulty of providing meaningful
execution quality statistics for such orders. One commenter to the 2018
Rule 606 Amendments observed: ``With non-marketable limit orders, what
matters is the skill of the broker in choosing the venue with the
highest probability of filling the order. Measuring execution quality
is difficult in that some limit orders are placed far away from the
NBBO and are unlikely to be filled. Others are cancelled after varying
lengths of time for any number of reasons. It may be difficult to tell
whether a cancelled order would have been filled later had it not been
cancelled.'' \296\ In offering suggestions to modernize Rule 605,
another commenter recommended including an additional ``away-from-the-
quote'' bucket for NMLOs, which the commenter stated would capture a
significantly greater number of self-directed orders from individual
investors.\297\
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\296\ Angel Letter at 7. See also Blackrock Letter at 3 (stating
in response to the Commission's Concept Release on Equity Market
Structure that revised Rule 605 disclosures should provide greater
transparency on NMLOs).
\297\ See FIF III at 4.
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The Commission recognizes that more meaningful measures of
execution quality for NMLOs, as well as orders submitted with stop
prices,\298\ would assist investors in measuring execution quality. A
large number of NMLOs are not captured because they are more than ten
cents away from the NBBO or submitted outside of regular market
hours.\299\ The Commission believes that it would be informative to
calculate execution quality statistics for those NMLOs and orders
submitted with a stop price that become ``executable.'' \300\ Because
execution quality for orders placed further away from the quote depends
heavily on prevailing market conditions,\301\ adding the concept of
``executable'' allows execution quality statistics to be measured from
a point where an order could be executed.\302\
---------------------------------------------------------------------------
\298\ See supra section IV.A.2.
\299\ An analysis of 80 stocks in March 2022 finds that away-
from-the-quote orders (i.e., NMLOs that are more than $0.10 away
from the NBBO) represent 23.8% of non-marketable share volume). See
infra section VII.C.2.(c)(1).
\300\ As discussed above, the Commission is proposing to modify
the definition of ``covered order'' to include NMLOs submitted
outside of regular trading hours or when an NBBO is not being
disseminated and orders submitted with a stop price. See supra
sections IV.A.1 and IV.A.2.
\301\ For example, even if a limit order is placed $0.05 away
from the quote, if the market moves away and only 25 minutes later
returns to a price level where the limit order executes, the time to
execution for that order is less reflective of execution quality
than of prevailing market conditions.
\302\ As discussed above (see supra section IV.A.2.), the
Commission also believes it would be helpful to investors to measure
the execution quality of orders submitted with stop prices.
Therefore, it is proposing to add a separate order type category of
``executable orders submitted with stop prices'' to the definition
of ``categorized by order type.'' See proposed Rule 600(b)(20).
---------------------------------------------------------------------------
As proposed, Rule 605 statistics would be collected for
``executable'' NMLOs. The Commission proposes the following definition
of ``executable'' for NMLOs (other than orders submitted with stop
prices): for any non-marketable buy order (excluding orders submitted
with stop prices), executable means that the limit price is equal to or
greater than the national best bid during regular trading hours, and,
for any non-marketable sell order (excluding orders submitted with stop
prices), that the limit price is equal to or less than the national
best offer during regular trading hours.\303\ This definition is
designed to capture NMLOs (including beyond-the-midpoint limit orders)
that, during their time in force, ``touched'' a price where they could
have been executed. For example, if the market is $10.05 x $10.10, a
limit order to buy at $10.02 would not be an executable NMLO unless the
market moved to a price at which that limit order could be executed--
for example, $10.02 x $10.06. As is the case for orders submitted with
stop prices, incorporation of the ``executable'' concept would have two
effects. First, NMLOs would only be reported as part of a Rule 605
report if they become executable during regular trading hours.\304\
Because there are substantial differences in the nature of the market
between regular trading hours and after-hours, this would provide a
basis for more comparable execution quality measures. Second, the point
that a NMLO first becomes executable would be used as an input for
several execution quality metrics: average time to execution
statistics,\305\ average effective spread,\306\ average percentage
effective and realized spread,\307\ and average effective over quoted
spread.\308\ The Commission is proposing to use the time an order first
becomes executable rather than the time of order receipt in order to
measure execution quality from a point in time when a liquidity-
providing order is priced at or better than the quote. Including
executable NMLOs within the scope of the Rule would help investors
compare the performance of market centers and broker-dealers from a
point in time when such orders could reasonably be expected to execute
and provides a more informative measure of execution quality by
controlling for market conditions.
---------------------------------------------------------------------------
\303\ See proposed Rule 600(b)(42). See also supra note 240 and
accompanying text (discussing the definition of ``executable'' as it
relates to orders submitted with stop prices).
\304\ See proposed Rule 600(b)(20) (defining ``categorized by
order type'' to include a category for ``executable non-marketable
limit orders'') (emphasis added).
\305\ See infra section IV.B.3.
\306\ See infra section IV.B.4.(b).
\307\ See infra section IV.B.4.(c).
\308\ See infra section IV.B.4.(d).
---------------------------------------------------------------------------
(b) Beyond-the-Midpoint Limit Orders
Under current Rule 605, inside-the-quote limit orders are a
separate order type category.\309\ Because they are not a marketable
order type (i.e., they do not fully cross the spread),\310\ current
Rule 605 does not require price improvement statistics to be calculated
for inside-the-quote limit orders.\311\
---------------------------------------------------------------------------
\309\ See 17 CFR 242.600(b)(14).
\310\ Cf. id. (marketable limit orders separated from inside-
the-quote limit orders).
\311\ Rule 605(a)(1)(i) specifies execution quality statistics
to be provided for all order types, and Rule 605(a)(1)(ii) specifies
execution quality statistics to be provided for marketable order
types. See 17 CFR 242.605(a)(1)(i) and (ii). For a discussion of the
changes that the Commission is proposing to make to the execution
quality statistics to be provided for all order types and for
marketable order types, see infra sections IV.B.4 and IV.B.5,
respectively. The Commission is also proposing to require additional
execution quality statistics to be provided for non-marketable order
types. See infra section IV.B.6.
---------------------------------------------------------------------------
Limit orders priced more aggressively than the midpoint may have
different execution quality statistics than other types of NMLOs
because market centers and broker-dealers may treat beyond-the-midpoint
limit orders as marketable limit orders in certain circumstances and as
NMLOs in others. An analysis of a sample of orders executed by the six
most active wholesalers for the period of Q1 2022 \312\ shows that
beyond-the-midpoint NMLOs executed by wholesalers tend to have much
faster time-to-executions and higher fill rates than other types of
inside-the-quote NMLOs, and are also somewhat more likely to be given
price improvement, indicating wholesalers often treat limit orders
priced more aggressively than the midpoint more like marketable limit
orders and may offer price improvement to these orders.\313\
---------------------------------------------------------------------------
\312\ See infra note 689 and accompanying text; Table 5.
\313\ See infra section VII.C.2.(c)(3).
---------------------------------------------------------------------------
The Commission is proposing to label those limit orders priced more
aggressively than the midpoint as ``beyond-the-midpoint limit orders.''
Because beyond-the-midpoint limit orders are a type of NMLO and could
therefore be covered orders even if received outside of regular trading
hours
[[Page 3811]]
or during a time when the NBBO is not being disseminated, the
Commission is proposing to define a beyond-the-midpoint limit order
with respect to orders received both when an NBBO is being disseminated
and when it is not. If the NBBO is being disseminated, ``beyond-the-
midpoint limit order'' would mean: (i) any non-marketable buy order
with a limit price that is higher than the midpoint of the national
best bid and national best offer at the time of order receipt, or (ii)
any non-marketable sell order with a limit price that is lower than the
midpoint of the national best bid and national best offer at the time
of order receipt.\314\ If the NBBO is not being disseminated, it would
mean: (i) any non-marketable buy order with a limit price that is
higher than the midpoint of the national best bid and national best
offer at the time that the national best bid and national best offer is
first disseminated after the time of order receipt, or (ii) any non-
marketable sell order with a limit price that is lower than the
midpoint of the national best bid and national best offer at the time
that the national best bid and national best offer is first
disseminated after the time of order receipt.\315\
---------------------------------------------------------------------------
\314\ See proposed Rule 600(b)(16). See also proposed Rule
600(b)(20) (modifying the definition of ``categorization by order
type'' to add beyond-the-midpoint limit orders to the list of order
types).
\315\ See proposed Rule 600(b)(16).
---------------------------------------------------------------------------
In addition, the Commission proposes to require that the execution
quality statistics for beyond-the-midpoint limit orders include the
additional information required of both marketable \316\ and non-
marketable \317\ order types. If beyond-the-midpoint orders instead
were treated solely as a non-marketable order type, similar to inside-
the-quote limit orders, then market centers and broker-dealers would
not be required to provide the types of execution quality statistics
specific to marketable orders for these orders. Because beyond-the-
midpoint limit orders may participate in the proposed qualified
auctions \318\ or be treated as marketable orders in certain
circumstances, it would be informative if reporting entities provided
these types of statistics for these orders, especially given the
increased likelihood that these types of orders may receive price
improvement in certain circumstances.\319\ However, because beyond-the-
midpoint limit orders may execute more like inside-the-quote limit
orders in other circumstances, the additional statistics required for
the non-marketable order types would also be required to be reported
for beyond-the-midpoint limit orders. This would facilitate comparisons
of beyond-the-midpoint limit orders with other types of NMLOs.
Therefore, the Commission proposes to add beyond-the-midpoint limit
orders to both the list of marketable order categories and the list of
non-marketable order categories for which those execution quality
statistics are required, as provided in proposed Rules 605(a)(1)(ii)
and 605(a)(1)(iii), respectively.
---------------------------------------------------------------------------
\316\ See proposed Rule 605(a)(1)(ii) (specifying additional
required information for market orders, marketable limit orders,
marketable immediate-or-cancel orders, and beyond-the-midpoint limit
orders).
\317\ See proposed Rule 605(a)(1)(iii) (specifying additional
required information for beyond-the-midpoint limit orders,
executable non-marketable limit orders, and executable orders with
stop prices).
\318\ See supra section III.B.
\319\ See infra note 689 and accompanying text; Table 5.
---------------------------------------------------------------------------
Unlike market, marketable limit, and marketable IOC orders, beyond-
the-midpoint limit orders may be covered orders even if received
outside of regular trading hours or when an NBBO is not being
disseminated.\320\ However, because beyond-the-midpoint limit orders
are priced more aggressively than the midpoint of the NBBO when
received, they are by definition executable from the time of order
receipt unless submitted prior to market open or during a trading halt.
In that case, they would be executable at the time the NBBO is first
disseminated after the time of order receipt during regular trading
hours. Therefore, the Commission proposes to modify the time to order
execution statistics to state, with respect to beyond-the-midpoint
limit orders, these time-based statistics should be measured from the
time such orders become executable to the time of order execution.\321\
---------------------------------------------------------------------------
\320\ The time-based execution quality statistics that would be
required for marketable order types other than beyond-the-midpoint
limit orders would be measured from the time of order receipt to the
time of order execution. See proposed Rule 605(a)(1)(ii)(C), (D),
(E), (G), (H), (I), (L), (M), and (N).
\321\ See proposed Rule 605(a)(1)(ii)(C), (D), (E), (G), (H),
(I), (L), (M), and (N).
---------------------------------------------------------------------------
(c) Marketable IOCs
Rule 605 reports group marketable IOCs together with other
marketable orders.\322\ The Commission included IOC orders in the scope
of the Rule, reasoning that IOC orders are functionally the same as
orders that are submitted and cancelled almost immediately
thereafter.\323\
---------------------------------------------------------------------------
\322\ Rule 600(b)(14) defines ``categorized by order type'' and
includes ``marketable limit orders'' within the listed categories of
order types. See 17 CFR 242.600(b)(14).
\323\ See Adopting Release, 65 FR 75414 (Dec. 1, 2000) at 75421.
---------------------------------------------------------------------------
The EMSAC, as well as commenters on the 2010 Equity Market
Structure Concept Release and the 2018 Rule 606 Amendments, suggested
separating IOCs within the categorization by order type.\324\ While the
Commission continues to believe that information regarding IOCs is
useful to measure execution quality, marketable IOCs may have a
different submitter profile (typically, institutional investors) \325\
and different execution quality characteristics.\326\ Analysis of Tick
Size Pilot data indicates that IOCs typically have much lower fill
rates than other market and marketable limit orders (on average 3.22%
as compared to 15.94%), particularly with respect to larger-sized
orders and orders received by wholesalers.\327\ This data also shows
that IOCs make up more than 90% of executed market and marketable share
volume.\328\ As a result, including them with other market and
marketable limit orders may be skewing fill rates downwards, especially
for larger-sized orders and orders handled by wholesalers.
---------------------------------------------------------------------------
\324\ See IHS Markit Letter at 11; EMSAC III at 2; FIF I at 2.
\325\ Analysis of CAT data of retail orders received at broker-
dealers with 10,000 or more individual accounts during June 2021
indicates that approximately only 0.02% of retail orders are
submitted with an IOC instruction. See infra note 722 and
accompanying text.
\326\ In offering recommendations to modernize Rule 605, a
commenter who supported separating IOC orders within Rule 605
statistics stated that such orders have a different profile and can
skew statistics. See FIF III at 5.
\327\ See infra note 723 and accompanying text; Table 6. This
analysis shows that wholesaler fill rates range between 60% to 90%
for non-IOC orders, but are mostly below 30% for IOC orders, and
even smaller with respect to larger order sizes. See id.
\328\ See infra note 723 and accompanying text; Table 6.
---------------------------------------------------------------------------
To address this issue, the Commission proposes to assign marketable
IOCs to a separate order type category so that they no longer would be
commingled with other order types. Specifically, the Commission
proposes to add a category for ``marketable immediate-or-cancel
orders'' and indicate that the category for ``marketable limit orders''
excludes IOC orders.\329\ Rule 605(a)(1)(i) and (ii) specify execution
quality statistics required for enumerated categories of orders,
including marketable limit orders. The Commission proposes to add
marketable immediate-or-cancel orders to the enumerated order
categories for those sets of execution quality statistics so that the
Rule would continue to require the same information for marketable IOCs
that is
[[Page 3812]]
required for other marketable order types.\330\
---------------------------------------------------------------------------
\329\ See proposed Rule 600(b)(20).
\330\ See proposed Rule 605(a)(i) and (ii). Additional
information that is currently calculated for market and marketable
limit orders (e.g., price improvement statistics) would continue to
be calculated for marketable IOCs.
---------------------------------------------------------------------------
Request for Comments
The Commission seeks comment on the proposed changes to the
definition of ``categorized by order type.'' In particular, the
Commission solicits comment on the following:
24. Should the proposed concept of executability be required to be
used as a benchmark for NMLO and stop order statistics? Why or why not?
Is another benchmark more appropriate, and if so why? Please explain
and provide data, if available.
25. Should beyond-the-midpoint limit orders have different
execution quality statistics than other types of NMLOs or marketable
limit orders? Why or why not?
26. Should marketable IOCs be required to be broken out into a
separate order type category? Why or why not? Do commenters agree that
marketable IOCs may have a different submitter profile and different
execution quality characteristics than market orders and marketable
limit orders? Please explain.
3. Timestamp Conventions
Rule 605 reports are required to include information on the number
of shares of covered orders executed within certain timeframes,
measured by seconds after the time of order receipt.\331\ Rule 600
definitions for ``time of order execution'' and ``time of order
receipt'' require that time be measured ``to the second.'' \332\
Further, the smallest time-to-execution category in current Rule 605
includes those covered orders executed from 0 to 9 seconds after the
time of order receipt. The Commission proposes to update the timestamp
conventions used for the time of order receipt \333\ and time of order
execution \334\ definitions to require that such times be measured ``in
increments of a millisecond or finer.'' The Commission also is
proposing to specify that the average time-to-execution statistics
currently required for marketable order types should be expressed in
increments of a millisecond or finer.\335\ Similarly, the proposed
definition of ``executable'' provides that the time an order becomes
executable ``shall be measured in increments of a millisecond or
finer.'' \336\ The equities markets now operate at much greater speeds
than they did in 2000 when timestamps were adopted with second
granularity. For example, an analysis of data from the SEC's MIDAS
analytics tool shows that in Q1 2022 more than half (51.6%) of on-
exchange NMLOs executed in less than one second in large market cap
stocks.\337\ Changes in technology have made more granular timestamp
information more cost effective and practicable and timestamp
information ``in increments of a millisecond or finer'' would result in
more informative reports.
---------------------------------------------------------------------------
\331\ See 17 CFR 242.605(a)(1)(i)(F)-(J).
\332\ See 17 CFR 242.600(b)(91) and (92). The Commission is
proposing to renumber the definitions of ``time of order execution''
and ``time of order receipt'' as proposed Rule 600(b)(108) and
(109), respectively.
\333\ See proposed Rule 600(b)(109).
\334\ See proposed Rule 600(b)(108).
\335\ For shares executed with price improvement, executed at
the quote, or executed outside the quote, respectively, see proposed
Rules 605(a)(1)(ii)(C), 605(a)(1)(ii)(G), and 605(a)(1)(ii)(L).
Current Rule 605 does not specify a level of granularity for the
existing time-to-execution statistics. However, the Plan requires
these fields to be expressed in number of seconds and carried out to
one decimal place. See Rule 605 NMS Plan section VI.a(21), (23), and
(26).
\336\ Proposed Rule 600(b)(42). As discussed above, the
Commission is also proposing to expand the scope of Rule 605
reporting to include certain NMLOs submitted outside of regular
trading hours, specifically NMLOs that become executable during
regular trading hours. See supra section IV.A.1.
\337\ See dataset ``Conditional Cancel and Trade Distribution''
available at https://www.sec.gov/marketstructure/downloads.html. See
also infra note 692 and accompanying text.
---------------------------------------------------------------------------
Numerous commenters have raised concerns about the Rule's timestamp
conventions, especially given the increases in the speed of the
market.\338\ One commenter stated that current time bucketing is
outdated and the Rule should provide average execution time for
marketable orders, measured in milliseconds (or microseconds).\339\
Another commenter suggested that Rule 605 should be re-written to
include statistics at a granular number of milliseconds from order
receipt time to either fill or cancel time.\340\
---------------------------------------------------------------------------
\338\ See, e.g., KOR Group I at 2, FIF I at 2.
\339\ See FIF III, Appendix 1 at 4.
\340\ See IHS Markit Letter at 26-27.
---------------------------------------------------------------------------
The proposed amendments would not require the use of reporting
increments finer than milliseconds for reports generated under Rule
605. The CAT NMS Plan requires CAT reporters to report CAT data to the
CAT in milliseconds and, to the extent a CAT reporter's order handling
or execution systems utilize timestamps in increments finer than
milliseconds, such CAT reporter is required to utilize such finer
increments up to nanoseconds when reporting CAT data to the CAT.\341\
CAT requires the use of such finer increments, when available, to
assist in the accurate sequencing of reportable events on an order-by-
order basis.\342\ In contrast, the order and execution quality
statistics under Rule 605 utilizing timestamp information are reported
in the aggregate. Timestamp information in millisecond increments would
allow for meaningful points of comparison between market centers or
broker-dealers for both aggregate data that utilizes timestamp
information and time-to-execution statistics such as average time to
execution. There would be limited additional utility in requiring Rule
605 reporting using increments finer than a millisecond.
---------------------------------------------------------------------------
\341\ See Securities and Exchange Commission File No. 4-698
(National Market System Plan Governing the Consolidated Audit
Trail), section 6.8(b). See also Securities Exchange Act Release No.
79318 (Nov. 15, 2016), 81 FR 84696 (Nov. 23, 2016).
\342\ See 17 CFR 242.613(d)(3) (requiring the use of timestamp
increments finer than the minimum so that all reportable events
``can be accurately sequenced'').
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In conjunction with the proposed requirement to use the more
granular timestamps, the Commission is proposing to eliminate the
current time-to-execution buckets.\343\ Average time to execution is
already required to be reported for market orders and marketable limit
orders,\344\ and generally provides a more informative metric for those
order types than the existing time-to-execution buckets given the speed
with which those order types typically execute. The vast majority of
market orders and marketable limit orders that execute are executed in
less than a second,\345\ an increment that results in almost all market
and marketable limit orders being contained in the smallest of the
existing time-to-execution buckets.\346\ As a result, the existing
time-to-execution buckets do not generally provide meaningful time-to-
execution differentiation for market orders and marketable limit
orders. The existing time-to-execution buckets only generally provide
meaningful information for non-marketable order
[[Page 3813]]
types. The Commission believes that requiring average time to execution
for all order types, in addition to statistics that would provide
information about the distribution of execution times within each order
type, would provide more meaningful information because these
statistics could be used to compare the average time to execution for a
particular order type, while still providing information about the
extent to which outlier values do or do not skew the average.
---------------------------------------------------------------------------
\343\ See 17 CFR 242.605(a)(1)(i)(F) through (J) (detailing
time-to-execution buckets of 0 to 9 seconds, 10 to 29 seconds, 30 to
59 seconds, 60 to 299 seconds and 5 to 30 minutes after the time of
order receipt).
\344\ See 17 CFR 242.605(a)(1)(ii)(D), (F), and (I), requiring
share-weighted average period from the time of order receipt to the
time of order execution for shares executed with price improvement,
at the quote, and outside the quote, respectively.
\345\ Analysis of Tick Size Pilot data shows more than 95% of
market and marketable limit orders that executed did so within 1
second. See analysis in infra Figure 12. See also infra section
VII.E.3.(b)(1) (analyzing execution speeds of market and marketable
limit orders, along with the three categories of NMLOs currently
required in Rule 605 (inside-the-quote, at-the-quote, and near-the-
quote)).
\346\ See 17 CFR 242.605(a)(1)(i)(F) (requiring the reporting of
the cumulative number of shares of covered orders executed from 0 to
9 seconds after the time of order receipt).
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Although average time to execution is currently required for
marketable order types,\347\ the Commission believes it would be both
feasible and useful to measure average time to execution for non-
marketable order types from the point in time they become executable.
As stated above, this would provide a control for prevailing market
conditions and benchmark orders from a point when such orders could
reasonably be expected to execute. Therefore, the proposal would
require the share-weighted average time to execution for non-marketable
order types, calculated from the time such orders become
executable.\348\
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\347\ See 17 CFR 242.605(a)(1)(ii)(D), (G), and (H) for shares
executed with price improvement, executed at the quote, or executed
outside the quote, respectively.
\348\ See proposed Rule 605(a)(1)(iii)(C), (D), and (E).
---------------------------------------------------------------------------
Because orders may execute near-instantaneously or over a number of
minutes, average time to execution within a category could be skewed by
outlier values. Given this, information about the distribution of
execution speeds in addition to the average would still be useful.
However, the existing time-to-execution buckets are of limited utility,
especially for the fastest executions, given that the smallest time-to-
execution bucket encompasses all orders executed between zero and nine
seconds. Although finer increments could be added below one second, it
would still be important to retain information for those orders that
take longer to execute. Rather than adding additional buckets to
provide this distribution information, the Commission proposes
requiring both share-weighted median and 99th percentile time-to-
execution statistics in order to provide additional descriptive
statistical information for executions of all covered order types.\349\
These two measurements would provide additional information to allow
users of the data to assess how quickly a market center or broker-
dealer is able to execute incoming orders and better understand whether
and to what extent the time to execution within a particular category
is affected by outlier values.
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\349\ See proposed Rule 605(a)(1)(ii)(D), (E), (H), (I), (M),
and (N), and proposed Rule 605(a)(1)(iii)(D) and (E), requiring
share-weighted median and share-weighted 99th percentile time to
execution information. These measures would represent the time at or
below which 50 percent of executions occur, weighted by number of
shares (in the case of the share-weighted median) and the time at or
below which 99 percent of executions occur, weighted by number of
shares (in the case of the share-weighted 99th percentile).
---------------------------------------------------------------------------
For these reasons, the Commission proposes to require share-
weighted median and 99th percentile time to execution for all order
types. Average time to execution statistics for marketable order types
(market orders, marketable limit orders, marketable IOCs, and beyond-
the-midpoint limit orders) would be required for each of: shares
executed with price improvement,\350\ at the quote,\351\ and outside
the quote.\352\ For the marketable order types, the Commission is
similarly proposing to require: (i) the share-weighted median period
from the time or order receipt to the time of order execution; \353\
and (ii) the share-weighted 99th percentile period from the time of
order receipt to order execution.\354\ For non-marketable order types
(beyond-the-midpoint limit orders, executable NMLOs, and executable
orders with stop prices NMLOs), the Commission proposes to require, for
executed orders: (i) the share-weighted average period from the time
the order becomes executable to the time of order execution; \355\ (ii)
the share-weighted median period from the time the order becomes
executable to the time of order execution; \356\ and (iii) the share-
weighted 99th percentile period from the time the order becomes
executable to the time of order execution.\357\
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\350\ See 17 CFR 242.605(a)(1)(ii)(C).
\351\ See 17 CFR 242.605(a)(1)(ii)(G).
\352\ See 17 CFR 242.605(a)(1)(ii)(L).
\353\ For shares executed with price improvement, executed at
the quote, or executed outside the quote, respectively, see proposed
Rules 605(a)(1)(ii)(D), 605(a)(1)(ii)(H), and 605(a)(1)(ii)(M).
\354\ For shares executed with price improvement, executed at
the quote, or executed outside the quote, respectively, see proposed
Rules 605(a)(1)(ii)(E), 605(a)(1)(ii)(I), and 605(a)(1)(ii)(N).
\355\ See proposed Rule 605(a)(1)(iii)(C).
\356\ See proposed Rule 605(a)(1)(iii)(D).
\357\ See proposed Rule 605(a)(1)(iii)(E). As a result, the use
of time-to-execution buckets would no longer be necessary. Rule
605(a)(1)(i)(F) through (J) requires statistics for the cumulative
number of shares of covered orders executed in separate time-to-
execution buckets. Those requirements would be eliminated.
---------------------------------------------------------------------------
The Commission considered compressing the current time-to-execution
buckets to a sub-second level (i.e., less than 50 milliseconds, 50-500
milliseconds, 500 milliseconds to 1 second, and greater than 1 second).
One commenter suggested that even more granular timestamps be
used.\358\ The proposed rule would not require the use of microsecond
timestamps, for the reasons discussed above. The Commission solicits
comment below on whether requiring the use of timestamps more granular
than a millisecond would be appropriate.
---------------------------------------------------------------------------
\358\ See Healthy Markets II at 3 (suggesting use of the
following execution time categories: less than 500 microseconds; 500
microseconds-1 millisecond; 1-10 milliseconds; 10-100 milliseconds;
100 milliseconds-1 second; and current categories).
---------------------------------------------------------------------------
Request for Comment
The Commission seeks comment generally on the changes to the
timestamp conventions within Rule 605. In particular, the Commission
solicits comment on the following:
27. Should Rule 605 require timestamps to be recorded at
millisecond level granularity? Why or why not? Would it be preferable
in Rule 605 for timestamps to be recorded at microsecond granularity
(as suggested by one commenter) or nanosecond granularity? Please
explain and provide data, if available. Should Rule 605 require market
centers and larger broker-dealers to utilize timestamps in increments
finer than milliseconds to the extent such entities' order handling or
execution systems utilize finer increments? Why or why not? Would
allowing some market centers and broker-dealers to utilize timestamps
in increments finer than milliseconds affect the comparability of their
execution quality statistics?
28. Do commenters believe the proposed level of timestamp
granularity would enhance the usefulness of execution quality
statistics? Why or why not?
29. Do commenters believe that the proposed statistical measures
that would be required for time to execution (i.e., average, median,
and 99th percentile) are appropriate? If not, what statistics should be
used?
30. Should the Commission require share-weighted average time to
execution for non-marketable order types, measured from the time the
order becomes executable? Should the Commission require share-weighted
median and 99th percentile time-to-execution statistics, measured from
the time an order becomes executable?
31. Should the Commission retain the required time-to-execution
buckets for all order types, with revisions to the time intervals used?
If so, should the Commission use the time buckets proposed by a
commenter (i.e., less than
[[Page 3814]]
500 microseconds; 500 microseconds-1 millisecond; 1-10 milliseconds;
10-100 milliseconds; 100 milliseconds-1 second; in addition to the
current categories)?
4. Changes to Information Required for All Types of Orders
(a) Realized Spread
Rule 605 requires calculation of average realized spread for
executions of all covered orders and is calculated by comparing the
execution price of an order and the midpoint of the NBBO as it stands
five minutes after the time of order execution.\359\ The smaller the
average realized spread, the more prices have moved adversely to
liquidity providers after the order was executed, which shrinks the
spread ``realized'' by the liquidity providers.\360\ A low average
spread indicates that a liquidity provider was providing liquidity even
though prices were moving against it.\361\ In the Adopting Release, the
Commission also stated that the realized spread statistic ``can
highlight the extent to which market centers receive uninformed orders
(as indicated by higher realized spreads than other market centers),
thereby potentially helping to spur more vigorous competition to
provide the best prices to these orders to the benefit of many retail
investors.'' \362\ To the extent realized spreads capture adverse
selection costs faced by liquidity providers, they provide a measure of
the potential profitability of trading for liquidity providers.\363\
---------------------------------------------------------------------------
\359\ See 17 CFR 242.600(b)(9). For buy orders, realized spread
is double the amount of difference between the execution price and
the midpoint of the NBBO five minutes after the time of order
execution. For sell orders, realized spread is double the amount of
difference between the midpoint of the NBBO five minutes after the
time of order execution and the execution price. See id. The
Commission is proposing to renumber the definition of ``average
realized spread'' as proposed Rule 600(b)(13).
\360\ See Adopting Release, 65 FR 75414 (Dec. 1, 2000) at 75424.
\361\ See id.
\362\ Id. See also Securities Exchange Act Release No. 84875
(Dec. 19, 2018), 84 FR 5202, n.587 (Feb. 20, 2019) (``The realized
spread is the portion of the spread that market makers `realize'
after adverse selection costs are taken into account.'').
\363\ See, e.g., Larry Harris, Trading and Exchanges: Market
Microstructure for Practitioners (Oxford University Press 2003) at
286 (``Informed traders buy when they think that prices will rise
and sell otherwise. If they are correct, they profit, and whoever is
on the other side of their trade loses. When dealers trade with
informed traders, prices tend to fall after the dealer buys and rise
after the dealers sell. These price changes make it difficult for
dealers to complete profitable round-trip trades. When dealers trade
with informed traders, their realized spreads are often small or
negative. Dealers therefore must be very careful when trading with
traders they suspect are well informed.'')
---------------------------------------------------------------------------
In order to proxy for this, realized spread measures the difference
between the execution price and a future price. An ideal measurement
horizon would be one that aligns with the amount of time an average
liquidity provider holds onto its inventory positions and must be
sufficiently long so that it captures a price reversal rather than a
series of trades representing the same demand as the initial trade but
not so long as to introduce unnecessary noise.\364\
---------------------------------------------------------------------------
\364\ See, e.g., Roger Huang & Hans Stoll, Dealer Versus Auction
Markets: A Paired Comparison of Execution Costs on NASDAQ and the
NYSE, 41 J. Fin. Econ. 313-357 (1996).
---------------------------------------------------------------------------
The equities market moves much faster than it did in 2000,\365\ and
correspondingly any changes in market maker or liquidity provider
positions and inventory occur much more quickly in the contemporary
market environment. There is academic literature that argues that the
current five-minute horizon has become inappropriate for a high-
frequency environment.\366\ One study posits that the five-minute time
horizon should be replaced with a horizon of no more than 15 seconds
for large cap stocks and 60 seconds for small cap stocks.\367\
---------------------------------------------------------------------------
\365\ See supra note 98.
\366\ See, e.g., Maureen O'Hara, High Frequency Market
Microstructure, 116(2) J. Fin. Econ. 257-270 (2015) (``O'Hara
2015''); Maureen O'Hara, Gideon Saar, & Zhuo Zhong, Relative Tick
Size and the Trading Environment, 9(1) Rev. of Asset Pricing Stud.
47-90 (2019) (``O'Hara et al.''); Jennifer S. Conrad & Sunil Wahal,
The Term Structure of Liquidity Provision, 136(1) J. Fin. Econ. 239-
259 (2020) (``Conrad and Wahal'').
\367\ See Conrad and Wahal.
---------------------------------------------------------------------------
Selecting an appropriate time horizon to calculate the realized
spread is important, as realized spreads vary significantly as the time
horizon is changed.\368\ In order to examine this issue, the Commission
analyzed how realized spreads vary when calculated over time horizons
ranging from one second to five minutes, as well as how they differ
based on market capitalization size, using TAQ data from February 2021
for a sample of 400 stocks from four different market capitalization
groups (less than $100 million, $100 million to $1 billion, $1 billion
to $10 billion, and over $10 billion).\369\
---------------------------------------------------------------------------
\368\ See infra Figure 13.
\369\ See infra note 706 for dataset description. This analysis
uses data from prior to the implementation of the MDI Rules and the
specific numbers may be different following the implementation of
the MDI Rules. In particular, for certain stocks, the NBBO midpoint
may change, though the Commission is uncertain of the direction of
this effect. This may impact statistics that are based on these
values, including realized spreads. See infra section VII.C.1.(d).
While specific numbers might change, the Commission does not expect
the relative variation in realized spreads across different time
horizons to change as a result of the implementation of the MDI
Rules.
---------------------------------------------------------------------------
The results are presented in Figure 1, and show that realized
spreads tend to decrease as the time horizon increases, and
additionally show that they tend to decline as market capitalization
size increases. Echoing results from the academic literature, the
persistence of these systematic differences in realized spreads across
market capitalization sizes implies that a time horizon that may be
ideal for large cap stocks may be too short for small cap stocks.\370\
As a result, the Commission believes that including multiple different
time horizons for realized spreads would make this measure more
relevant across a wider range of stocks.
---------------------------------------------------------------------------
\370\ See Conrad and Wahal.
---------------------------------------------------------------------------
Figure 1: Average Realized Spreads by Market Capitalization, February
2021
[[Page 3815]]
[GRAPHIC] [TIFF OMITTED] TP20JA23.000
Further, the analysis of different time horizons and market
capitalization shows that most of the difference in realized spread
\371\ is captured for the largest stocks at 15 seconds, but less than a
third is captured for smaller cap stocks, as shown in Table 1
below.\372\ However, at least half of the difference is captured for
smaller cap stocks at one minute.\373\ Therefore, the proposed time
horizons of 15 seconds and one minute would capture most of the
realized spread information, in particular for the largest stocks.\374\
---------------------------------------------------------------------------
\371\ Generally, if most of the difference between realized
spreads is captured at a particular time horizon, then this implies
that most of the relevant information has been incorporated into the
realized spreads.
\372\ Specifically, analysis shows the 15-second horizon
captures over 66.2% of the overall decline in realized spreads for
the group corresponding to the largest stocks, but captures less
than a third of this decline in the two groups corresponding to
smaller stocks. Analysis also shows that the 15-second horizon
captures almost 50% of the overall decline in realized spreads for
those stocks with a market capitalization of between $1 billion and
$10 billion.
\373\ By the one-minute horizon, realized spreads have captured
more than 50% of the overall decline in realized spreads for all
stocks, and a substantial majority for the two groups of larger
stocks (79% and 94.9%).
\374\ For the two smaller-stock groups, a sizeable proportion of
the overall decline (37%) does not occur until the five-minute
horizon. See infra section VII.E.3.(c)(1) for a discussion of
including additional time horizons, including the five-minute
horizon, for calculating realized spreads.
Table 1--Variation in Average Realized Spread, by Time Horizon
----------------------------------------------------------------------------------------------------------------
Horizon
Market cap group 1 sec-5 min -----------------------------------------------
($) 15 sec (%) 1 min (%) 5 min (%)
----------------------------------------------------------------------------------------------------------------
<$100 million................................... 0.021 22.5 40.2 37.3
$100 million-$1 billion......................... 0.019 33.2 29.7 37.1
$1 billion-$10 billion.......................... 0.017 48.5 30.5 21.0
>$10 billion.................................... 0.013 66.2 28.7 5.1
----------------------------------------------------------------------------------------------------------------
Table 1: Variation in Average Realized Spread, by Time Horizon. This table presents the difference between
dollar realized spreads calculated using a 1-second time horizon and realized spreads calculated using a 5-
minute time horizon, along with the percentage of variation in this difference that is captured at various
time horizons (15 seconds, 1 minute, and 5 minutes), using data from TAQ. See infra note 722 for dataset
description. This analysis uses data from prior to the implementation of the MDI Rules and numbers may be
different following the implementation of the MDI Rules. See supra note 369 and infra section VII.C.1.(d).
Based on this analysis, for executions of covered orders, the
Commission proposes that the average realized spread be calculated at
specified intervals of 15 seconds and one minute after the time of
execution.\375\ The Commission believes that these timeframes are
appropriate for liquid stocks and for thinly traded stocks because, as
suggested by available academic literature and supported by the
analysis in this release, realized spreads are likely to be most
impacted during the first 15 seconds, for large stocks, and one minute,
for small stocks, following a trade.\376\ The Commission is proposing
to require realized spreads to be calculated at both intervals in order
[[Page 3816]]
to provide relevant information for symbols with different liquidity
characteristics. While commenters supported moving away from the
current five-minute calculation, they suggested different time
horizons.\377\ Although both shorter (50ms, 100ms) and longer (three
minute, five minute) \378\ time horizons would provide useful
information for certain groups of stocks, each additional time horizon
adds to the computational burden of preparing the reports and increases
the size and complexity of the reports, adding to the costs that market
participants face when collecting, interpreting, and evaluating Rule
605 reports. Additional time horizons would likely only provide
additional benefits for smaller subsets of stocks, while the 15-second
and one minute time horizons would generally provide informative
average realized spread metrics across the universe of stocks with
different market capitalization and different liquidity
characteristics.
---------------------------------------------------------------------------
\375\ See proposed Rule 605(a)(1)(i)(G) and(I). In order to
accommodate calculation of ``average realized spread'' at two
different time intervals, the Commission proposes to modify the
existing definition of ``average realized spread'' to replace the
reference to five minutes with a ``specified interval.'' See
proposed Rule 600(b)(13).
\376\ See Conrad and Wahal.
\377\ Two commenters suggested expanding realized spread into
50ms, 100ms, and three minute buckets to better identify adverse
selection. See KOR Group I at 4; Healthy Markets II at 3. One
commenter suggested that if the realized spread statistic is to
remain, the Commission should either determine an appropriate time-
scale for the measurement or re-affirm the current five minutes
duration. See FIF III at 10.
\378\ Analysis shows that retaining a five-minute horizon, in
addition to the proposed one-minute and 15-second horizon, would
capture additional information about realized spreads, particular
for the smallest stocks. See infra section VII.D.1.(b)(1)(c)(ii).
However, as stated above, the one-minute time horizon would still
capture more than 50% of the variation in realized spreads for the
smallest cap stocks. See supra note 373.
---------------------------------------------------------------------------
Finally, in connection with both the average realized spread and
average effective spread \379\ statistics, the Commission has also
considered, but is not including in the proposed rule text, an updated
method by which the spread is calculated by incorporating a weighted
midpoint.\380\ However, as is discussed in section VII.E.3.(c)(3)
below, the midpoint requires data only on the best available bid and
ask price.\381\ In contrast, calculating the weighted midpoint would
require that reporting entities additionally collect data on the depth
available at the NBBO.\382\ Furthermore, the midpoint may be easier to
compute and interpret, as it is more familiar to market participants
than the weighted midpoint.
---------------------------------------------------------------------------
\379\ See infra section IV.B.4.b).
\380\ The weighted midpoint is calculated using the following
formula: weighted midpoint = ((bid price x quantity at the ask
price) + (ask price x quantity at the bid price))/(quantity at the
ask price + quantity at the bid price). See, e.g., Bj[ouml]rn
Hagstr[ouml]mer, Bias in the Effective Bid-Ask Spread, 142(1) J.
Fin. Econ. 314-337 (2021).
\381\ See infra section VII.E.3.(c)(3).
\382\ This might not be a significant additional cost, as
reporting entities would be required to collect information on NBBO
depth for computing the size improvement benchmark measure under the
proposed amendments. See infra section IV.B.4.(e).
---------------------------------------------------------------------------
(b) Average Effective Spread
Rule 600(b)(8) defines ``average effective spread'' as the share-
weighted average of effective spreads for order executions calculated,
for buy orders, as double the amount of difference between the
execution price and the midpoint of the national best bid and national
best offer at the time of order receipt and, for sell orders, as double
the amount of difference between the midpoint of the national best bid
and national best offer at the time of order receipt and the execution
price.\383\ Currently, average effective spread is required to be
calculated only for market and marketable limit order types and doing
so requires the comparison of the execution price of an order with the
midpoint of the NBBO at the time of order receipt. The Commission
proposes to expand effective spread reporting requirements to include
all covered orders, and to modify the methodology for calculating this
metric for executable NMLOs, beyond-the-midpoint limit orders, and
executable stop orders.
---------------------------------------------------------------------------
\383\ See 17 CFR 242.600(b)(8). All orders that require
reference to a consolidated BBO that has been crossed for 30 seconds
or more are exempt. See Letter from Annette L. Nazareth, Director,
Division, Commission, to Stuart J. Kaswell, Senior Vice President
and General Counsel, Securities Industry Association (Mar. 12, 2001)
(``SIA Exemption Letter'').
---------------------------------------------------------------------------
Average effective spread provides a measure of spread actually paid
by investors at a particular market center.\384\ Generally, for
marketable order types, average effective spread provides a measure of
the price paid for the immediacy of execution. However, because they
are less aggressively priced, NMLOs are not typically submitted with
the expectation that they will be executed immediately. Instead, they
are submitted with the expectation that they rest and provide liquidity
(if executed). Therefore, average effective spread for NMLOs and orders
submitted with stop prices provides a measure of the amount a liquidity
provider could expect to earn for providing liquidity. The Commission
proposes to revise the definition of ``average effective spread'' to
specify that, for order executions of NMLOs \385\ and orders submitted
with stop prices, average effective spread be calculated from the time
the order becomes executable.\386\ Because the concept of
``executable'' controls for prevailing market conditions, benchmarking
average effective spread statistics for these non-marketable order
types from the time such orders become executable would permit average
effective spread statistics for these order types to be more
informative of execution quality received.
---------------------------------------------------------------------------
\384\ See Adopting Release, 65 FR 75414 (Dec. 1, 2000) at 75415.
\385\ As noted above, beyond-the-midpoint limit orders are a
type of NMLO.
\386\ See proposed Rule 600(b)(10).
---------------------------------------------------------------------------
The Commission proposes to prescribe the collection of this data
point for executable NMLOs, beyond-the-midpoint limit orders, and
executable stop orders by adding proposed Rule 605(a)(1)(i)(K) to
require the calculation of average effective spread for executions of
covered orders, which includes executable NMLOs and executable stop
orders.\387\
---------------------------------------------------------------------------
\387\ See proposed Rule 605(a)(1)(i). The Commission also
proposes to delete the current average effective spread calculation
requirement in Rule 605(a)(1)(ii)(A), which previously applied only
to market and marketable limit orders, because this measurement,
with the inclusion of marketable IOCs, beyond-the-midpoint limit
orders, executable NMLOs, and executable orders with stop prices,
would be included in proposed Rule 605(a)(1)(i)(K).
---------------------------------------------------------------------------
(c) Percentage Spreads (Effective and Realized)
Currently, Rule 605 statistics include the average realized spread
and average effective spread for executions of covered orders. To
compare these dollar-based statistics across the data population while
taking into account the wide range of stock prices, dollar-based
statistics need to be converted into percentages. While obtaining
historical price information for individual securities is possible, in
the Commission's experience since the implementation of Rule 605, such
calculations are time- and resource-intensive, especially across
multiple time periods and securities. Furthermore, the Commission
believes that using percentage-based spread measures could provide
additional information at the individual stock level if a stock's price
changes significantly during a month.
Therefore, the Commission proposes requiring dollar-based spread
statistics (i.e., effective spread and realized spread) to also be
reported as percentages because a percentage measure would account for
differing underlying stock prices and better facilitate comparisons of
spread statistics across different time periods and securities.\388\
The proposed definitions for ``average percentage effective spread''
and ``average percentage realized spread'' would provide the same
calculation as the dollar-based effective and realized spread
statistics for the numerator.\389\
[[Page 3817]]
The denominator for dollar-based spread percentages would be the
midpoint of the NBBO at either the time of order receipt (for
marketable order types) or the time an order first becomes executable
(for non-marketable order types) in order to provide a consistent
measure of the prevailing stock price from the point when an order
could reasonably be expected to execute. This would then be averaged on
a share-weighted basis for the month.
---------------------------------------------------------------------------
\388\ See proposed Rule 605(a)(1)(i)(H), (J), and (L).
\389\ See proposed Rule 600(b)(11) and (12).
---------------------------------------------------------------------------
Specifically, average percentage effective spread would be
calculated for each transaction as double the amount of the difference
between the execution price and the midpoint divided by the midpoint.
The midpoint used would be at either the time of order receipt \390\ or
the time of executability.\391\ Then the percentage would be averaged
on a share-weighted basis.\392\
---------------------------------------------------------------------------
\390\ The time of order receipt would be used for market orders,
marketable limit orders, and marketable IOCs. See proposed Rule
600(b)(11).
\391\ The time an order becomes executable would be used for
NMLOs, beyond-the-midpoint limit orders, and orders submitted with
stop prices. See proposed Rule 600(b)(11).
\392\ See proposed Rule 600(b)(11).
---------------------------------------------------------------------------
Similarly, average percentage realized spread would be calculated
as the realized spread for an order, divided by the midpoint of the
NBBO at the time of order receipt (for marketable order types) or
executability (for non-marketable order types).\393\ For each buy
transaction, realized spread would be double the amount of difference
between the execution price and the midpoint of the NBBO at both 15
seconds and one minute after the time of order execution.\394\ For each
sell transaction, realized spread would be double the amount of
difference between the midpoint of the NBBO at both 15 seconds and one
minute after the time of order execution and the execution price.\395\
Then the percentage would be averaged on a share-weighted basis for the
month to calculate that month's average 15-second and one-minute
realized spread percentage for each category.
---------------------------------------------------------------------------
\393\ See proposed Rule 600(b)(12).
\394\ Proposed Rule 600(b)(12) provides that the midpoint would
be calculated at a ``specified interval'' after the time of order
execution. Proposed Rule 605(a)(1)(i)(H) and (J) would require
average percentage realized spread to be calculated at 15 seconds
and one minute, respectively, after the time of execution. The
Commission is proposing the use of the 15 second and one minute time
period for the reasons discussed in supra section IV.B.4.(a).
\395\ See proposed Rule 600(b)(12) and proposed Rule
605(a)(1)(i)(G) and (I).
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(d) Effective Over Quoted Spread (E/Q)
The Commission understands that market participants often use
effective over quoted spread (``E/Q'') \396\ as a measure of execution
quality.\397\ E/Q is generally expressed as a percentage that
represents how much price improvement an order received.\398\ An E/Q of
100% means a buy order was executed at the national best offer or a
sell order was executed at the national best bid. An E/Q of 0% means an
order was executed at the midpoint of the NBBO.
---------------------------------------------------------------------------
\396\ Quoted spread is the difference between the national best
bid and the national best offer at the time an order is received.
\397\ See, e.g., Bill Alpert ``Who Makes Money on Your Stock
Trades,'' Barron's, Feb. 28, 2015 (retrieved from Factiva database)
(stating ``the industry's acid-test [execution] quality measure is
the ratio of effective spread over the quoted spread, or E/Q'');
https://investor.vanguard.com/about-us/brokerage-order-execution-
quality#:~:text=Effective%20over%20quoted%20spread*,in%20our%20low%20
E%2F. A commenter stated that E/Q is a commonly used metric of
execution quality that measures how effectively a market maker
prices a customer's order relative to the prevailing NBBO. See Citi
Letter at 3.
\398\ See, e.g., https://us.etrade.com/trade/execution-
quality#:~:text=Effective%20spread%20over%20quoted%20spread,between%2
0the%20bid%20and%20offer.
---------------------------------------------------------------------------
Rule 605 does not require quoted spreads to be reported, although
average quoted spread can be derived from existing Rule 605
statistics.\399\ However, along with the proposed requirement to
include percentage-based realized and effective spread statistics, it
would improve the comparability of price improvement statistics across
symbols to include share-weighted average E/Q. Further, the Commission
understands E/Q is already often-used and well-understood by industry
participants. Currently, although average E/Q can be derived under Rule
605, E/Q is a relatively simple metric to capture contemporaneously
with an execution. Given the common usage of the metric, requiring a
separate field for E/Q would increase the ability of market
participants to access and utilize E/Q to compare price improvement
statistics across securities, and across market centers and broker-
dealers.
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\399\ Average quoted spread can be derived on a per symbol basis
by adding average effective spread and double the amount of total
average per share price improvement or dis-improvement (i.e., amount
of price improvement times price improved share count, less amount
of price dis-improvement times price dis-improved share count,
divided by total number of executed shares).
---------------------------------------------------------------------------
Deriving average quoted spread from the existing reports involves
additional computational burdens. Further, there are likely to be
differences in E/Q on a per transaction basis that may yield a
different average E/Q than extrapolating an average quoted spread for
the month and using that to calculate an average monthly E/Q, which is
a noisier measure of E/Q.\400\ Therefore, the Commission proposes to
require, for executions of all covered orders, a statistic for the
average effective over quoted spread, expressed as a percentage.\401\
Share-weighted average E/Q would be calculated by dividing effective
spread by quoted spread \402\ for each transaction and then averaging
that over the month (weighted by number of shares). The quoted spread
would be the difference between the national best bid and the national
best offer at either the time of order receipt (for marketable order
types) or the time an order first becomes executable (for non-
marketable order types).\403\ This would provide a consistent measure
of the prevailing quoted spread at the point when an order could
reasonably be expected to execute. Expressing share-weighted average E/
Q as a percentage would provide an additional data point that could be
used to evaluate price improvement across symbols or the entire data
population.
---------------------------------------------------------------------------
\400\ See infra note 878 and accompanying text.
\401\ See proposed Rule 605(a)(1)(i)(M).
\402\ See proposed Rule 600(b)(9) (defining ``average effective
over quoted spread'').
\403\ See id.
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(e) Size Improvement
Rule 605 reports are required to include price improvement metrics
but do not indicate whether orders received an execution of more than
the displayed size at the quote. The Commission considered whether to
add a measure of ``size improvement'' or ``liquidity enhancement'' when
adopting Rule 605, but did not add this type of measure in part to
minimize the complexity and quantity of statistics, and in part because
certain measures, such as effective spread, already reflected a market
center's ability to execute above the displayed size.\404\ Share-
weighted effective spread metrics may provide information about size
improvement, since effective spread will be larger for orders that have
to ``walk the book'' (i.e., consume available depth beyond the best
quotes). However, effective spread combines both price and size
information; therefore, it is difficult to distinguish whether, for
example, a low effective spread arises because the market center
consistently offered better prices to small orders, or was able to
offer better prices to several very large orders. Market participants
have expressed support for a size improvement measure,\405\ and orders
are
[[Page 3818]]
often larger than the displayed size at the NBBO.\406\ The Commission
also stated in the MDI Adopting Release that the decimalization of
securities pricing in 2001, and the resulting shift away from the
larger fractional quoting and trading increments, had significant
implications for the amount of liquidity available at the top of
book.\407\ Market participants have raised concerns about reduced price
transparency and difficulty executing large transactions at the best
prices due to lower concentrations of trading interest at the top of
book.\408\ The Commission believes that the use of size improvement
statistics could help address these concerns by providing users of the
statistics with information relating to which market centers and
broker-dealers are more likely to be able to fill larger-sized orders
at or better than the NBBO.
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\404\ See Adopting Release, 65 FR at 75425.
\405\ See, e.g., FIF III, at 2; Virtu Petition at 3-4. The
petitioner states that the ``single biggest shortcoming'' of Rule
605 is that it does not reflect any benefits received by retail
investors on orders that outsize the NBBO, including size
improvement. See Virtu Petition at 3. The petitioner states that
retail investors deserve more complete execution quality reports
that provides transparency about the amount of size improvement that
their orders are receiving. See id. at 4. The petitioner
specifically states that Rule 605 reporting would be more complete
if market participants could assess execution quality by comparing
the fill prices on their orders to a reference benchmark that
includes all displayed liquidity on exchanges, including resting
odd-lots that are visible in market data feeds. See id.
\406\ For example, the petitioner stated that ``approximately
45% of shares (and 54% of the value traded) filled by [the
petitioner] in 2020 were from orders that outsized the NBBO.'' Virtu
Petition at 3.
\407\ See MDI Adopting Release, 86 FR 18596 (Apr. 9, 2021) at
18606.
\408\ See id. at 16751 n.278 and accompanying text (citing the
Investment Company Institute letter describing the difficulty of
institutional investors' ability to execute large orders). Shortly
after decimalization became a reality, the GAO noted that the
average executed trades size declined by 67% on NYSE and 41% on
NASDAQ. See GAO Report, ``Decimal Pricing Has Contributed to Lower
Trading Cost and a More Challenging Trading Environment,'' May 2005,
at 37.
---------------------------------------------------------------------------
The Commission proposes adding a benchmark metric that would, in
combination with information about execution sizes, indicate the level
of size improvement, i.e., whether orders received an execution greater
than the displayed size at the quote. Analysis of a sample of 100
symbols during March of 2019 indicates only a moderate level of
correlation between standard price improvement metrics and a measure of
size improvement, indicating that these measures may contain different
information about execution quality.\409\ Given that existing execution
quality metrics do not include metrics for size improvement, nor any
metrics that serve as an adequate proxy for a size improvement
statistic, the Commission proposes to include a benchmark metric for
all executions of covered orders. Specifically, proposed Rule
605(a)(1)(i)(F) requires, for executions of all covered orders, the
reporting of the cumulative number of shares of the full displayed size
of the protected bid at the time of execution, in the case of a market
or limit order to sell; and for the full displayed size of the
protected offer at the time of execution, in the case of a market or
limit order to buy. This would capture the full displayed size at the
quote on the side of the NBBO against which a buy or sell order would
be expected to execute. Pursuant to the proposed rule, for each order,
the share count shall be capped at the order size if the full displayed
size of the national best bid or national best offer is larger than the
order. This would prevent skewing of the size improvement benchmark if
the national best bid or national best offer outsized any particular
order. By limiting this measure to only the full displayed size of the
protected bid or offer that would have been available to a particular
order, the benchmark would represent what could be have been executed
at the protected bid or offer.
---------------------------------------------------------------------------
\409\ See infra section VII.E.3.(d)(1). See infra notes 882-883
for a description of the sample selection and analysis.
---------------------------------------------------------------------------
This benchmark metric can be combined with information about the
number of shares that a market center or broker-dealer executed at or
above the quote to measure a market center or broker-dealer's ability
to offer customers execution at the quote (or better), even when an
order's full size at the quote is not available. For example, if a
market center executes a 500 share order to buy at a price at or better
than the national best offer, and there are currently 200 shares
displayed at the national best offer, the associated benchmark metric
for the order would be 200 shares because there were only 200 shares
available to fill the order at the best displayed quote. This benchmark
share count could then be compared to the number of shares executed at
the best displayed quote (in this case, 500 shares) to capture whether
the market center filled any part of the customer order at the national
best offer (or better), even when there was no depth available at the
national best offer (``size improvement share count''). To continue the
preceding example, the size improvement share count would be 500-200 =
300 shares, since the market center was able to offer the best
displayed quote to 300 shares more than the depth available at the
best-displayed quote.\410\
---------------------------------------------------------------------------
\410\ Note that capping the benchmark metric at the order size
prevents the size improvement share count from turning negative in
situations when depth at the best displayed quote exceeds the
customer-requested order size. For example, consider a case in which
a market center executes an order for 200 shares when there are
currently 500 shares displayed at the national best offer. If the
benchmark share count were not capped at the order size, the size
improvement share count would be 200-500 = -300 and would become
more negative the more depth there is available at the NBBO, which
would reduce a market center's total monthly size improvement share
count, simply for fulfilling the customer's request to only execute
200 shares and not the full 500 shares that were available at the
national best offer. Instead, the benchmark share count would be
capped at the order size, and the benchmark share count would still
be 200 shares. The size improvement share count would be 200-200 = 0
shares, capturing the fact that the market center did not offer the
national best offer price (or better) to any shares over and above
the depth available at the best displayed quote.
---------------------------------------------------------------------------
The petitioner suggested an alternative metric: real price
improvement (``RPI''), which combines price improvement (i.e., trades
at prices better than the NBBO price) and size improvement (i.e.,
transactions executed for share quantities greater than shares
displayed at the NBBO and at prices at or better than the NBBO
price).\411\ The petitioner stated that RPI reflects the true benefits
received by retail investors.\412\ RPI would use as its benchmark a
price that ``reflects the equivalent size of shares--including depth of
book quotes and odd lot quotes.'' \413\ Because the calculation of RPI
takes into account the complete set of information related to the
consolidated depth of book, RPI may be a more informative measure of
size improvement than a measure that can be calculated using the size
improvement benchmark metric proposed. However, because the complete
set of consolidated depth of book information is not available from
public data sources, the RPI would require market centers and reporting
broker-dealers to subscribe to all exchanges' proprietary depth-of-book
data feeds, which would entail a significant cost for those reporting
entities that do not already subscribe to these feeds.\414\ The
[[Page 3819]]
proposed rule would not require an RPI benchmark or measure, as the
Commission preliminarily believes the benefits to market participants
from having access to a potentially more accurate measure of size
improvement are not justified by these potentially significant
additional costs to reporting entities.\415\
---------------------------------------------------------------------------
\411\ See Virtu Petition at 3.
\412\ See id. Additionally, the EMSAC suggested a similar
measure--Enhanced Liquidity--designed to indicate for the proportion
of shares greater than the available shares displayed at NBBO that
were executed at or better than the NBBO. See EMSAC III at 2, n.3
and accompanying text.
\413\ Virtu Petition at 5.
\414\ In a white paper, one market center estimated its costs
related to subscribing to depth of book data feeds for 11 exchanges
to be between $51,480 and $226,320 per exchange per year. See IEX,
Jan. 2019, ``The Cost Of Exchange Services,'' available at https://iextrading.com/docs/The%20Cost%20of%20Exchange%20Services.pdf.
\415\ See also infra section VII.E.3.(d)(1) for a more detailed
discussion of the potential benefits and costs of RPI.
---------------------------------------------------------------------------
(f) Riskless Principal
In effecting riskless principal transactions, a market center
submits a principal order to another market center in order to fulfill
a customer order. Upon execution at the away market center, the
receiving market center executes the customer transaction on the same
terms as the principal execution.\416\ Generally, under the current
Rule, a market center that executes the riskless principal leg of the
trade (i.e., the receiving market center's execution of the customer
order on the same terms as the principal transaction) reports those
orders in its Rule 605 statistics as part of the cumulative number of
shares of covered orders that were executed at the receiving market
center under Rule 605(a)(1)(i)(D), rather than as a part of the
cumulative number of shares of covered orders executed at any other
venue under Rule 605(a)(1)(i)(E).\417\ However, because the away market
center is also reporting execution of the principal order as part of
its shares executed at the receiving market center, this results in
both of these legs of the transaction being counted as executed at the
receiving market center, which could obscure information about how
often a market center internalizes orders. Wholesalers may choose
between internalizing orders or executing orders on a riskless
principal basis. This choice has an effect on execution quality because
internalized orders are not exposed to competition, whereas the
principal order associated with a riskless principal transaction may be
exposed to trading interest from other market participants. Therefore,
it would be useful for investors to be able to observe what percentage
of orders a wholesaler internalizes.
---------------------------------------------------------------------------
\416\ See Securities Exchange Act Release No. 47364 (Feb. 13,
2003), 68 FR 8686, n. 33 (Feb. 24, 2003) (generally describing
riskless principal transactions ``as trades in which, after
receiving an order to buy (or sell) from a customer, the broker-
dealer purchases (or sells) the security from (or to) another person
in a contemporaneous offsetting transaction'').
\417\ We note that Commission staff has taken the position that
the market center executing an order as riskless principal should
reflect the order on its monthly report as executed at such market
center, and not at another venue, using the time that the order was
executed at such market center. See Staff Legal Bulletin No. 12R,
``Frequently Asked Questions About Rule 11Ac1-5'' (June 22, 2001).
---------------------------------------------------------------------------
Accordingly, Rule 605's execution quality statistics would be more
informative to market participants and other users of the Rule 605
reports if riskless principal orders were reported as executed at
another venue, rather than as executed at the market center. The
Commission proposes to carve riskless principal orders out from
proposed Rule 605(a)(1)(i)(D) by providing that the number of shares of
covered orders executed at the receiving market center, broker, or
dealer excludes shares that the market center, broker, or dealer
executes on a riskless principal basis.\418\ As a result, the market
center that executes the riskless principal order would include these
shares as part of the cumulative number of shares executed at any other
venue under Rule 605(a)(1)(i)(E), and only the market center that
executes the corresponding principal order would include those shares
as part of the cumulative number of shares executed at the receiving
market center under proposed Rule 605(a)(1)(i)(D).
---------------------------------------------------------------------------
\418\ See proposed Rule 605(a)(1)(i)(D).
---------------------------------------------------------------------------
Request for Comment
The Commission seeks comment generally on the changes to the
information required for all order types, including the calculation of
average realized spread for executed orders, the calculation of average
effective spread for NMLOs, percentage-based spread statistics, E/Q
statistics, size improvement measures, and the treatment of riskless
principal transactions. In particular, the Commission solicits comment
on the following:
32. Should realized spread be required to be calculated 15 seconds
and one minute after execution? Why or why not? If not, what
alternative interval(s) do commenters recommend and why? Please explain
and provide data, if available.
33. Some academic research suggests that the use of a weighted
midpoint would be more appropriate when calculating realized and
effective spreads.\419\ Do commenters believe a weighted midpoint would
be more appropriate? If so, why? Would additional costs be associated
with utilizing a weighted midpoint?
---------------------------------------------------------------------------
\419\ See supra note 380.
---------------------------------------------------------------------------
34. Should average effective spread be required to be calculated
for NMLOs and orders submitted with stop prices? Do commenters agree
with the proposed average effective spread calculation methodology that
would be required for executable NMLOs and executable stop loss orders?
35. Should dollar-based spread statistics (i.e., effective and
realized spread) also be required to be reported as a percentage? Do
commenters believe there are other ways to represent spread statistics
that could be helpful? If so, how should spread statistics also be
reported?
36. Should share-weighted average E/Q expressed as a percentage be
required to be calculated for all order types? Do commenters agree that
share-weighted average E/Q expressed as a percentage would improve the
comparability of price improvement statistics across symbols? If not,
why?
37. With respect to proposed Rule 605(a)(1)(i)(F), do commenters
support adding a requirement to include the proposed metric designed
to, in combination with execution metrics, indicate whether orders
received an execution greater than the displayed size at the quote
(i.e., size improvement)? Why or why not?
38. The Commission seeks comment on whether the addition of the
proposed metric for size improvement would be sufficient to indicate
whether orders received an execution greater than the displayed size of
the quote. Should the Commission require a comparison of fill prices to
a reference benchmark that includes depth of book and odd-lot
information (i.e., RPI), or some other liquidity measurement? \420\ If
so, why?
---------------------------------------------------------------------------
\420\ As is noted above, the petitioner specifically states that
Rule 605 reporting would be more complete if market participants
could assess execution quality by comparing the fill prices on their
orders to a reference benchmark that includes all displayed
liquidity on exchanges, including resting odd-lots that are visible
in market data feeds. See Virtu Petition at 4.
---------------------------------------------------------------------------
39. Should riskless principal orders not be required to be counted
as orders executed at the receiving market center, broker, or dealer
for the purpose of computing Rule 605 statistics and instead be
classified as orders executed away? Why or why not?
5. Additional Required Information for Market, Marketable Limit,
Marketable IOC, and Beyond-the-Midpoint Limit Orders
The MDI Rules expanded the data that will be made available for
dissemination within the national market system (``NMS data'').\421\
One goal of the expansion of NMS data is to increase transparency about
the best-priced quotations available in the market. To further increase
transparency about the
[[Page 3820]]
availability of the best priced odd-lot orders in the market, the
Commission also included certain odd-lot information in NMS data as
part of the MDI Rules.\422\ The Commission is proposing to add a
definition for ``best available displayed price,'' which would include
the best priced odd-lot if that price is inside the NBBO in order to
provide additional price improvement statistics.\423\
---------------------------------------------------------------------------
\421\ See MDI Adopting Release.
\422\ See 17 CFR 242.600(b)(59); MDI Adopting Release, 86 FR
18596 (Apr. 9, 2021) at 18613. The Commission outlined a phased
transition plan for the implementation of the MDI Rules, including
the implementation of odd-lot order information. See MDI Adopting
Release, 86 FR at 18698-701.
\423\ The Commission is separately proposing to, among other
things, amend the definition of odd-lot information to include a new
data element to identify the best odd-lot orders available in the
market inside the NBBO. See Minimum Pricing Increments Proposal. The
Commission encourages commenters to review that proposal to
determine whether it might affect their comments on this proposing
release.
---------------------------------------------------------------------------
Odd-lot information is defined as (1) odd-lot transaction data
disseminated pursuant to the effective national market system plan or
plans required under 17 CFR 242.603(b) as of April 9, 2021,\424\ and
(2) odd-lots at a price greater than or equal to the national best bid
and less than or equal to the national best offer, aggregated at each
price level at each national securities exchange and national
securities association.\425\ The Commission stated that making the best
priced quotations available in core data is consistent with the
Commission's goal in expanding the content of NMS information--
enhancing the availability and usefulness of the information.\426\
---------------------------------------------------------------------------
\424\ Odd-lot transaction information is currently collected,
consolidated, and disseminated by the exclusive SIPs. See Securities
Exchange Act Release Nos. 70793 (Oct. 31, 2013), 78 FR 66788 (Nov.
6, 2013) (order approving Amendment No. 30 to the UTP Plan to
require odd-lot transactions to be reported to consolidated tape);
70794 (Oct. 31, 2013), 78 FR 66789 (Nov. 6, 2013) (order approving
Eighteenth Substantive Amendment to the Second Restatement of the
CTA Plan to require odd-lot transactions to be reported to
consolidated tape).
\425\ See 17 CFR 242.600(b)(59); MDI Adopting Release, 86 FR
18596 (Apr. 9, 2021) at 18613. The Commission is separately
proposing to, among other things, accelerate the implementation of
the round lot and the odd-lot information definitions. See Minimum
Pricing Increments Proposal.
\426\ See MDI Adopting Release, 86 FR 18596 (Apr. 9, 2021) at
18613.
---------------------------------------------------------------------------
The Commission is proposing to add a definition for ``best
available displayed price'' which shall mean, with respect to an order
to buy, the lower of (i) the national best offer at the time of order
receipt or (ii) the price of the best odd-lot order to sell at the time
of order receipt as disseminated pursuant to an effective transaction
reporting plan or effective national market system plan; and, with
respect to an order to sell, the higher of (i) the national best bid at
the time of order receipt or (ii) the price of the best odd-lot order
to buy at the time of order receipt as disseminated pursuant to an
effective transaction reporting plan or effective national market
system plan.\427\ In each case, an order to buy or an order to sell
would be benchmarked against the best price on the side of the market
against which it could expect to receive an immediate execution.
Because a beyond-the-midpoint limit order may be a covered order even
if received outside of regular trading hours or when an NBBO is not
being disseminated, the Commission proposes to specify that, for
beyond-the-midpoint limit orders, the best available displayed price
shall be determined at the time such order becomes executable instead
of the time of order receipt.\428\ Generally, the time of order receipt
and the time the order is considered executable would be the same for a
beyond-the-midpoint-limit order, except in those cases where it is
received outside of regular trading hours or when an NBBO is not being
disseminated. Therefore, measuring from the point of executability
would ensure that a best available displayed price can be determined.
---------------------------------------------------------------------------
\427\ See proposed Rule 600(b)(14). Because the best odd-lot
order to buy or sell would be inside the NBBO, the national best bid
or national best offer would only be used if there is not a best
odd-lot price on the same side of the market as the order.
\428\ See id.
---------------------------------------------------------------------------
The Commission is further proposing to add two definitions relating
to the best available displayed price in order to add price improvement
statistics. ``Executed outside the best available displayed price''
shall mean, for buy orders, execution at a price higher than best
available displayed price; and, for sell orders, execution at a price
lower than the best available displayed price.\429\ ``Executed with
price improvement relative to the best available displayed price''
shall mean, for buy orders, execution at a price lower than the best
available displayed price and, for sell orders, execution at a price
higher than the best available displayed price.\430\ Similar to the
existing definitions for ``executed outside the quote'' \431\ and
``executed with price improvement,'' \432\ these definitions would
classify order executions based on their execution price relative to
the best available displayed price.
---------------------------------------------------------------------------
\429\ See proposed Rule 600(b)(44).
\430\ See proposed Rule 600(b)(47).
\431\ See 17 CFR 242.600(b)(35). The Commission is proposing to
renumber the definition of ``executed outside the quote'' as
proposed Rule 600(b)(45).
\432\ See 17 CFR 242.600(b)(36). The Commission is proposing to
renumber the definition of ``executed with price improvement'' as
proposed Rule 600(b)(46).
---------------------------------------------------------------------------
The Commission also proposes to add to Rule 605(a)(1)(ii)
additional price improvement statistics specifically related to the
best available displayed price. These statistics mirror the existing
price improvement statistics for marketable order types executed better
than, at, and outside the quote. Specifically, for each category, these
additional price improvement statistics would provide a cumulative
share count and a share-weighted average amount per share that prices
were improved as compared to the best available displayed price. The
Commission is proposing Rule 605(a)(1)(ii)(O), which would require the
reporting of the cumulative number of shares of covered orders executed
with price improvement relative to the best available displayed price.
Proposed Rule 605(a)(1)(ii)(P) would require, for shares executed with
price improvement relative to the best available displayed price, the
share-weighted average amount per share that prices were improved as
compared to the best available displayed price. Proposed Rule
605(a)(1)(ii)(Q) would require the reporting of the cumulative number
of shares of covered orders executed at the best available displayed
price. Proposed Rule 605(a)(1)(ii)(R) would require the reporting of
the cumulative number of shares of covered orders executed outside the
best available displayed price. Finally, proposed Rule 605(a)(1)(ii)(S)
would require, for shares executed outside the best available displayed
price, the share-weighted average amount per share that prices were
outside the best available displayed price. These five metrics, in
conjunction with each other, would allow market participants to
evaluate how well market centers and broker-dealers perform in
executing covered orders relative to the best available displayed
price.
The Commission outlined a phased transition plan for the
implementation of the MDI Rules, including the implementation of odd-
lot order information.\433\ The Commission stated that competing
consolidators could offer a product that contains only information on
the best priced odd-lot on each exchange.\434\ The Commission is
separately proposing to, among other things: (1) accelerate the
implementation of the round lot and the odd-lot information
definitions; and (2) amend the definition of odd-lot
[[Page 3821]]
information to include a new data element to identify the best odd-lot
orders available in the market inside the NBBO.\435\
---------------------------------------------------------------------------
\433\ See MDI Adopting Release, 86 FR 18596 (Apr. 9, 2021) at
18698-701.
\434\ See id. at 18753.
\435\ See Minimum Pricing Increments Proposal.
---------------------------------------------------------------------------
As is discussed above \436\ and in the MDI Adopting Release, orders
currently defined as odd-lots often reflect superior pricing.\437\ A
recent academic working paper shows that odd-lots offer better prices
than the NBBO 18% of the time for bids and 16% of the time for
offers.\438\ The Commission believes it would be beneficial to require
price improvement statistics relative to the best available displayed
price for marketable order types (i.e., market, marketable limit,
marketable IOC, and beyond-the-midpoint limit orders). In some cases,
this may be equal to the national best bid or national best offer.
However, in some cases, the best price available may be reflected in an
odd-lot price. Under the current 605 reporting requirements, an order
executed inside the NBBO would be an order executed with price
improvement. Currently, there is no way for market participants to
evaluate the performance of broker-dealers and market centers relative
to the best inside the NBBO odd-lot when such better-priced orders are
present. The Commission believes requiring price improvement statistics
relative to the best available displayed price in the market, whether
that is the NBBO or the best odd-lot order to buy or sell, would
enhance the ability of market participants to evaluate order
performance.
---------------------------------------------------------------------------
\436\ See supra section IV.B.1.
\437\ See MDI Adopting Release, 86 FR 18596 (Apr. 9, 2021) at
18729 (describing analysis that found, among other things, that in
May 2020, ``40% of [odd-lot] transactions (representing
approximately 35% of all odd-lot volume) occurred at a price better
than the NBBO'').
\438\ See Bartlett et al. (2022). The authors found that this
percentage increases monotonically in the stock price, for example,
for bid prices, increasing from 5% for the group of lowest-price
stocks in their sample, to 42% for the group of highest-priced
stocks.
---------------------------------------------------------------------------
Request for Comment
The Commission seeks comment generally on changes to information
required for market, marketable limit, marketable IOC, and beyond-the-
midpoint limit orders, including time-to-execution statistics and price
improvement statistics relative to the best available displayed price.
In particular, the Commission solicits comment on the following:
40. Do commenters agree with the proposed definition of ``best
available displayed price''? Do commenters believe this definition
would be helpful in the calculation of the price improvement
statistics? Why or why not?
41. Should the execution quality statistics be required to include
price improvement relative to the best available displayed price? Why
or why not? What additional statistics would be beneficial?
42. If odd-lot price information is not disseminated pursuant to an
effective transaction reporting plan, what do commenters believe would
be a viable substitute for a best odd-lot price for purposes of
calculating price improvement statistics relative to the best available
displayed price? Would use of substitute data provide a sufficiently
standardized benchmark? Please explain.
6. Additional Required Information for Executable NMLOs, Executable
Stop Orders, and Beyond-the-Midpoint Limit Orders
As discussed above,\439\ the Commission recognizes the need for
more meaningful measures of execution quality for NMLOs and orders
submitted with stop prices.
---------------------------------------------------------------------------
\439\ See supra section IV.B.2.
---------------------------------------------------------------------------
First, proposed Rule 605(a)(1)(iii)(A) would require the reporting
of the number of orders that received either a complete or partial
fill. Although the cumulative number of shares executed is required to
be reported for all order types,\440\ the Commission believes the
number of orders filled would provide important additional information
about the nature of a market center or broker-dealer's NMLO and stop
order executions--e.g., whether a high executed cumulative share count
represents, on average, larger execution sizes or a higher count of
orders receiving executions.
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\440\ See proposed Rule 605(a)(1)(i)(D) and (E) (for shares
executed at the receiving market center or broker-dealer and shares
executed away, respectively).
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Second, the Commission is proposing Rule 605(a)(1)(iii)(B) to
require the reporting of the cumulative number of shares executed
regular way at prices that could have filled the order while the order
was in force, as reported pursuant to an effective transaction
reporting plan or effective national market system plan.\441\ The
Commission believes that market participants would benefit from more
information about the number of shares that executed while an
executable NMLO or executable order submitted with a stop price was in
force. If a market center or broker-dealer is unable to execute NMLOs
or stop orders despite a large number of shares executing in the market
at large, market participants may want to take that into account when
selecting a market center or broker-dealer. One commenter suggested a
new execution quality metric called a ``non-marketable benchmark.''
\442\ The commenter's benchmark would ``provide a reference for
evaluating the extent to which an NMLO could have been filled'' and
considers shares executed on national market system exchanges as well
as regular way off-exchange executions reported to the FINRA trade
reporting facility.\443\ Under the proposal, the share count for each
order would be capped at the order size. This would allow market
participants to see how much activity took place while executable NMLOs
and executable orders submitted with stop prices were in force and
could give market participants an indication of how effective the
market center or broker-dealer is at executing NMLOs and stop orders.
This is similar to the benchmark metric suggested by the commenter
(i.e., including both exchange and TRF trades), but is qualified by
whether or not the NMLO or stop order is executable (not merely that it
was in force). The Commission believes that by proposing to restrict
the benchmark metric to only those NMLOs or stop orders that are
executable would give a more realistic view of the opportunities
available to that order. If a NMLO or stop order is never actually
executable, inclusion of the order in the metrics could distort the
overall view of a market center or broker-dealer's performance. When
combined with execution information, the metric should provide
information about how many trades executed while a NMLO or stop order
could have been filled. This metric could then be combined with
information on total executions in order to estimate a fill rate that
is conditional on whether market prices reached levels at which NMLOs
or stop order could have been filled (``conditional fill rate'').
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\441\ Generally, ``regular way'' refers to bids, offers, and
transactions that embody the standard terms and conditions of a
market whereas a non-regular way transaction refers to one executed
other than pursuant to standardized terms and conditions, such as a
transaction that has extended settlement terms. See, e.g.,
Regulation NMS Adopting Release, 70 FR 37496 (Jun. 29, 2005) at
37537 n.326.
\442\ See FIF III, Appendix 1 at 8-10.
\443\ Id.
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For example, if a NMLO for 200 shares becomes executable and the
tape reveals that subsequently 100 consolidated shares were executed at
the NMLO's limit price, then the benchmark metric would be 100 shares.
If a market center partially executed 50 shares of the NMLO, the
conditional fill rate would be 50 shares/100 shares =
[[Page 3822]]
50%.\444\ If the market center does not execute the NMLO, the
conditional fill rate would be 0 shares/100 shares = 0%.
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\444\ The unconditional fill rate (i.e., the number of executed
shares divided by the number of submitted shares) in this case would
be 50 shares/200 shares = 25%, revealing that only a quarter of the
NMLO was executed. The conditional fill rate adjusts for the fact
that available market depth was insufficient to fill the entire
order, and only compares the number of executed shares to the number
of shares that are available at the limit price.
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On the other hand, if the tape reveals that 500 consolidated shares
were executed at the 200-share NMLO's limit price subsequent to the
limit order becoming executable, the benchmark metric would be capped
at the order size to be 200 shares, since the market center would have
been able to fully execute the 200-share order. If the NMLO executes,
the conditional fill rate would be 200 shares/200 shares = 100%.\445\
If the NMLO does not execute, the conditional fill rate would be 0
shares/200 shares = 0%. If the market center has two such NMLOs, one
that executes and one that does not, the total conditional fill rate
would be (0 + 200)/(200 + 200) = 50%.
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\445\ Note that, if the metric were not capped at the order
size, the conditional fill rate would be 200 shares/500 shares =
40%, which reflects that the order size was smaller than the
cumulative number of shares executed during the NMLO's lifespan.
Capping at the order size therefore will result in the metric only
capturing whether broker-dealers were able to fill order sizes as
given.
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Request for Comment
The Commission seeks comment generally on the reporting of certain
information for beyond-the-midpoint limit orders, executable NMLOs, and
executable orders with stop prices. In particular, the Commission
solicits comment on the following:
43. Should market centers and broker-dealers be required to report
the number of orders that received either a complete or partial fill?
Why or why not?
44. Should the Commission also require these entities to report the
cumulative number of shares executed regular way at prices that could
have filled the order while the order was in force? Do commenters
believe this statistic would provide a meaningful point of comparison
for execution quality for non-marketable order types? Why or why not?
Should the Commission require an alternative metric? Why or why not?
V. Proposed Summary Execution Quality Reports
Rule 605 requires market centers to prepare detailed execution
quality statistics and, as required by the Rule 605 NMS Plan, make this
data available via large electronic data files.\446\ The required
format for the reports makes them machine-readable and suitable for
further processing and analysis.\447\ However, the sheer number of rows
needed to provide symbol-by-symbol data and the fact that human-
readable formatting is not required means that Rule 605 reports are not
readily usable by market participants and other interested parties that
may prefer to review summary statistics, rather than conducting further
analysis on the data. Furthermore, some market participants and other
interested parties do not have access to software or possess
programming skills necessary to conduct such analysis. Accordingly, the
Commission is proposing to require all market centers and broker-
dealers that are subject to Rule 605's reporting obligations to produce
summary execution quality statistics, in addition to the more detailed
reports required by Rule 605(a)(1).\448\
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\446\ See 17 CFR 242.605(a)(1) and (2); Rule 605 NMS Plan, at V
and VI.
\447\ See Rule 605 NMS Plan, at V (``Files shall be prepared in
standard, pipe-delimited (`[bond]') ASCII format and compressed
using standard Zip compression.'').
\448\ While current Rule 605 applies to market centers only, the
Commission also is proposing to expand Rule 605's reporting
obligations to broker-dealers, subject to a customer account
threshold for reporting. See supra section III.A. Requiring broker-
dealers to produce summary reports would align those entities that
would be required to produce detailed execution quality statistics
with those entities that would be required to produce the summary
reports.
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As recognized by several commenters to the 2018 Rule 606
Amendments, in recent years a working group associated with the
Financial Information Forum \449\ developed a standardized template
that firms may use when publicly disclosing summary information about
execution quality for retail investor orders in exchange-listed stocks
(``FIF Template'').\450\ Although the reports produced using the FIF
Template may be useful, given that this disclosure is voluntary, only a
few firms are making or have made such disclosures.\451\ Commenters
have suggested that the Commission require broker-dealers to produce a
similar summary report.\452\ For example, one commenter on the 2018
Rule 606 Amendments \453\ stated that this proposal ``neglect[ed] to
include any meaningful retail disclosure requirements relating to
execution quality, either on a customer-specific or publicly aggregated
basis,'' and that the type of disclosure provided in the FIF Template
``must be added to enable investors, third-party analysts, academic
[[Page 3823]]
researchers, and regulators to examine the extent to which retail
brokers are best serving their clients.'' \454\
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\449\ According to the Financial Information Forum, the
organization was formed in 1996 to provide a centralized source of
information on the implementation issues that impact financial
services and technology firms, and its participants include trading
and back office service bureaus, broker-dealers, market data
vendors, and exchanges. See FIF II at 1 n.1.
\450\ See Financial Services Roundtable Letter at 4 (stating
that the Financial Information Forum has established a Rule 605/606
working group that has sought to improve the execution quality
statistics for retail investors and that the FIF Template includes
order size, average order size, shares executed at the market quote
or better, price improvement percentage, average savings per order,
and execution speed); Fidelity Letter at 8 (identifying the
commenter as one of the few firms that voluntarily publishes these
industry-standardized statistics); IHS Markit Letter at 30 (stating
that the introduction of voluntary reporting of execution quality
metrics, under the auspices of the Financial Information Forum, has
demonstrated improvement in execution quality). See also Financial
Information Forum, Retail Execution Quality Statistics, available at
https://fif.com/tools/retail-execution-quality-statistics.
\451\ See EMSAC I at 0099:10-12 (Bill Alpert, Barron's) (``These
are selective disclosures. Only a few brokers and market makers are
making them, so a mandate would be nice.''); Healthy Markets I at 7
n.17 (stating that this information provided is ``incredibly
valuable,'' even if participation is very limited, with just three
retail brokers and three wholesale market-making firms providing
data). See also infra notes 553-555 and accompanying text
(discussing the limited number of firms that have produced reports
utilizing the FIF Template at various points in time).
\452\ See Healthy Markets I at 7 (suggesting that the Commission
mandate at least the same level of disclosure for retail orders as
was provided pursuant to the FIF Template); Fidelity Letter at 7-8
(suggesting that the Commission require brokers to make publicly
available on their website execution statistics, such as price
improvement, execution price, execution speed, and effective
spread); Financial Services Forum at 5 (stating that although the
disclosed metrics do not have to mirror the FIF Template, the
Commission should consider requiring similar metrics that are output
driven). See also Fidelity Letter at 9 (stating that dividing data
between S&P 500 stocks and other exchange-listed stocks is a
standard metric that is used to break down execution quality
statistics in the FIF Template).
\453\ Rule 606(b)(1) requires broker-dealers to produce to
customers, upon request, a human-readable report with high-level
customer-specific order routing information, but these reports do
not contain any execution quality information. See supra note 54 and
accompanying text. Although the 2018 Rule 606 Amendments modified
the orders covered by Rule 606(b)(1), the required disclosures under
Rule 606(b)(1) did not change. See 2018 Rule 606 Amendments Release,
83 FR 58338 (Nov. 19, 2018) at 58340 n.24.
\454\ Consumer Federation II at 1 (suggesting that the
Commission add to the FIF Template information about the NBBO at the
time a marketable order is received, the NBBO at the time the order
is executed, and any difference between them, and stating that these
metrics would give additional information about whether any delays
in routing and execution affect the ultimate price the investor
pays). See also Angel Letter at 3-7 (suggesting that brokerage firms
be required to display summary execution quality statistics on their
websites, providing several alternative formats as samples, and
suggesting that the statistics include information about the number
of customer complaints received); Angel Letter at 2 (stating that
the Rule 605 reports are too raw for most investors and few
investors have the expertise to interpret the reports).
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When adopting Rule 605, the Commission made a decision to require
market centers to produce detailed reports in order to avoid the
dangers of overly general statistics.\455\ The Commission stated that
``[a]ssigning a single `execution quality' score to market centers, for
example, would hide major differences in execution quality, potentially
creating far more problems than it solved.'' \456\ The large volume of
statistical data in the Rule 605 reports allows market participants and
other interested parties to select the order characteristics that they
find are most appropriate to use to compare execution quality, and
their ability to conduct analyses would be enhanced by the
modifications to Rule 605 proposed herein.\457\ Yet many commenters
have observed that also requiring firms to produce summary reports of
the voluminous Rule 605 statistics would be useful,\458\ and some
market centers have voluntarily posted summary statistics based on the
detailed execution quality statistics in their Rule 605 reports.\459\
These voluntary reports have some utility, but the practice of
producing summary statistics is not uniform and, even where summary
statistics are provided, different formats may inhibit comparisons
across firms.
---------------------------------------------------------------------------
\455\ See supra note 161 and accompanying text.
\456\ Adopting Release, 65 FR 75414 (Dec. 1, 2000) at 75419.
\457\ See supra note 164 and accompanying text.
\458\ See supra notes 134-135 and 452-454 and accompanying text.
\459\ See supra notes 450-454 and accompanying text.
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Requiring market centers and broker-dealers to produce summary
execution quality reports, in addition to the more detailed reports,
would allow market participants and other interested parties to have
more ready access to high-level data that would allow them to compare
some of the more significant aspects of the execution quality provided
by specific market centers and broker-dealers. In particular, it is
currently challenging for individual investors to use Rule 605 reports,
and these individual investors would be more readily able to use a
summary report to make a more informed choice than they can currently
about selection of a broker-dealer. Because these reports would be
human-readable, individual investors could assess the data by reviewing
and comparing summary reports without needing technical expertise or
relying on an intermediary. The proposed summary reports would contain
significantly more detail than a ``single `execution quality' score''
\460\ and thus would contain quantitative data for interested parties
to assess, rather than imposing a single metric that might require a
subjective judgement or obscure meaningful differences about a market
center's or broker-dealer's execution quality. Moreover, by requiring
reporting entities to produce summary reports in addition to, rather
than instead of, the more detailed statistics called for by the current
Rule, those market participants or other observers that would like to
perform a more detailed or specific analysis would be able to download
the more granular underlying data files and perform such analysis.\461\
---------------------------------------------------------------------------
\460\ See supra note 456 and accompanying text.
\461\ Those market participants or other observers that perform
their own analyses using data from Rule 605 reports might find it
useful also to review firms' summary reports to obtain quick access
to an overview of the data or assess information outside the scope
of their own data analyses. Conversely, even if consumers of the
summary reports do not review the more detailed Rule 605 data
themselves, they might benefit from the detailed Rule 605 reports if
independent analysts, consultants, broker-dealers, the financial
press, and market centers analyze the disclosures and produce more
digestible information using the data, which analysis might include
details not present in the summary reports.
---------------------------------------------------------------------------
Proposed Rule 605(a)(2) would require every market center, broker,
or dealer to make publicly available for each calendar month a report
providing summary statistics on all executions of covered orders that
are market and marketable limit orders that it received for execution
from any person.\462\ Individual investors trading NMS stocks primarily
use marketable orders (including market orders and marketable limit
orders) that seek to trade immediately at the best available price in
the market. Individual investors would be the most likely consumers of
the summary reports, and therefore it would provide significant benefit
for the summary reports to cover the types of orders that individual
investors use most frequently.\463\ Other order types, such as NMLOs,
would not be included in the summary reports because including these
types of orders would increase the amount of information contained in
the summary report, and thus detract from its summary nature, and the
summary execution quality information about these types of orders would
be less likely to be useful to individual investors. In addition to
representing a smaller share of trades by individual investors, a
significant risk of including NMLOs is that they may be more likely to
not be executed during the time period that they are executable and
have a time lag before they become executable again, and therefore it
would become more difficult to assess other aspects of execution
quality, particularly at an aggregate level.
---------------------------------------------------------------------------
\462\ See proposed Rule 605(a)(2).
\463\ Similarly, the FIF Template covers standard market orders.
See Fidelity Brokerage Services LLC, Retail Execution Quality
Statistics, available at https://www.fidelity.com/bin-public/060_www_fidelity_com/documents/FIF-FBS-retail-execution-quality-stats.pdf. But see Angel Letter, at 7 (recommending summary
statistics specific to NMLOs).
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The proposed summary report would include a section for NMS stocks
that are included in the S&P 500 Index as of the first day of the month
and a section for other NMS stocks.\464\ Rule 606(a)(1) similarly
separates the required quarterly report on order routing into a section
for securities that are included in the S&P 500 Index and a section for
other NMS stocks.\465\ When adding this provision to Rule 606 in the
2018 Rule 606 Amendments, the Commission stated that the handling of
NMS stocks may vary based on their market capitalization value and
trading volume, and thus customers that place held orders could benefit
from a delineation based on the S&P 500 Index.\466\ The same reasoning
applies to the proposed summary reports pertaining to execution quality
statistics under Rule 605. Moreover, within each section, each symbol
would be equally weighted based on share volume.\467\ Equal weighting
of each symbol would facilitate the comparability of execution quality
statistics among market centers or broker-dealers that receive for
execution different mixes of stocks and prevent the nature of the
stocks traded from making it more difficult to determine how the
reporting entity performed with respect to execution quality for the
particular mix of orders that it received for execution.\468\ Further,
equal weighting by share volume could be calculated using data
collected to produce the Rule 605(a)(1) reports and would not require
the collection of additional data.
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\464\ See proposed Rule 605(a)(2).
\465\ See 17 CFR 242.606(a)(1). The FIF Template also segregates
the reported execution quality statistics based on whether or not
the securities are in the S&P 500 Index, and one commenter stated
that this is a standard metric. See supra note 452.
\466\ See 2018 Rule 606 Amendments Release, 83 FR 58338 (Nov.
19, 2018) at 58378.
\467\ See proposed Rule 605(a)(2).
\468\ For example, without equal weighting, differences in
summary-level execution quality statistics between a market center
that receives more high-priced stocks for execution and market
center that receives more low-priced stocks for execution may be
more attributable to the different mix of stocks, rather than
differences in the behavior of the market center.
---------------------------------------------------------------------------
Each section of the report would include, for market orders and
marketable limit orders, the following
[[Page 3824]]
summary statistics for executed orders: (i) the average order size;
(ii) the percentage of shares executed at the quote or better; (iii)
the percentage of shares that received price improvement; (iv) the
average percentage price improvement per order; (v) the average
percentage effective spread; (vi) the average effective over quoted
spread, expressed as a percentage; and (vii) the average execution
speed, in milliseconds.\469\ Together, the proposed summary-level
statistics are intended to provide an overview of price-based
information and execution speed. The Commission notes that these
categories of statistics are very similar to those used in the FIF
Template, and that both the summary statistics in proposed Rule
605(a)(2) and the statistics reflected in the FIF Template focus on
statistics that are most relevant to evaluating what type of pricing
orders received and how quickly orders were executed.\470\ The proposed
summary report would include average percentage of price improvement
per order, average percentage effective spread, and average E/Q,
expressed as a percentage, whereas the FIF Template includes average
savings per order, expressed in dollars. The three statistics that
would be in the proposed summary report each provide a different view
of the pricing provided to orders, and, if anything, provide a more
robust picture of this pricing than the single metric in the FIF
Template. For example, average effective spread is a comprehensive
statistic that is a useful single measure of the overall liquidity
premium paid by those submitting orders for execution.\471\
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\469\ See proposed Rule 605(a)(2)(i)-(vii).
\470\ See supra note 450 and accompanying text. The categories
in the FIF Template for average order size (shares); shares executed
at current market quote or better (%); price improvement (%); and
average execution speed (seconds) appear to be directly comparable
to the categories in proposed Rule 605(a)(2) for the average order
size, the percentage of shares executed at the quote or better, the
percentage of shares that received price improvement, and the
average execution speed, in milliseconds. Moreover, the proposed use
of milliseconds, rather than seconds, to measure average execution
speed is consistent with proposed changes to the timestamp
conventions, as discussed above. See supra section IV.B.3.
\471\ See Adopting Release, 65 FR 75414 (Dec. 1, 2000) at 75424.
The statistics proposed to be included in the summary report are
also generally consistent with commenters' suggestions that the
summary report either follow the FIF Template or provide similar
metrics. See supra notes 452-454 and accompanying text. One
commenter suggested that the summary report include information
about the NBBO at the time of order receipt and at the time of order
execution to give information about whether delays in routing and
execution affect the execution price. See supra note 454. This
effect would likely also be evident in the average effective spread
and average E/Q.
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The Commission is proposing to require that the summary reports
must be made available using the most recent version of the XML schema
and the associated PDF renderer published on the Commission's
website.\472\ The requirement to use the Commission's XML schema is
intended to ensure that the data is provided in a format that is
structured and machine-readable, and this would allow users to more
easily process and analyze the data, as well as provide consistency of
format across reports. Further, the requirement that the same data
should be provided through the use of a PDF renderer is intended to
ensure that the reports are also available in a human-readable format
and consistently presented across reports. A human-readable format
would be a format that can be naturally read by an individual.
Preparing reports in a human-readable format allows users that prefer
only to review individual reports, and not necessarily aggregate or
conduct large-scale data analysis on the data, to access the data
easily. The Commission notes that Rule 606 similarly provides that the
required reports on order routing shall be made available using the
most recent versions of the Commission's XML schema and associated PDF
renderer.\473\ In addition, although the FIF Template is a general
template and does not specify a particular format for the reports,
market participants choose to voluntarily prepare reports using the FIF
Template. The number of reporting entities that would be required to
prepare summary reports under proposed Rule 605(a)(2) would be much
greater than the number of entities that have chosen to produce reports
voluntarily using the FIF Template, and requiring a uniform format
would facilitate users' ability to compare information across reports.
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\472\ See proposed Rule 605(a)(2). The Commission's schema would
be a set of custom XML tags and XML restrictions designed by the
Commission to reflect the disclosures in proposed Rule 605(a)(2).
XML enables data to be defined, or ``tagged,'' using standard
definitions. The tags establish a consistent structure of identity
and context. This consistent structure can be automatically
recognized and processed by a variety of software applications, such
as databases, financial reporting systems, and spreadsheets, and
then made immediately available to the end-user to search,
aggregate, compare, and analyze. In addition, the XML schema could
be easily updated to reflect any changes to the open standard. XML
and PDF are ``open standards,'' which is a term that is generally
applied to technological specifications that are widely available to
the public, royalty-free, at no cost.
\473\ See 17 CFR 242.606(a)(1), (b)(1)(iii), and (b)(3). When
adopting the 2018 Rule 606 Amendments, the Commission stated that
the XML schema was designed to ensure that the data is provided in
an XML format that is structured and machine-readable, so that the
data can be more easily processed and analyzed, and that by
requiring use of the associated PDF renderer, the XML data would be
instantly presentable in a human-readable PDF format and
consistently presented across reports. See 2018 Rule 606 Amendments
Release, 83 FR 58338 (Nov. 19, 2018) at 58364. The Commission shares
the same goals in proposing that the Rule 605(a)(2) reports be
produced according to an XML schema and associated PDF renderer.
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Rule 605 requires every national securities exchange on which NMS
stocks are traded and each national securities association to act
jointly in establishing procedures for market centers to make the
reports required by Rule 605(a)(1) available to the public in a
uniform, readily accessible, and usable electronic form.\474\ The
Commission is proposing to amend this provision, which would be
reorganized into proposed Rule 605(a)(3), so that the proposed summary
reports would also be made available in accordance with the procedures
established by the Plan.\475\ Rule 605 also specifies that the detailed
reports required by Rule 605(a)(1) must be posted on an internet
website that is free and readily accessible to the public for a period
of three years from the initial date of posting.\476\ As proposed,
these same requirements would be reorganized into proposed Rule
605(a)(5) and would be extended to the summary reports for the same
reasons expressed when these requirements were adopted for the Rule
605(a)(1) reports and because it would be useful to users of the
reports for the Rule 605(a)(1) reports and proposed
[[Page 3825]]
Rule 605(a)(2) reports to be available for the same period of
time.\477\
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\474\ See 17 CFR 242.605(a)(2). As discussed above, the
Commission is proposing to expand this requirement, and the other
procedural requirements in proposed Rule 605(a)(2) and (3), to cover
broker-dealers. See supra note 155 and accompanying text.
\475\ See proposed Rule 605(a)(3). Among other things, the Plan
requires each market center to arrange with a single plan
participant to act as the market center's Designated Participant.
See Plan, at section VIII. Inclusion of proposed Rule 605(a)(2)'s
summary reports within the scope of the Plan would promote
consistent administration of Rule 605 and allow the Designated
Participant for each reporting entity to play a role with respect to
the reports required by Rule 605(a)(1) and proposed Rule 605(a)(2).
The Plan also establishes the formats and fields for the reports
currently required under Rule 605(a)(1). Because proposed Rule
605(a)(2) requires the use of the Commission's XML schema and
associated PDF renderer, the Plan would not establish the formats
and fields for the summary reports. Further, as proposed, the
existing provision that states that, in the event there is no
effective market system plan, market centers shall prepare their
reports in a consistent, usable, and machine-readable electronic
format and make such reports available for downloading from an
internet website that is free and readily accessible to the public
would be reorganized as proposed Rule 605(a)(4) and modified to
explicitly refer to the requirements in Rule 605(a)(1). See proposed
Rule 605(a)(4). As proposed, this provision would not apply to the
summary reports that would be required by proposed Rule 605(a)(2).
The proposed summary reports would not need to be included in
proposed Rule 605(a)(4) because the XML schema and associated PDF
renderer would specify the necessary format for the reports and
proposed Rule 605(a)(5) would contain the requirement for internet
posting.
\476\ 17 CFR 242.605(a)(2).
\477\ See proposed Rule 605(a)(5). See also 2018 Rule 606
Amendments Release, 83 FR at 58380 (stating that the requirement to
keep Rule 605(a)(1) reports posted on a website that is free and
readily accessible for three years is appropriate because a three-
year retention period is consistent with the requirement under Rule
17a-4(b) that broker-dealers preserve certain documents for a period
of not less than three years; the reports will be useful and not
lead to misleading analyses because the Commission expects customers
and the public to use historical information to compare information
from the same time period; and the public information will provide a
historical record of a market center's order execution information).
---------------------------------------------------------------------------
Further, Rule 605 specifies that the detailed reports required by
Rule 605(a)(1) must be made available within one month after the end of
the month addressed in the report.\478\ The Commission is proposing to
renumber this provision as proposed Rule 605(a)(6) and to extend this
requirement to the Rule 605(a)(2) reports.\479\ The Commission believes
that firms could produce the proposed Rule 605(a)(2) report alongside
the Rule 605(a)(1) report, which must be produced monthly, because both
reports are based on the same underlying data. Additionally, it would
be useful for users of the reports to have access to the detailed
reports and summary reports at the same time so that they could review
the aggregated data in the summary reports and then conduct further
analysis using the detailed reports, as needed.
---------------------------------------------------------------------------
\478\ 17 CFR 242.605(a)(3).
\479\ See proposed Rule 605(a)(6).
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Request for Comment
The Commission seeks comment generally on the proposed requirement
that market centers and brokers-dealers that are required to produce
detailed execution quality statistics also provide a summary report. In
particular, the Commission solicits comment on the following:
45. Should a market center or broker-dealer that is subject to Rule
605's reporting requirement be required to also provide a summary
report reflecting aggregated execution quality information? Why or why
not? Do commenters agree that summary reports would make execution
quality information more accessible to individual investors? Please
explain.
46. Should the summary report be required to be divided into
separate categories according to whether or not securities are included
in the S&P 500 Index? Why or why not? Are there any alternative means
to group securities that have higher market capitalization or trading
volume that should be required to be used to organize the summary
statistics, instead of or in addition to dividing the securities
included in the report according to whether or not they are included in
the S&P 500 Index? Should the summary report include order size
categories? Why or why not? Please explain and provide data, if
available.
47. Should stocks be required to be equally weighted by symbol
based on share volume within each section? Why or why not? Is there
another method of weighting the stocks that would be preferable (e.g.,
equal weighting by symbol based on dollar volume or applying a common
weighting scheme across securities)? Please explain.
48. Should the summary report be limited to covered orders that are
market or marketable limit orders? Why or why not? Would it be
preferable to include other specific categories of covered orders
(i.e., marketable IOCs, beyond-the-midpoint limit orders, executable
NMLOs, executable orders with stop prices) or to include all covered
orders? Do commenters agree with the proposed aggregated statistics to
include in the summary report? Are there any aggregated statistics that
commenters would eliminate? Are there any execution quality statistics
that would be required pursuant to proposed Rule 605(a)(1) for which
commenters would add corresponding aggregated statistics to the summary
report? Please explain.
49. Should the summary reports be required to be made available
using the most recent version of an XML schema and an associated PDF
renderer as published by the Commission? Why or why not? Is there an
alternative, machine-readable and/or human-readable format, that would
be preferable? Would it be preferable for the Plan to establish the
required format, including an associated schema, for the summary
reports?
50. Should the Commission require that summary Rule 605 reports be
posted in a centralized location? Alternatively, should the Commission
require both summary and detailed reports to be posted in a centralized
location? Why or why not? Do commenters have a view on how centralized
posting could be implemented? Are there other ways the Commission could
improve the accessibility of the reports?
VI. Paperwork Reduction Act
Certain provisions of the proposed rule amendments contain
``collection of information'' requirements within the meaning of the
Paperwork Reduction Act of 1995 (``PRA'').\480\ The Commission is
submitting these collections of information to the Office of Management
and Budget (``OMB'') for review in accordance with 44 U.S.C. 3507(d)
and 5 CFR 1320.11. An agency may not conduct or sponsor, and a person
is not required to respond to, a collection of information unless the
agency displays a currently valid control number. The Commission is
proposing to alter an existing collection of information and apply such
collection of information to new categories of respondents. The title
of such existing collection of information is: Rule 605 of Regulation
NMS (f/k/a Rule 11Ac1-5).\481\
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\480\ 44 U.S.C. 3501 et seq.
\481\ OMB Control Number 3235-0542.
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A. Summary of Collection of Information
The proposed amendments create burdens under the PRA by: (1) adding
new categories of respondents to the existing collection of information
and (2) modifying the requirements of such existing collection of
information. The proposed amendments do not create any new collections
of information.
The categories of new respondents subject to Rule 605, as proposed
to be amended, are larger broker-dealers and new market centers,
consisting of SDPs and entities that would operate proposed qualified
auctions or act as market centers for orders that were previously not
covered by the Rule, e.g., fractional share orders.
The proposed amendments would modify both the scope of the
standardized monthly reports required under Rule 605 and the required
information. Rule 605, as proposed to be amended: (1) expands the
definition of ``covered order'' to include certain orders submitted
outside of regular trading hours, certain orders submitted with stop
prices, and non-exempt short sale orders; (2) modifies the existing
order size categories to base them on round lots rather than number of
shares and includes additional order size categories for fractional
share, odd-lot, and larger-sized orders; (3) creates a new order type
category for marketable IOCs and replaces three existing categories of
non-marketable order types with three new categories of order types
(beyond-the-midpoint limit orders, executable NMLOs, and executable
orders with stop prices); (4) eliminates current time-to-execution
reporting buckets and requires average time to execution, median time
to execution, and 99th percentile time to execution, each as measured
in increments of a
[[Page 3826]]
millisecond or finer; (5) modifies realized spread statistics to
require realized spread to be calculated after 15 seconds and one
minute; and (6) requires new statistical measures of execution quality
including average effective over quoted spread, percentage effective
and realized spread statistics, a size improvement benchmark, and
certain statistical measures that could be used to measure execution
quality of NMLOs. The proposed amendments would require all reporting
entities to make a summary report available that would be formatted in
the most recent versions of the XML schema and the associated PDF
renderer as published on the Commission's website. Finally, as a result
of the proposed amendments to Rule 605, the current Rule 605 NMS Plan
participants would need to amend the NMS Plan to account for the new
proposed data fields.
B. Proposed Use of Information
The purpose of the information collection is to make information
about order execution practices available to the public and allow
investors, broker-dealers, and market centers (which include exchange
markets, OTC market makers, and ATSs) \482\ to undertake a comparative
analysis of these practices across markets. Broker-dealers may use the
information to make more informed choices in deciding where to route
orders for execution and to evaluate their internal order handling
practices. Investors may use the information to evaluate the order
handling practices of their broker-dealers. Market centers may use the
information to compete on the basis of execution quality.
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\482\ See 17 CFR 242.600(b)(46).
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C. Respondents
The collection of information obligations of Rule 605 apply to
larger broker-dealers and market centers that receive covered orders in
national market system securities (collectively, ``reporting
entities''). The Commission estimates that there are currently
approximately 236 reporting entities (93 OTC market makers, plus 16
national securities exchanges, 1 national securities association, 94
exchange market makers, and 32 ATSs).\483\ However, under the proposed
amendments, the Commission believes there would be 359 reporting
entities (93 OTC market makers, 85 broker-dealers that introduce or
carry 100,000 or more customer accounts,\484\ 16 national securities
exchanges, 1 national securities association, 94 exchange market
makers, 32 ATSs,\485\ plus 38 new market center respondents \486\) that
would be subject to the collection of information obligations of Rule
605. Each of these respondents would be required to respond to the
collection of information on a monthly basis.
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\483\ The current PRA for Rule 605 estimates 319 reporting
entities (153 OTC market makers, plus 24 exchanges, 1 securities
association, 80 exchange market makers, and 61 ATSs). Based on
updated estimates of the number of respondents, the Commission
estimates that there are only 236 current reporting entities.
\484\ These 85 brokers-dealers include 37 broker-dealers that
act as introducing brokers.
\485\ As of September 30, 2022, there are 32 NMS Stock ATSs that
have filed an effective Form ATS-N with the Commission.
\486\ These 38 new market center respondents would consist of 20
market centers that would need to produce reports as a result of
including fractional share orders within the scope of Rule 605, 10
SDPs, and 8 qualified auctions.
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In addition, the proposed amendments to Rule 605 would require the
existing NMS Plan participants (16 national securities exchanges and 1
national securities association) to prepare and file an amendment to
the existing NMS Plan.
D. Total PRA Burdens
As proposed, Rule 605 would require broker-dealers and market
centers to make available to the public monthly order execution reports
in electronic form. The Commission believes that broker-dealers and
market centers retain most, if not all, of the underlying raw data
necessary to generate these reports in electronic format or, if they do
not, may obtain this information from publicly available data
sources.\487\ Consequently, the Rule would not require additional data
collection or recordkeeping burdens. Respondents could either program
their systems to generate the statistics and reports, or transfer the
data to a service provider (such as an independent company in the
business of preparing such reports or an SRO) that would generate the
statistics and reports.
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\487\ National securities exchanges, national securities
associations, and registered brokers and dealers are subject to
existing recordkeeping and retention requirements including Rule
17a-1 (for self-regulatory organizations (``SROs'')); Rules 17a-3
and 17a-4 (for broker-dealers). See 17 CFR 240.17a-1, 17 CFR
240.17a-3, and 17 CFR 240.17a-4. The Commission's estimates include
the Rule's requirement that reporting market centers and broker-
dealers keep Rule 605 reports posted on an internet website that is
free and readily accessible to the public for a period of three
years from the initial date of posting on the internet website. See
proposed Rule 605(a)(5).
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The Commission estimates that the initial and ongoing burdens would
be different for those respondents that are currently required to
prepare reports and for new respondents. The Commission estimates that
proposed Rule 605 amendments would result in an initial burden for
current respondents of 50 hours per respondent \488\ for systems
updates to ensure that data responsive to the amended requirements is
correctly collected and formatted. The initial burden estimate
represents the work that would need to be done by existing respondents
to modify their systems to collect data required under the proposed
amendments to Rule 605 and generate the monthly reports. The estimate
includes time required to program and test automated systems to collect
the necessary data, as well as review and approval by compliance
personnel. The Commission does not believe the information required to
be aggregated and included in Rule 605 reports, as proposed to be
amended, would require existing respondents to acquire new hardware or
systems to process the information required in the reports. The
Commission further estimates that the proposed Rule 605 amendments
would result in an ongoing monthly burden of 8 hours per respondent to
collect the necessary data and to prepare the required Rule 605
reports, for a total annual burden of 96 hours per respondent.\489\
This estimate represents the time that would be required to verify
automated processes are functioning as intended and post and prepare
the required reports, or transfer data to a service provider to
generate the reports.\490\ With an
[[Page 3827]]
estimated 236 respondents currently subject to Rule 605, the total
initial burden to comply with the Rule 605 amendments is estimated to
be 11,800 hours while the monthly reporting requirement is estimated to
be 22,656 hours per year (236 x 96). The burdens for respondents
currently reporting under Rule 605 are likely to be lower than those of
new reporting entities because currently-reporting entities already
have systems in place to collect the data necessary to generate reports
under the current Rule. These estimates include the impact of preparing
and making summary reports available using the most recent versions of
the XML schema and the associated PDF renderer as published on the
Commission's website.
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\488\ The Commission believes the monetized initial burden for
this requirement to be $4,368,360. The Commission derived this
estimate based on per hour figure from SIFMA's Management &
Professional Earnings in the Securities Industry 2013, modified by
Commission staff to account for an 1,800-hour work-year and
inflation, and multiplied by 5.35 to account for bonuses, firm size,
employee benefits and overhead: [(Sr. Programmer at $368 for 25
hours) + (Sr. Systems Analyst at $316 for 10 hours) + (Compliance
Manager at $344 for 10 hours) + (Director of Compliance at $542 for
5 hours)] = $18,510 per respondent for a total initial monetized
burden of $4,368,360 ($18,510 x 236 respondents).
\489\ The Commission believes the monetized annual burden for
this requirement to be $8,847,168. The Commission derived this
estimate based on per hour figure from SIFMA's Management &
Professional Earnings in the Securities Industry 2013, modified by
Commission staff to account for an 1,800-hour work-year and
inflation, and multiplied by 5.35 to account for bonuses, firm size,
employee benefits and overhead: [((Compliance Attorney at $406 for 6
hours) + (Compliance Manager at $344 for 2 hours)) x 12 reports per
year] = $37,488 per respondent for a total annual monetized burden
of $8,847,168 ($37,488 x 236 respondents).
\490\ The Commission's currently approved PRA for Rule 605 (OMB
Control Number 3235-0542), last updated in April 2022, estimates
that current respondents each will spend 6 hours per month to
collect the data necessary to generate the reports, or 72 hours per
year. Although the proposed amendments to Rule 605 would require
additional data fields and the generation of summary reports, the
Commission believes the data collection and report generation
process should be an automated process that would not require
substantial additional burden hours after initial set-up.
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The Commission estimates that proposed Rule 605 amendments would
result in an initial burden for new respondents of 100 hours for each
respondent \491\ for systems updates to ensure that data responsive to
the amended requirements is correctly gathered and formatted. This
burden is higher than the estimated burden for current respondents
because new respondents do not currently have in place the systems to
collect the information required for current Rule 605 reports. These
respondents would likely require additional time to collect the
relevant information. In addition, this estimate includes additional
time for programming and testing automated systems to collect the
necessary data and additional hours for review and approval by
compliance personnel. Once the relevant data is collected, respondents
could either program their systems to generate the reports, or transfer
the data to a service provider that would generate the reports.
Respondents would likely not be required to acquire new hardware or
other technological resources to be able to collect the data required
by the proposed rule given that respondents would already have
computing systems in place to, for example, transmit and process order
information, and such systems could be leveraged to collect the
required data. Further, to the extent a respondent does not have the
technological capabilities or resources to generate the reports in-
house, such respondents would likely utilize a service provider, as
discussed below. The Commission estimates that the proposed Rule 605
amendments would result in an ongoing monthly burden of 8 hours to
collect the necessary data and to prepare the required Rule 605
reports, for a total annual burden of 96 hours per respondent.\492\
With an estimated 123 new respondents subject to Rule 605, the total
initial burden to comply with the Rule 605 amendments is estimated to
be 12,300 hours while the monthly reporting requirement is estimated to
be 11,808 hours per year (123 x 96). These estimates include the impact
of preparing and making summary reports available using the most recent
versions of the XML schema and the associated PDF renderer as published
on the Commission's website.
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\491\ The Commission believes the monetized initial burden for
this requirement to be $4,553,460. The Commission derived this
estimate based on per hour figure from SIFMA's Management &
Professional Earnings in the Securities Industry 2013, modified by
Commission staff to account for an 1,800-hour work-year and
inflation, and multiplied by 5.35 to account for bonuses, firm size,
employee benefits and overhead: [(Sr. Programmer at $368 for 50
hours) + (Sr. Systems Analyst at $316 for 20 hours) + (Compliance
Manager at $344 for 20 hours) + (Director of Compliance at $542 for
10 hours)] = $37,020 per respondent for a total initial monetized
burden of $4,553,460 ($37,020 x 123 respondents).
\492\ The Commission believes the monetized annual burden for
this requirement to be $4,611,024. The Commission derived this
estimate based on per hour figure from SIFMA's Management &
Professional Earnings in the Securities Industry 2013, modified by
Commission staff to account for an 1,800-hour work-year and
inflation, and multiplied by 5.35 to account for bonuses, firm size,
employee benefits and overhead: [((Compliance Attorney at $406 for 6
hours) + (Compliance Manager at $344 for 2 hours)) x 12 reports per
year] = $37,488 per respondent for a total annual monetized burden
of $4,611,024 ($37,488 x 123 respondents).
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BILLING CODE 8011-01-P
Table 2--Respondent Burdens for Producing Rule 605 Reports
[[Page 3828]]
[GRAPHIC] [TIFF OMITTED] TP20JA23.001
BILLING CODE 8011-01-C
[[Page 3829]]
The Commission estimates that in lieu \493\ of preparing both
summary and detailed monthly reports in-house, an individual respondent
could retain a service provider to prepare its monthly reports for
between approximately $3,000 and $3,500 per month or approximately
$36,000 to $42,000 per year.\494\ This per-respondent estimate is based
on the rate that a reporting entity could expect to obtain if it
negotiated on an individual basis. Based on the $3,000 to $3,500
estimate, the monthly cost to the 359 respondents to retain service
providers to prepare reports would be between approximately $1,077,000
and $1,256,000 ((359 x $3,000) and (359 x $3,500), respectively), or a
total annual cost of between approximately $12,924,000 and $15,078,000
(($1,077,000 x 12) and ($1,256,000 x 12), respectively).
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\493\ In the case of annual burdens, the burden per respondent
is the burden hours multiplied by the number of responses per year.
\494\ The Commission's currently approved PRA for Rule 605
estimates that the retention of a service provider to prepare a
monthly report would cost $2,978 per month, or approximately $35,736
per year. Although the individual line items required by the Rule
605 amendments would be different than the current Rule, the
Commission does not believe that the overall cost of creating the
required reports would differ substantially from these current
estimates.
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Finally, the 16 national securities exchanges and 1 national
securities association would be required to amend the NMS Plan to
account for the new data fields required to be reported and to include
references to larger broker-dealers in addition to market centers. The
Commission estimates that there would be a one-time (or initial) burden
of 5 hours per respondent \495\ to amend the NMS Plan to account for
the new reporting fields and reporting parties, for a total burden of
85 hours (17 x 5). The Commission does not estimate that there would be
any ongoing annual burden associated with the NMS Plan amendment to
account for the new reporting fields and reporting parties. The
Commission has based its estimate of SRO burden hours to amend the NMS
Plan on the burden hours for existing NMS plans, while also taking into
account the limited nature of the updates to the NMS Plan that would be
required under the proposed amendments to Rule 605.
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\495\ The Commission believes the monetized initial burden for
this requirement to be $40,222. The Commission derived this estimate
based on per hour figure from SIFMA's Management & Professional
Earnings in the Securities Industry 2013, modified by Commission
staff to account for an 1,800-hour work-year and inflation, and
multiplied by 5.35 to account for bonuses, firm size, employee
benefits and overhead: [(Attorney at $462 for 4 hours) + (Assistant
General Counsel at $518 for 1 hour)] = $2,366 per respondent for a
total initial monetized burden of $40,222 ($2,366 x 17 respondents).
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The Commission estimates that there would be outsourcing of legal
time to develop and draft the NMS Plan amendment in order to account
for additional data fields and reporting parties. The NMS Plan
amendment would be an update to the list of formats and fields to track
the data elements set forth in the Rule and add references to broker-
dealers subject to the Rule, and therefore the Commission estimates the
hours necessary to develop and draft the amendment would be
significantly lower than other recent NMS plan amendments. The
Commission staff estimates that, on average, each exchange and
association would outsource 2 hours of legal time to prepare and file
an amendment to the NMS Plan, at an average hourly rate of $496.\496\
The Commission estimates that the aggregate one-time reporting burden
for preparing and filing an amendment to the NMS Plan would be
approximately $992 in external costs per national securities exchange
or national securities association, for an aggregate external cost of
$16,864 resulting from outsourced legal work [(2 hours @ $496 per hour
= $992) x (16 national securities exchanges and 1 national securities
association)].
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\496\ The Commission's estimates of the relevant wage rates for
outside legal services takes into account staff experience, a
variety of sources including general information websites, and
adjustments for inflation.
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The Commission currently estimates a total initial burden of 24,169
hours for all respondents and a total annual burden of 34,368 hours for
all respondents.\497\
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\497\ (11,800 + 12,300 + 119) = 24,219 initial burden hours.
(22,656 + 11,808) = 34,464 annual burden hours. The Commission
estimates the monetized initial burden for all respondents to be
$8,978,906 ($4,368,360 + $4,553,460 + $57,086) and the monetized
annual burden for all respondents to be $13,458,192 ($8,847,168 +
$4,611,024).
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E. Request for Comment
Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits
comments to:
51. Evaluate whether the proposed collection of information is
necessary for the proper performance of the Commission's functions,
including whether the information shall have practical utility;
52. Evaluate the accuracy of the Commission's estimates of the
burden of the proposed collection of information;
53. Determine whether there are ways to enhance the quality,
utility, and clarity of the information to be collected;
54. Evaluate whether there are ways to minimize the burden of
collection of information on those who are to respond, including
through the use of automated collection techniques or other forms of
information technology; and
55. Evaluate whether the proposed amendments would have any effects
on any other collection of information not previously identified in
this section.
Persons submitting comments on the collection of information
requirements should direct them to the Office of Management and Budget,
Attention: Desk Officer for the Securities and Exchange Commission,
Office of Information and Regulatory Affairs, Washington, DC 20503, and
should also send a copy of their comments to Secretary, Securities and
Exchange Commission, 100 F Street NE, Washington, DC 20549-1090, with
reference to File Number S7-29-22. Requests for materials submitted to
OMB by the Commission with regard to this collection of information
should be in writing, with reference to File Number S7-29-22 and be
submitted to the Securities and Exchange Commission, Office of FOIA/PA
Services, 100 F Street NE, Washington, DC 20549-2736. As OMB is
required to make a decision concerning the collection of information
between 30 and 60 days after publication, a comment to OMB is best
assured of having its full effect if OMB receives it within 30 days of
publication.
VII. Economic Analysis
A. Introduction
The Commission is mindful of the economic effects that may result
from the proposed amendments, including the benefits, costs, and the
effects on efficiency, competition, and capital formation.\498\ The
following economic analysis identifies and considers the costs and
benefits--including the effects on efficiency, competition, and capital
formation--that could result from the proposed amendments to Rule 605.
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\498\ Exchange Act section 3(f) requires the Commission, when it
is engaged in rulemaking pursuant to the Exchange Act and is
required to consider or determine whether an action is necessary or
appropriate in the public interest, to consider, in addition to the
protection of investors, whether the action will promote efficiency,
competition, and capital formation. See 15 U.S.C. 78c(f). In
addition, Exchange Act section 23(a)(2) requires the Commission,
when making rules pursuant to the Exchange Act, to consider among
other matters the impact that any such rule will have on competition
and not to adopt any rule that would impose a burden on competition
that is not necessary or appropriate in furtherance of the purposes
of the Exchange Act. See 15 U.S.C. 78w(a)(2).
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When the Commission adopted Rule 11Ac1-5, which was later re-
designated as Rule 605, in 2000, it stated that the
[[Page 3830]]
rule should facilitate comparisons across market centers and provoke
more vigorous competition on execution quality and broker-dealer order
routing performance.\499\ However, under current Rule 605 reporting
requirements, variations across broker-dealers in terms of the
execution quality achieved by their order routing services are not
currently observable by market participants using publicly available
execution quality reports. Furthermore, in the subsequent decades,
substantial changes in equity markets, including increases in trading
speeds and fragmentation, have made it so that Rule 605 reports are
less informative than they were when the Rule was adopted. Furthermore,
the Commission believes that the proposed amendments to Rule 605,
including expanding the scope of reporting entities, modernizing its
content, and broadening its accessibility, would increase the relevance
and use of the information contained in Rule 605 reports, and promote
competition among market centers and broker-dealers. This increase in
competition would ultimately lead to improved execution quality for
investors.
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\499\ See Adopting Release, 65 FR 75414 (Dec. 1, 2000) at 75417.
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The Commission recognizes that the proposed amendments would entail
additional costs to market centers and broker-dealers of disclosing the
required execution quality information. Market centers would face
initial compliance costs when updating their methods for preparing Rule
605 reports, and broker-dealers that were previously not required to
publish Rule 605 reports would face initial compliance costs, including
but not limited to developing the systems and processes and organizing
the resources necessary to generate the reports pursuant to Rule 605,
and ongoing compliance costs to continue to publish Rule 605 reports
each month.
The Commission has considered and is describing the economic
effects of the proposed amendments to Rule 605 and wherever possible
has quantified the likely economic effects of the proposed amendments.
The Commission has incorporated data and other information, such as
academic literature, to assist in the analysis of the economic effects
of the proposal. However, because the Commission does not have, and in
certain cases does not believe that it can reasonably obtain, data that
may inform on certain economic effects, the Commission is unable to
quantify those economic effects. Further, even in cases where the
Commission has some data, the number and type of assumptions necessary
to quantify certain economic effects would render any such
quantification unreliable. Our inability to quantify certain costs,
benefits, and effects does not imply that such costs, benefits, or
effects are less significant. The Commission requests that commenters
provide relevant data and information to assist the Commission in
quantifying the economic consequences of the proposed amendments to
Rule 605.
B. Market Failure
The Commission is proposing to update the disclosure of order
execution information and expand the scope of reporting entities under
Rule 605 to achieve a variety of improvements to market participants'
access to information about execution quality, which the Commission
does not believe are likely to occur through a market-based solution.
Because equity markets have changed substantially since the initial
adoption of Rule 605's predecessor in 2000, and yet the content of the
disclosures required by Rule 605 has not been substantively updated
since then,\500\ the utility of Rule 605 reports has been eroded, which
has limited the Rule's ability to address the market failures
identified in the Adopting Release, including market centers' limited
incentives to produce publicly available, standardized execution
quality reports.\501\ Instead, the metrics currently required to be
reported by Rule 605 are no longer as useful for comparing execution
quality across market centers as they were when Rule 605 was adopted,
and other metrics that would be useful for this purpose are not
currently included in reporting requirements, which limits the current
benefits of Rule 605 for promoting competition among market centers and
improving execution quality for all types of investors.
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\500\ In 2018, while amending Rule 606, the Commission also
modified Rule 605 to require that the public order execution quality
report be kept publicly available for a period of three years. See
supra note 11.
\501\ See Adopting Release, 65 FR 75414 (Dec. 1, 2000) at 75414-
15.
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The Commission does not believe that updates to Rule 605 metrics
are likely to be achieved through a market-based solution.\502\ Even if
all markets centers were incentivized to voluntarily produce updated
statistics for competitive or reputational reasons (e.g., they may lose
business if their competitors provide reports and they do not), under
current rules, there is little incentive for all market centers to
agree on a standardized set of updated statistics. For example, market
centers may be incentivized to design ad hoc reports to highlight areas
where they believe they compare well to their competitors. Without a
standardized set of statistics, it could be difficult for market
participants to easily compare execution quality across market centers.
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\502\ In the Adopting Release, the Commission stated that, while
some market centers may have voluntarily made order execution
information privately available to independent companies or broker-
dealers, the information in these reports generally had not been
publicly disseminated. To the extent such information had been made
available, not all of it was useful or in a form that would allow
for cross-market comparisons. See Adopting Release, 65 FR 75414
(Dec. 1, 2000) at 75431.
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Furthermore, it may be difficult for certain market participants to
compute accurate and relevant execution quality metrics from data
sources other than data collected pursuant to Rule 605, due to the lack
of granularity and significant time delay of many other publicly
available datasets, which can lead to imprecise or stale measures. This
limits certain market participants' ability to conduct analyses that
examine and compare execution quality across market centers and may
thereby further inform investors. Therefore, rulemaking to modernize
the information required by Rule 605 may prove beneficial.\503\
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\503\ See supra sections IV.A and IV.B describing, respectively,
the proposed amendments modifying the scope of orders covered and
information required to be disclosed pursuant to Rule 605.
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In addition to the need to modernize the content of Rule 605, it
may also be appropriate to expand the scope of entities that would be
required to prepare Rule 605 reports to include larger broker-
dealers.\504\ Broker-dealers and their customers are subject to a
classic principal-agent relationship in which the customer (the
principal) submits an order to a broker-dealer (the agent) to handle
its execution on the customer's behalf; however, information
asymmetries prevent the customer from being able to directly observe
the broker-dealer's handling of the customer's order.\505\ This limits
the extent to which broker-dealers need to compete for order flow on
the basis of
[[Page 3831]]
execution quality, which may result in lower execution quality for
their customers.
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\504\ See supra note 1 defining ``larger broker-dealer'' as a
broker-dealer that meets or exceeds the ``customer account
threshold,'' as defined in proposed Rule 605(a)(7). See also supra
section III.A describing the proposed amendments expanding the scope
of Rule 605 reporting entities to include larger broker-dealers.
\505\ Similar information asymmetries were recognized in the
Adopting Release, which stated that ``the decision about where to
route a customer order is frequently made by the broker-dealer, and
broker-dealers may make that decision, at least in part, on the
basis of factors that are unknown to their customers.'' See Adopting
Release, 65 FR 75414 (Dec. 1, 2000) at 75433.
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As with market centers, most broker-dealers also do not necessarily
have incentives to produce public and standardized execution quality
reports, and in that way are subject to the same market failures
identified in the Rule 605 Adopting Release and described above.
Furthermore, as discussed above in the context of market centers, even
if broker-dealers are incentivized to produce execution quality
reports, for example for marketing purposes or to protect against
reputation loss, there are few incentives for broker-dealers to provide
execution quality information that is standardized.\506\ As a result,
individual investors and, to some extent, institutional investors,\507\
have limited access to standardized information that could be used to
compare how execution quality varies across broker-dealers.\508\
Therefore, it may be appropriate to engage in rulemaking to expand Rule
605 reporting requirements to larger broker-dealers.
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\506\ While the FIF Template provides a standardized template
for summary information about execution quality for retail investor
orders in exchange-listed stocks (see supra note 450), the
Commission understands that currently only one retail broker
voluntarily provides reports using the FIF Template. See also infra
notes 554-555 and accompanying text (discussing the limited number
of firms that have produced reports utilizing the FIF Template at
various points in time). There are also some broker-dealers that
disclose their own execution quality metrics on their respective
websites, but the disclosures tend to differ in ways that make them
difficult to compare, such as reporting different metrics, using
different methodologies, or different samples of stocks. See, e.g.,
Order Execution Quality, TD Ameritrade, available at https://www.tdameritrade.com/tools-and-platforms/order-execution.html;
Execution Quality, E*TRADE from Morgan Stanley, available at https://us.etrade.com/trade/execution-quality; Our Execution Quality,
Robinhood, available at https://robinhood.com/us/en/about-us/our-execution-quality/.
\507\ While institutional investors are likely to have access to
alternative sources of execution quality information, such as Rule
606(b)(3) reports and transaction cost analysis, the information on
execution quality that is individually collected by institutional
investors is typically non-public and highly individualized, and
therefore limited to the execution quality obtained from broker-
dealers with which the institutional investors currently does
business. Since Rule 605 reports are public, institutional investors
could use these reports to assess the execution quality of the
broker-dealers and market centers with which they do not currently
do business. See infra section VII.C.1.(c)(2) for further
discussion.
\508\ Institutional and individual investor customers of broker-
dealers may differ in their abilities to request execution quality
information from their broker-dealers. See infra sections
VII.C.1.(c)(1) and VII.C.1.(c)(2) for further discussion.
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While ``data available for downloading from a free website in a
consistent, usable, and machine-readable electronic format'' is
currently accessible under Rule 605,\509\ the data generated under Rule
605 is complex, and the raw data may be difficult for individual
investors to access and aggregate. Rule 605 reporting entities have
little incentive to voluntarily summarize their execution quality in a
standardized way. Instead, in summarizing their execution quality
information, reporting entities may be incentivized to select the
measures and aggregation methodologies that make them look the most
favorable. Therefore, absent regulation, there is little incentive for
Rule 605 reporting entities to coordinate on a standardized summary
report that could be used to easily and accurately compare execution
quality across reporting entities.\510\
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\509\ See Adopting Release, 65 FR 75414 (Dec. 1, 2000) at 75436.
\510\ See supra section V describing the proposed amendments
requiring Rule 605 reporting entities to prepare summary reports of
execution quality information.
---------------------------------------------------------------------------
C. Baseline
The baseline against which the costs, benefits, and the effects on
efficiency, competition, and capital formation of the proposed
amendments are measured consists of the regulatory baseline, which
frames investors' current access to execution quality information under
Rule 605, as well as market participants' present ability to use the
information contained in current Rule 605 reports to evaluate and
compare execution quality across reporting entities. Lastly, the
baseline consists of the extent to which Rule 605 currently promotes
competition on the basis of execution quality, both among broker-
dealers and among market centers.
1. Regulatory Baseline
(a) Current Rule 605 Disclosure Requirements
Currently, Rule 605 requires market centers to make available, on a
monthly basis, standardized information concerning execution quality
for covered orders in NMS stocks.\511\ Under the Rule, aggregated
execution quality information on covered orders is reported for each
individual security, with the information for each security broken out
into multiple order type and size categories.\512\ This format serves
the purpose of allowing market participants to control for differences
in market centers' order flow characteristics when assessing execution
quality information, facilitating more apples-to-apples comparisons of
execution quality across market centers. This is because a particular
market center's order flow may be made up of a different mixture of
securities, order types, and order sizes, which may impact or constrain
that market center's overall execution quality level.\513\
---------------------------------------------------------------------------
\511\ See 17 CFR 242.605.
\512\ See supra notes 39-40 for a discussion and definitions of
these order categories.
\513\ For example, larger order sizes are typically more
difficult to ``work'' than smaller order sizes, so the execution
quality information of a market center that tends to handle larger
order sizes would likely be more constrained than that of a market
center that tends to handle smaller order sizes.
---------------------------------------------------------------------------
The execution quality information required to be disclosed in Rule
605 reports pertains to several different aspects of execution quality,
including execution prices, execution speeds, and fill rates.
Information on execution prices includes, for market orders and
marketable limit orders, the average effective spread,\514\ number of
shares executed at prices better than the quote, at the quote, or
outside the quote,\515\ as well as average dollar amount per share that
orders were executed better than the quote or outside the quote.\516\
Information on execution speeds includes, for all order types, the
cumulative number of shares executed within different time-to-execution
buckets \517\ and, for market and marketable limit orders, the share-
weighted average time to execution of orders executed better than the
quote, at the quote, or outside the quote.\518\ Information that can be
used to calculate fill rates includes, for all order types, the
cumulative number of shares of covered orders, the cumulative number of
shares of covered orders executed at the receiving market center, and
the cumulative number of shares of covered orders executed at any other
venue.\519\
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\514\ See 17 CFR 242.605(a)(1)(ii)(A).
\515\ See 17 CFR 242.605(a)(1)(ii)(B), 17 CFR
242.605(a)(1)(ii)(E) and 17 CFR 242.605(a)(1)(ii)(G), respectively.
\516\ See 17 CFR 242.605(a)(1)(ii)(C) and 17 CFR
242.605(a)(1)(ii)(H), respectively.
\517\ The time-to-execution categories currently defined in Rule
605 are shares executed from 0 to 9 seconds, shares executed from 10
to 29 seconds, shares executed from 30 to 59 seconds, shares
executed from 60 to 299 seconds, and shares executed from 5 to 30
minutes. See 17 CFR 242.605(a)(1)(i)(F)-(J).
\518\ See 17 CFR 242.605(a)(1)(ii)(D), 17 CFR
242.605(a)(1)(ii)(F) and 17 CFR 242.605(a)(1)(ii)(I), respectively.
\519\ See 17 CFR 242.605(a)(1)(i)(B), 17 CFR 242.605(a)(1)(i)(D)
and 17 CFR 242.605(a)(1)(i)(E). The fill rate can be calculated as
Fill Rate = (Cumulative Number of Shares Executed at Receiving
Market Center + Cumulative Number of Shares Executed at Other
Venues)/(Cumulative Number of Covered Shares).
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Market participants have access to public information about the
execution quality of market centers other than Rule 605. For example,
some
[[Page 3832]]
wholesalers and ATSs make additional order flow and execution quality
statistics other than those required under Rule 605 available either on
their websites or as part of their ATS-N filings.\520\ However, these
sources are either not standardized \521\ or are not available across
all market centers,\522\ such that Rule 605 is an important source of
standardized information about market center execution quality.
---------------------------------------------------------------------------
\520\ If an ATS provides one or more of its subscribers with
aggregate platform-wide order flow and execution statistics that
were not otherwise required disclosures under Rule 605, that ATS is
required to either attach that information to its Form ATS-N, or
certify that the information is available on its website. See Item
26 of Form ATS-N, available at https://www.sec.gov//files/formats-n.pdf.
\521\ For example, reports contain different execution quality
metrics or, if they contain the same execution quality metrics,
these metrics are calculated using different methodologies,
different samples of stocks, and/or different time horizons, making
it difficult to compare across reporting entities. For example, some
ATSs produce execution quality information on a monthly basis (see,
e.g., Unlocking Global Liquidity, UBS, available at https://www.ubs.com/global/en/investment-bank/electronic-trading/equities/unique-liquidity.html), while at least one ATS operator produces
reports on a quarterly basis (see, e.g., JPM-X & JPB-X U.S.
Quarterly Summary, J.P. Morgan, available at https://www.jpmorgan.com/solutions/cib/markets/jpm-x-jpb-x-us-quarterly-summary).
\522\ While the FIF Template represents a standardized set of
execution quality statistics, only one wholesaler currently produces
reports using the FIF Template. See infra note 555.
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The Commission believes that standardized execution quality
information is relevant to many market participants, including to both
individual and institutional investors and their broker-dealers,\523\
who are subject to a principal-agent relationship in which an order
submitter (the principal) submits an order to an agent to handle on its
behalf, but information asymmetries prevent the principal from being
able to directly observe the agent's handling of the order. This can
create possible conflicts of interest, in which the agent's incentives
may not coincide with the interests of the principal.\524\ These
information asymmetries exist both between broker-dealers and their
customers, who do not directly observe their broker-dealers' handling
of their orders,\525\ and between market centers and broker-dealers,
who typically do not directly observe market centers' executions of
their routed orders. Rule 605 serves to alleviate these information
asymmetries by, first, giving broker-dealers access to information
about the execution quality of market centers, which they can use to
inform their routing decisions and, second, in conjunction with broker-
dealer routing information from Rule 606 reports,\526\ giving investors
access to information about the execution quality achieved by the
market centers to which their broker-dealers typically route.\527\
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\523\ See infra sections VII.C.1.(c)(1) and VII.C.1.(c)(2) for
further discussions of how publicly available execution quality
information may be useful for both individual and institutional
investors.
\524\ If there were no information asymmetries and the principal
could perfectly observe the agent's handling of its order, and if
there is competition among agents, then the principal-agent
relationship would not necessarily result in any conflicts of
interest as the principal would be able to directly observe the
agent's actions and switch to another agent.
\525\ See supra note 505, noting that a similar principal-agent
problem was recognized in the Adopting Release.
\526\ See infra section VII.C.2.(a)(1), which discusses issues
with the usage of Rule 606 broker-dealer routing information and
Rule 605 execution quality information to infer the execution
quality achieved by broker-dealers.
\527\ Some market participants may have access to sources of
execution quality information that reduce these information
asymmetries and may serve as an alternative to Rule 605 data. See
infra section VII.C.1.(c) for a detailed discussion. Note that any
source of ex post execution quality information is unlikely to
eliminate this information asymmetry entirely, as it is likely
infeasible for any agent to perfectly observe ex ante or even in
real time how a principal will perform in executing their order.
---------------------------------------------------------------------------
Information on the execution quality obtained by broker-dealers is
particularly important for investors. As broker-dealers that route
customer orders have many choices about where to route orders for
execution,\528\ their routing decisions affect the execution quality
that their customers' orders receive, leading to significant variations
in execution quality across broker-dealers. For example, a broker-
dealer may route a marketable IOC order to a market center that is not
posting any liquidity at the NBBO (in which case the order would be
cancelled), or a broker-dealer may route a NMLO to a market center that
is not attracting any trading interest (in which case the NMLO would
likely be cancelled at the end of day, if not earlier). The authors of
one recent academic working paper ran an experiment in which they
placed identical simultaneous market orders across various broker-
dealers, and found that the execution quality of these orders differed
significantly in terms of average price improvement and effective
spreads.\529\ The authors argue that these differences in execution
quality across broker-dealers are economically significant, as they
estimate that every basis point difference in execution quality is
equivalent to an annual cost to investors of $2.8 billion.\530\ Given
this evidence that there are significant differences in execution
quality across broker-dealers, without access to standardized
information about broker-dealer execution quality, it is difficult for
investors to compare these differences when choosing a broker-dealer.
---------------------------------------------------------------------------
\528\ See infra section VII.C.3.(b)(1) for a discussion of
fragmentation in the market for trading services.
\529\ See Christopher Schwarz, Brad M. Barber, Xing Huang,
Philippe Jorion & Terrance Odean, The `Actual Retail Price' of
Equity Trades (Aug. 28, 2022) available at https://ssrn.com/abstract=4189239 (retrieved from SSRN Elsevier database). The
authors find that this dispersion is due to off-exchange wholesalers
systematically giving different execution prices for the same trades
to different brokers.
\530\ See id. at 24.
---------------------------------------------------------------------------
Given that Rule 605 reports contain aggregated information, some
information asymmetries regarding the order execution quality achieved
at different market centers are not fully addressed by Rule 605 because
the principal is not able to use Rule 605 reports to observe the
execution quality that the agent achieved for the principal's
individual orders. However, the principal is able to receive a signal
of the execution quality that the agent has achieved for comparable
orders over a certain time period. This signal can be a useful proxy
that investors and their broker-dealers can use to assess and compare
the execution quality that they can expect to receive across market
centers, and there is evidence that Rule 605 reports have indeed been
used for this purpose. One academic study examining the introduction of
Rule 605 found that the routing of marketable order flow by broker-
dealers became more sensitive to changes in execution quality across
market centers after Rule 605 reports became available.\531\ The
authors attribute this effect to broker-dealers factoring in
information about the execution quality of market centers from Rule 605
reports when making their order routing decisions.
---------------------------------------------------------------------------
\531\ See Boehmer et al.
---------------------------------------------------------------------------
(b) Current Rule 606 Disclosure Requirements
Currently, under Rule 606, broker-dealers are required to identify
the venues, including market centers, to which they route customer
orders for execution.\532\ Specifically, with respect to held orders,
Rule 606(a)(1) requires broker-dealers to produce quarterly public
reports containing information about the venues to which the broker-
dealer regularly routed non-directed orders for execution, including
any payment relationship between the broker-dealer and the venue, such
as
[[Page 3833]]
any PFOF arrangements.\533\ In addition, Rule 606(b)(1) requires
broker-dealers to provide to their customers, upon request, reports
that include high-level customer-specific order routing information,
such as the identity of the venues to which the customer orders were
routed for execution in the prior six months and the time of the
transactions, if any, that resulted from such orders.\534\ For orders
submitted on a held basis, the reports required by Rule 606 do not
contain any execution quality information.
---------------------------------------------------------------------------
\532\ See 17 CFR 242.606.
\533\ See 17 CFR 242.606(a)(1). See also corresponding
discussion in section III.A, supra.
\534\ See 17 CFR 242.606(a)(2). See also corresponding
discussion in section III.A, supra.
---------------------------------------------------------------------------
When the Commission adopted the predecessor to Rule 606, it was
intended to supply investors with information on where their orders are
routed, which could be used along with information from Rule 605 about
the quality of execution from the market centers to which their orders
are routed in order to make more informed decisions with respect to
their orders.\535\ In theory, investors should be able to use Rule 606
reports to identify the market centers to which their broker-dealers
are routing orders, and then use Rule 605 to estimate the execution
quality offered by those market centers.\536\ These market centers'
aggregated execution quality metrics could then be used as a proxy for
the execution quality that broker-dealers achieved for their customers'
orders.
---------------------------------------------------------------------------
\535\ See Adopting Release, 65 FR 75414 (Dec. 1, 2000) at 75435
(``Rule 11Ac1-6 is designed to address the complementary need for
broker-dealers to disclose to customers where their orders are
routed for execution. The primary objective of the rule is to afford
customers a greater opportunity to monitor their broker-dealer's
order routing practices. Supplied with information on where their
orders are routed, as well as information about the quality of
execution from the market centers to which their orders are routed,
investors will be able to make better informed decisions with
respect to their orders. The information also may assist investors
in selecting a broker-dealer.'').
\536\ See infra section VII.C.2.(a)(1) for a discussion of
current issues with using information from Rule 606 reports to infer
the execution quality of broker-dealers.
---------------------------------------------------------------------------
Following amendments to Rule 606 in 2018,\537\ broker-dealers are
subject to requirements under Rule 606 that provide information about
the execution quality achieved by their broker-dealers for not held
orders, which are typically used by institutional investors.\538\
Specifically, Rule 606(b)(3) requires broker-dealers to produce reports
pertaining to order handling upon the request of a customer that
places, directly or indirectly, one or more orders in NMS stocks that
are submitted on a not held basis, subject to a de minimis
exception.\539\ These reports include aggregated execution quality
metrics such as fill rate, percentage of shares executed at the
midpoint, and percentages of total shares executed that were priced on
the side of the spread more favorable to the order and on the side of
the spread less favorable to the order.\540\
---------------------------------------------------------------------------
\537\ See supra note 60 and accompanying text for a discussion
of these amendments.
\538\ An analysis included in the 2018 Rule 606 Amendments
Release looked at orders submitted from customer accounts of 120
randomly selected NMS stocks listed on NYSE during the sample period
of December 5, 2016, to December 9, 2016, consisting of 40 large-cap
stocks, 40 mid-cap stocks, and 40 small-cap stocks. The analysis
found that among the orders received from the institutional
accounts, about 69% of total shares and close to 39% of total number
of orders in the sample are not held orders, whereas among the
orders received from the individual accounts, about 19% of total
shares and about 12% of total number of orders in the sample are not
held orders. See 2018 Rule 606 Amendments Release, 83 FR 58338 (Nov.
19, 2018) at 58393. See also supra note 56 and accompanying text,
describing the Commission's understanding that held orders are
typically used by individual investors.
\539\ See 17 CFR 242.606(b)(3). In addition, Rule 606(b)(5)'s
customer-level de minimis exception exempts broker-dealers from
providing upon request execution quality reports for customers that
traded on average each month for the prior six months less than
$1,000,000 of notional value of not held orders in NMS stocks
through the broker-dealer. See 17 CFR 242.606(b)(5).
\540\ See 17 CFR 242.606(b)(3)(ii).
---------------------------------------------------------------------------
(c) Current Usage of Rule 605 Reports
Rule 605 data is currently used by some market participants, such
as broker-dealers and investment advisers as part of their review of
execution quality. However, the use of this data by both individual and
institutional investors to directly evaluate and compare execution
quality across market centers is currently limited.
(1) Usage of Rule 605 Reports by Individual Investors
It is likely that the extent to which individual investors directly
access Rule 605 reports is currently limited. Several market
participants have stated that Rule 605 reports have low usage among
individual investors, including at least one commenter to the
Commission's Concept Release on Equity Market Structure,\541\ and some
EMSAC committee members.\542\
---------------------------------------------------------------------------
\541\ See, e.g., Letter from Daniel Keegan, Managing Director,
Citigroup Global Markets Inc. re Concept Release on Equity Market
Structure (Release No. 34-61358; File No. S7-02-10) (May 5, 2010)
(``Citigroup Letter II'') at 6.
\542\ See supra note 112 and accompanying text.
---------------------------------------------------------------------------
Rule 605 reports are designed to be machine-readable, rather than
human-readable. While machine-readable data is useful for facilitating
further processing and analysis,\543\ it is not readily usable by
market participants and other interested parties that may prefer to
review summary statistics, and is not easily consumable by market
participants who do not have the access to necessary software or
programming skills. This may limit the usability of Rule 605 reports
for individual investors in particular, who are less likely to have
access to these resources. In the Adopting Release, the Commission
anticipated that, rather than individual investors obtaining and
digesting Rule 605 reports themselves, independent analysts,
consultants, broker-dealers, the financial press, and market centers
would analyze the information and produce summaries that respond to the
needs of investors.\544\ Although the Commission is unable to observe
the full extent to which this has occurred, some third parties have
produced information based on Rule 605 reports that is meant for public
consumption. For example, data obtained from Rule 605 reports are used
by academics to study a variety of topics related to execution quality,
including liquidity measurement, exchange competition, zero commission
trading, and broker-dealer execution quality,\545\ and at least one
market participant used Rule 605 data in an analysis supporting its
letter to the Commission commenting on one national securities
exchange's registration application.\546\ Rule 605 data is also used in
the financial press.\547\
---------------------------------------------------------------------------
\543\ See discussion in infra section VII.C.1.(c)(2).
\544\ See Adopting Release, 65 FR 75414 (Dec. 1, 2000) at 75419.
\545\ See, e.g., Ruslan Y. Goyenko, Craig W. Holden & Charles
Trzcinka, Do liquidity measures measure liquidity? 92 J. Fin. Econ.
153 (2009); Edward D. Watson & Donovan Woods, Exchange introduction
and market competition: The entrance of MEMX and MIAX, 54 Glo. Fin.
J. (2022) 100756; Pankaj K. Jain, Suchismita Mishra, Shawn
O'Donoghue & Le Zhao, Trading Volume Shares and Market Quality: Pre-
and Post-Zero Commissions (working paper Dec. 2, 2020), available at
https://ssrn.com/abstract=3741470 SSRN 3741470 (retrieved from SSRN
Elsevier database); Schwarz et al (2022).
\546\ See, e.g., Letter from David Weisberger, Managing
Director, Markit, New York, New York Re: Investor's Exchange LLC
Form 1 Application; Release No. 34-75925; File No. 10-222 (Feb. 16,
2016), available at https://www.sec.gov/comments/10-222/10222-394.pdf.
\547\ See, e.g., Bill Alpert ``Who Makes Money on Your Stock
Trades,'' Barron's, Feb. 28, 2015 (retrieved from Factiva database)
(stating that ``we ran each market maker's Rule 605 execution
reports through statistical-analysis scripts that we wrote in the
widely used open-source math software known as `R.' '').
---------------------------------------------------------------------------
Unlike institutional investors,\548\ individual investors typically
have limited access to alternative sources of standardized execution
quality information that could be used to compare across broker-dealers
other than information obtained (directly or
[[Page 3834]]
indirectly) from Rule 605 reports.\549\ The requirement in Rule
606(b)(3) for broker-dealers to provide individualized reports of
execution quality to their customers upon request does not extend to
held orders, which are mostly used by individual investors,\550\ and
contains a customer-level de minimis exception that likely excludes
most individual investors.\551\ In addition, many individual investors
do not have access to the information or expertise required to
calculate their own execution quality metrics, which makes it difficult
for them to compare how execution quality varies across broker-
dealers.\552\
---------------------------------------------------------------------------
\548\ See discussion in infra section VII.C.1.(c)(2).
\549\ There are also some broker-dealers that disclose their own
execution quality metrics on their respective websites, but the
disclosures are not standardized and tend to differ in ways that
make them difficult to compare, such as reporting different metrics,
using different methodologies, or different samples of stocks. See
supra note 506.
\550\ See supra note 538 describing an analysis showing that not
held orders made up only 19% of total shares and about 12% of total
number of orders among the sample of orders received from the
individual accounts.
\551\ See supra note 539 describing the customer-level de
minimis exception of Rule 606(b)(5).
\552\ See infra section VII.C.2.(a)(1) discussing several
analyses that find significant differences in execution quality
across retail brokers.
---------------------------------------------------------------------------
One exception is the recent efforts by a few brokers-dealers and
wholesalers to make available voluntary summary disclosures of
execution quality in exchange-listed stocks for individual investors
using the FIF Template.\553\ Although the reports produced using the
FIF Template may be useful, this disclosure is voluntary, and only a
few firms are making or have made such disclosures. The Commission
understands that only three retail brokers began producing reports
using the FIF Template in 2015 on a quarterly basis, and that one of
these broker-dealers was acquired and stopped producing these reports
in 2017, and another stopped producing these reports in 2018, such that
only one retail broker currently produces reports using the FIF
Template.\554\ Likewise, the Commission understands that there is
currently only one wholesaler producing reports using the FIF
Template.\555\
---------------------------------------------------------------------------
\553\ See supra note 450 and accompanying text for further
discussion of the FIF Template.
\554\ See Retail Execution Quality Statistics, Financial
Information Forum, available at https://fif.com/tools/retail-execution-quality-statistics; Retail Execution Quality Statistics
Q2--2022, Fidelity, available at https://www.fidelity.com/bin-public/060_www_fidelity_com/documents/FIF-FBS-retail-execution-quality-stats.pdf.
\555\ See Retail Execution Quality Statistics, Financial
Information Forum, available at https://fif.com/tools/retail-execution-quality-statistics; Retail Execution Quality Statistics--
Wholesale Market Maker Perspective, Two Sigma, available at https://www.twosigma.com/businesses/securities/execution-statistics/. The
Commission is aware of at least two wholesalers that formerly
produced reports using the FIF Template, but stopped in Q3 2019.
---------------------------------------------------------------------------
(2) Usage of Rule 605 Reports by Institutional Investors
The Commission preliminarily understands that, while the usage of
Rule 605 reports by institutional investors may be limited by several
factors, Rule 605 reports nevertheless contain information about
execution quality that is otherwise useful for institutional investors.
First, institutional investors typically have access to alternative
sources of execution quality information. Many institutional investors
regularly conduct, directly or through a third-party vendor,
transaction costs analysis (``TCA'') of their orders to assess
execution quality against various benchmarks. Institutional investors
that perform their own in-house analyses of execution quality or obtain
analyses of execution quality from third-party vendors would be less
likely to rely on information from Rule 605 reports in order to
estimate the execution quality of their orders. Furthermore, the
requirement in Rule 606(b)(3) for broker-dealers to provide
individualized reports of execution quality of not held orders upon
request,\556\ which is most likely to be utilized by institutional
investors,\557\ provides institutional investors with another
alternative source of information about the execution quality of their
orders. While broker-dealers are currently required to provide their
customers only with execution quality information about their not held
orders under Rule 606(b)(3), which are not covered by Rule 605
reporting requirements, given the large size of most institutional
investors and their business, institutional investors may have
sufficient bargaining power such that broker-dealers have strong
incentives to provide them with this information about the execution
quality of their held orders when asked.
---------------------------------------------------------------------------
\556\ See supra Section VIII.C.1.(b) discussing broker-dealer
reporting requirements under Rule 606.
\557\ See supra note 538 discussing an analysis showing that
institutional investors are more likely than individual investors to
use not held orders. See also supra note 539 describing the
customer-level de minimis exception of Rule 606(b)(5).
---------------------------------------------------------------------------
However, because Rule 605 reports are public, institutional
investors can use these reports to assess the execution quality of the
broker-dealers and market centers with which they do not currently do
business. The information on execution quality that is individually
collected by institutional investors is typically highly individualized
and non-public.\558\ Therefore, institutional investors would not be
able to use these individualized reports to compare their broker-
dealers' execution quality to that of broker-dealers with which they do
not currently have a relationship, or to examine the execution quality
of a market center to which their broker-dealers do not currently route
orders. Furthermore, any ad hoc reports that institutional investors
may receive from their broker dealers containing information about
their held orders are unlikely to be sufficiently standardized to allow
for easy comparisons across broker-dealers or market centers.
---------------------------------------------------------------------------
\558\ In 2018, the Commission proposed but ultimately did not
adopt a requirement that broker-dealers that handle orders subject
to the customer-specific disclosures required by Rule 606(b)(3)
issue a quarterly public aggregated disclosure on order handling.
See 2018 Rule 606 Amendments Release, 83 FR 58338 (Nov. 19, 2018) at
58369.
---------------------------------------------------------------------------
Second, Rule 605 reports only contain information about the
execution quality of investors' held orders. Not held orders, which are
excluded from the definition of ``covered order,'' \559\ are excluded
from Rule 605 metrics.\560\ As many institutional orders tend to be not
held,\561\ this may limit the extent to which Rule 605 reports contain
relevant information for institutional investors. Rule 605 reports may
contain information that is relevant for institutional investors,
however, as large institutional ``parent'' orders are often split into
multiple smaller ``child'' orders, which may be handled as held orders
and reflected in Rule 605 reports. This would allow institutional
investors to use the information in Rule 605 reports to evaluate the
performances of their broker-dealers. For example, institutional
investors may incorporate information from Rule 605 reports into their
TCA when evaluating the performance of their broker-dealers'
[[Page 3835]]
Smart Order Router (``SOR'') algorithms.\562\
---------------------------------------------------------------------------
\559\ Currently there are no requirements for aggregated
information about the execution quality of not held orders to be
made public. The Commission believes that the potential ability for
customers and broker-dealers to use aggregated order handling
information for not held orders to better understand broker-dealers'
routing behavior or compare broker-dealers' order routing
performance is limited as a result of the disparate behavior of
customers when using not held orders. See, e.g., 2018 Rule 606
Amendments Release, 83 FR 58338 (Nov. 19, 2018) at 58369-70, in
which the Commission stated that, in contrast to held orders, not
held order flow is diverse and customers may provide specific order
handling instructions to their broker-dealers, limit the order
handling discretion of their broker-dealers, or have specific needs
that impact the broker-dealers' handling of these orders. See also
supra note 63 for further discussion.
\560\ See supra note 60 and accompanying text discussing broker-
dealers requirements under Rule 606(b)(3) to provide individualized
reports of execution quality upon request for not held orders.
\561\ See supra note 538 discussing an analysis showing that
institutional investors are more likely than individual investors to
use not held orders.
\562\ See infra section VII.C.3.(a)(1)(b) discussing the use of
SORs by broker-dealers to split a large institutional ``parent''
order into multiple ``child'' orders in a way that achieves the best
execution for the parent order.
---------------------------------------------------------------------------
The Commission believes that, due to their typically larger
resources, institutional investors may be more likely than individual
investors to access Rule 605 reports directly. Rule 605 reports are
machine-readable, which makes them useful for facilitating further
processing and analysis by market participants that have access to the
resources necessary for handling large amounts of raw data, such as
many institutional investors. However, the Commission understands some
institutional investors may currently use aggregated statistics or
summaries of Rule 605 reports prepared by third parties, who make these
reports available, possibly for a fee.
(3) Other Users of Rule 605 Reports
While the direct usage of Rule 605 reports by individual and
institutional investors is likely limited, Rule 605 reports are
currently used by other market participants, including analysts and
researchers,\563\ as well as financial service providers, such as
investment advisers and broker-dealers, that are subject to best
execution obligations.
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\563\ See, e.g., supra notes 545-547, describing the use of Rule
605 data in academic literature, in comment letters related to
Commission and SRO rulemaking, and the financial press.
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In particular, the Commission understands that investment advisers
and broker-dealers typically use Rule 605 reports as part of their
internal review of execution quality. As fiduciaries, investment
advisers owe their clients a duty of care and a duty of loyalty.\564\
The duty of care includes, among other things, the duty to seek best
execution of a client's transactions where the investment adviser has
the responsibility to select broker-dealers to execute client
trades.\565\ Broker-dealers also have an obligation to seek best
execution of customer orders.\566\ The Commission understands that
these financial service providers often have Best Execution Committees
that periodically review order execution quality, and typically use
Rule 605 reports as part of their review.\567\
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\564\ See Investment Advisers Act Release No. 5248 (June 5,
2019), 84 FR 33669 (July 12, 2019) (Commission Interpretation
Regarding Standard of Conduct for Investment Advisers) (``IA
Fiduciary Interpretation'').
\565\ See, e.g., Investment Advisers Act Rule 206(3)-2(c). The
Commission previously has described the contours of an investment
adviser's duty to seek best execution. IA Fiduciary Interpretation,
84 FR 33669 (Jul. 12, 2019) at 33674-75. In addition, the Commission
has brought a variety of enforcement actions against registered
investment advisers in connection with their alleged failure to
satisfy their duty to seek best execution. See, e.g., In the Matter
of Aventura Capital Management, LLC, Investment Advisers Act Release
No. 6103 (Sept. 6, 2022) (settled action); In the Matter of Madison
Avenue Securities, LLC, Investment Advisers Act Release No. 6036
(May 31, 2022) (settled action).
\566\ See supra note 69 and accompanying text for further
discussion of broker-dealers' best execution requirements.
\567\ See, e.g., Practical Considerations for Your `Best
Execution Compliance Program', Ernst & Young (Mar. 2017), available
at http://documents.sifma.org/uploadedFiles/Events/2017/Compliance_and_Legal_Society_Annual_Seminar/EY_CL%20Annual_Marketing%20PDF.pdf (stating the broker-dealers rely
on ``traditional 605 metrics'' for best execution review). See also
Citigroup Letter II at 7 (stating that, ``under the current market
structure, broker-dealers closely review and analyze Rule 605
statistics as part of their regular and rigorous review for best
execution'').
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(d) Rules Addressing Consolidated Market Data
In 2020, the Commission adopted a new rule and amended existing
rules to establish a new infrastructure for consolidated market
data,\568\ and the regulatory baseline includes these changes to the
current arrangements for consolidated market data. However, as
discussed in more detail below, the MDI Rules have not been
implemented, and so they have not yet affected market practice. As a
result, the data used to measure the baseline below reflects the
regulatory structure in place for consolidated market data prior to the
implementation of the MDI Rules. Accordingly, this section first will
briefly summarize the regulatory structure for consolidated market data
prior to the implementation of the MDI Rules. It then will discuss the
current status of the implementation of the MDI Rules and provide an
assessment of the potential effects that the implementation of the MDI
Rules could have on the baseline estimations.
---------------------------------------------------------------------------
\568\ See supra section IV.B.5, discussing the MDI Rules.
---------------------------------------------------------------------------
(1) Regulatory Structure for Consolidated Market Data Prior to the MDI
Rules
Consolidated market data is made widely available to investors
through the national market system, a system set forth by Congress in
section 11A of the Exchange Act \569\ and facilitated by the Commission
in Regulation NMS.\570\ Market data is collected by exclusive
SIPs,\571\ which consolidate that information and disseminate an NBBO
and last sale information. For quotation information, only the 16
national securities exchanges that currently trade NMS stocks provide
quotation information to the SIPs for dissemination in consolidated
market data.\572\ FINRA has the only SRO display-only facility (the
Alternative Display Facility, or ADF). No broker-dealer, however,
currently uses it to display quotations in NMS stocks in consolidated
market data. Disseminated quotation information includes each
exchange's current highest bid and lowest offer and the shares
available at those prices, as well as the NBBO.
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\569\ See supra note 3 and accompanying text.
\570\ 17 CFR 242.600 through 242.614.
\571\ See supra note 195 and accompanying text.
\572\ Currently, these national securities exchanges are: Cboe
BYX Exchange, Inc. (``Cboe BYX''); Cboe BZX Exchange, Inc. (``Cboe
BZX''); Cboe EDGA Exchange, Inc. (``Cboe EDGA''); Cboe EDGX
Exchange, Inc. (``Cboe EDGX''); Investors Exchange LLC (``IEX'');
Long-Term Stock Exchange, Inc. (``LTSE''); MEMX LLC (``MEMX''); MIAX
Pearl, LLC (``MIAX PEARL''); Nasdaq BX, Inc. (``Nasdaq BX''); Nasdaq
PHLX LLC (``Nasdaq Phlx''); The Nasdaq Stock Market LLC
(``Nasdaq''); NYSE; NYSE American LLC (``NYSE American''); NYSE
Arca, Inc. (``NYSE Arca''); NYSE Chicago, Inc. (``NYSE CHX''); and
NYSE National, Inc. (``NYSE National''). The Commission approved
rules proposed by BOX Exchange LLC (``BOX'') for the listing and
trading of certain equity securities that would be NMS stocks on a
facility of BOX known as BSTX LLC (``BSTX''), but BSTX is not yet
operational. See Securities Exchange Act Release Nos. 94092 (Jan.
27, 2022), 87 FR 5881 (Feb. 2, 2022) (SR-BOX-2021-06) (approving the
trading of equity securities on the exchange through a facility of
the exchange known as BSTX); 94278 (Feb. 17, 2022), 87 FR 10401
(Feb. 24, 2022) (SR-BOX-2021-14) (approving the establishment of
BSTX as a facility of BOX). BSTX cannot commence operations as a
facility of BOX until, among other things, the BSTX Third Amended
and Restated Limited Liability Company Agreement approved by the
Commission as rules of BOX is adopted. Id. at 10407.
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For transaction information, currently all of the national
securities exchanges that trade NMS stocks and FINRA provide real-time
transaction information to the SIPs for dissemination in consolidated
market data. Such information includes the symbol, price, size, and
exchange of the transaction, including odd-lot transactions.
(2) Unimplemented Market Data Infrastructure Rules
Among other things, the unimplemented MDI Rules update and expand
the content of consolidated market data to include: (1) certain odd-lot
information; \573\ (2) information about certain orders that are
outside of an exchange's best bid and best offer (i.e., certain depth
of book data); \574\ and (3) information about orders that are
participating in opening, closing, and
[[Page 3836]]
other auctions.\575\ The Rules also introduce a four-tiered definition
of round lot that is tied to a stock's average closing price during the
previous month.\576\ For stocks with prices greater than $250, a round
lot is defined as consisting of between 1 and 40 shares, depending on
the tier.\577\ The MDI Rules also introduce a decentralized
consolidation model under which competing consolidators, rather than
the existing exclusive SIPs, will collect, consolidate, and disseminate
certain NMS information.\578\
---------------------------------------------------------------------------
\573\ See supra note 422 and accompanying text for further
discussion of changes to the availability of odd-lot information
under the MDI Rules.
\574\ See MDI Adopting Release, 86 FR 18596 (Apr. 9, 2021) at
18625.
\575\ See id. at 18630.
\576\ See id. at 18617.
\577\ See id. The Commission adopted a four-tiered definition of
round lot: 100 shares for stocks priced $250.00 or less per share,
40 shares for stocks priced $250.01 to $1,000.00 per share, 10
shares for stocks priced $1,000.01 to $10,000.00 per share, and 1
share for stocks priced $10,000.01 or more per share.
\578\ See id. at 18637.
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In the MDI Adopting Release, the Commission established a
transition period for the implementation of the MDI Rules.\579\ The
``first key milestone'' for the transition period was to be an
``amendment of the effective national market system plan(s),'' which
``must include the fees proposed by the plan(s) for data underlying''
consolidated market data (``Proposed Fee Amendment'').\580\ The
compliance date for the Infrastructure Rules was set with reference to
the date that the Commission approved the Proposed Fee Amendment.\581\
The end of the transition period was to be at least two years after the
date the Commission approved the Proposed Fee Amendment.\582\
---------------------------------------------------------------------------
\579\ See id. at 18698-18701.
\580\ See id. at 18699.
\581\ See, e.g., id. at 18700 n. 355 (compliance date for
amendment to Rule 603(b) to be ``180 calendar days from the date of
the Commission's approval of the amendments to the effective
national market system plan(s)'').
\582\ See id. at 18700-18701 (specifying consecutive periods of
90 days, 90 days, 90 days, 180 days, 90 days, a period for filing
and approval of another national market system plan amendment to
effectuate the cessation of the operations of the SIPS (with a 300-
day maximum time for Commission action after filing to approve or
disapprove the filing), and a 90-day period).
---------------------------------------------------------------------------
The MDI Adopting Release did not specify a process for continuing
the transition period if the Commission disapproved the Proposed Fee
Amendment. On September 21, 2022, the Commission disapproved the
Proposed Fee Amendment, because the Participants had not demonstrated
that the proposed fees were fair, reasonable and not unreasonably
discriminatory.\583\ Accordingly, there currently is no date to begin
the at-least-two-year period for implementation of the MDI Rules, and
there is no date that can be reasonably estimated for the
implementation of the MDI Rules to be completed.
---------------------------------------------------------------------------
\583\ Securities Exchange Act Release No. 95851 (Sept. 21, 2022)
(Order Disapproving the Twenty-Fifth Charges Amendment to the Second
Restatement of the CTA Plan and Sixteenth Charges Amendment to the
Restated CQ Plan).
---------------------------------------------------------------------------
Given that the MDI Rules have not yet been implemented, they have
not affected market practice and therefore data that would be required
for a comprehensive quantitative analysis of a baseline that includes
the effects of the MDI Rules is not available. It is possible that the
baseline (and therefore the economic effects relative to the baseline)
could be different once the MDI Rules are implemented. The following
discussion reflects the Commission's assessment of the anticipated
economic effects of the MDI Rules described in the MDI Adopting Release
as they relate to the baseline for this proposal.\584\
---------------------------------------------------------------------------
\584\ See MDI Adopting Release, 86 FR 18596 (Apr. 9, 2021) at
18741-18799.
---------------------------------------------------------------------------
The Commission anticipated that the new round lot definition will
result in narrower NBBO spreads for most stocks with prices greater
than $250 because, for these stocks, fewer odd-lot shares will need to
be aggregated together (possibly across multiple price levels \585\) to
form a round lot and qualify for the NBBO.\586\ The reduction in
spreads will be greater in higher-priced stocks because the definition
of a round lot for these stocks will include fewer shares, such that
even fewer odd-lot shares will need to be aggregated together.\587\
This could cause statistics that are measured against the NBBO to
change because they will be measured against the new, narrower NBBO.
For example, execution quality statistics on price improvement for
higher-priced stocks may show a reduction in the number of shares of
marketable orders that received price improvement because price
improvement will be measured against a narrower NBBO. In addition, the
Commission anticipated that the NBBO midpoint in stocks priced higher
than $250 could be different under the MDI Rules than it otherwise
would be, resulting in changes in the estimates for statistics
calculated using the NBBO midpoint, such as effective spreads. In
particular, at times when bid odd-lot quotations exist within the
current NBBO but no odd-lot offer quotations exist (and vice versa),
the midpoint of the NBBO resulting from the rule will be higher than
the current NBBO midpoint.\588\ More broadly, the Commission
anticipated that the adopted rules will have these effects whenever the
new round lot bids do not exactly balance the new round lot offers.
However, the Commission stated that it does not know to what extent or
direction such odd-lot imbalances in higher priced stocks currently
exist, so it is uncertain of the extent or direction of the
change.\589\
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\585\ The calculation of the NBBO includes odd-lots that, when
aggregated, are equal to or greater than a round lot. Under CFR
242.600(b)(21)(ii), ``such aggregation shall occur across multiple
prices and shall be disseminated at the least aggressive price of
all such aggregated odd-lots.'' For example, if there is one 50-
share bid at $25.10, one 50-share bid at $25.09, and two 50-share
bids at $25.08, the odd-lot aggregation method would show a
protected 100-share bid at $25.09.
\586\ For example, if there is one 20-share bid at $250.10, one
20-share bid at $250.09, and two 50-share bids at $250.08, prior to
MDI the NBB would be $250.08, as even aggregated together the odd
lot volume would not add up to at least a round lot. After MDI, the
NBB would be $25.09, as the odd-lot aggregation method would show a
protected 40-share round lot bid at $25.09.
\587\ See supra note 577. An analysis in the MDI Adopting
Release showed that the new round lot definition caused a quote to
be displayed that improved on the current round lot quote 26.6% of
the time for stocks with prices between $250.01 and $1,000, and
47.7% of the time for stocks with prices between $1,000.01 and
$10,000. See MDI Adopting Release, 86 FR at 18743.
\588\ For example, if the NBB is $260 and the NBO is $260.10,
the NBBO midpoint is $260.05. Under the adopted rules a 40 share buy
quotation at $260.02 will increase the NBBO midpoint to $260.06.
Using this new midpoint, calculations of effective spread will be
lower for buy orders, but will be higher for sell orders.
\589\ See MDI Adopting Release, 86 FR 18596 (Apr. 9, 2021) at
18750.
---------------------------------------------------------------------------
The Commission also anticipated that the MDI Rules could result in
a smaller number of shares at the NBBO for most stocks in higher-priced
round lot tiers.\590\ To the extent that this occurs, there could be an
increase in the frequency with which marketable orders must walk the
book to execute. This would affect statistics that are calculated using
consolidated depth information, such as measures meant to capture
information about whether orders received an execution of more than the
displayed size at the quote, i.e., ``size improvement.''
---------------------------------------------------------------------------
\590\ However, this effect will depend on how market
participants adjust their order submissions. See id. at 18746 for
further discussion.
---------------------------------------------------------------------------
The MDI Rules may also result in a higher number of odd-lot trades,
as the inclusion of odd-lot quotes that may be priced better than the
current NBBO in consolidated market data may attract more trading
interest from market participants that previously did not have access
to this information.\591\ However, the magnitude of this effect depends
on the extent to which market participants who rely solely on SIP data
and lack information on odd-lot quotes choose to receive the odd-lot
information and trade on it. The Commission states in the MDI Adopting
[[Page 3837]]
Release that it believes it is not possible to observe this willingness
to trade with existing market data.\592\
---------------------------------------------------------------------------
\591\ See id. at 18754.
\592\ See id.
---------------------------------------------------------------------------
The MDI Rules may have implications for broker-dealers' order
routing practices. For those market participants that rely solely on
SIP data for their routing decisions and that choose to receive the
expanded set of consolidated market data, the Commission anticipated
that the additional information contained in consolidated market data
will allow them to make more informed order routing decisions. This in
turn would help facilitate best execution, which would reduce
transaction costs and increase execution quality.\593\
---------------------------------------------------------------------------
\593\ See id. at 18725.
---------------------------------------------------------------------------
The MDI Rules may also result in differences in the baseline
competitive standing among different trading venues, for several
reasons. First, for stocks with prices greater than $250, the
Commission anticipated that the new definition of round lots may affect
order flows as market participants who rely on consolidated data will
be aware of quotes at better prices that are currently in odd-lot
sizes, and these may not be on the same trading venues as the one that
has the best 100 share quote.\594\ Similarly, it anticipated that
adding information on odd-lot quotes priced at or better than the NBBO
to expanded core data may cause changes to order flow as market
participants take advantage of newly visible quotes.\595\ However, the
Commission stated that it was uncertain about the magnitude of both of
these effects.\596\ To the extent that it occurs, a change in the flow
of orders across trading venues may result in differences in the
competitive baseline in the market for trading services.
---------------------------------------------------------------------------
\594\ See id. at 18744.
\595\ See MDI Adopting Release, 86 FR 18596 (Apr. 9, 2021) at
18754.
\596\ See id. at 18745, 18754.
---------------------------------------------------------------------------
Second, national securities exchanges and ATSs have a number of
order types that are based on the NBBO, and so the Commission
anticipated that the changes in the NBBO caused by the new round lot
definitions may affect how these order types perform and could also
affect other orders with which they interact.\597\ The Commission
stated that these interactions may affect relative order execution
quality among different trading platforms, which may in turn affect the
competitive standing among different trading venues, with trading
venues that experience an improvement/decline in execution quality
attracting/losing order flow.\598\ However, the Commission stated that
it was uncertain of the magnitude of these effects.\599\
---------------------------------------------------------------------------
\597\ See id. at 18748.
\598\ See id.
\599\ See id.
---------------------------------------------------------------------------
Third, the Commission anticipated that, as the NBBO narrows for
securities in the smaller round lot tiers, it may become more difficult
for the retail execution business of wholesalers to provide price
improvement and other execution quality metrics at levels similar to
those provided under a 100 share round lot definition.\600\ To the
extent that wholesalers are held to the same price improvement
standards by retail brokers in a narrower spread environment, the
wholesalers' profits from executing individual investor orders might
decline,\601\ and to make up for lower revenue per order filled in a
narrower spread environment, wholesalers may respond by changing how
they conduct their business in a way that may affect retail brokers.
However, the Commission stated that it was uncertain as to how
wholesalers may respond to the change in the round lot definition, and,
in turn, how retail brokers may respond to those changes, and so was
uncertain as to the extent of these effects.\602\ If wholesalers do
change how they conduct business, it may impact wholesalers'
competitive standing in terms of the execution quality offered,
particularly to individual investor orders.
---------------------------------------------------------------------------
\600\ See id. at 18747.
\601\ Individual investor orders typically feature lower adverse
selection than other types of orders, such as institutional orders.
See infra note 608 and accompanying text, describing how it is
generally more profitable for any liquidity provider, including
wholesalers, to execute against orders with lower adverse selection
risk.
\602\ See MDI Adopting Release, 86 FR 18596 (Apr. 9, 2021) at
18748.
---------------------------------------------------------------------------
Where implementation of the above-described MDI Rules may affect
certain numbers in the baseline, the description of the baseline below
notes those effects.
2. Current Rule 605 Disclosure Requirements
The Commission believes that there are several areas where market
participants' current access to information about execution quality
under Rule 605 could be improved. Specifically, currently broker-
dealers that are not market centers are not required to report under
Rule 605, which limits market participants' ability to assess and
compare the execution quality that broker-dealers obtain for their
customers. Furthermore, changes in equity market conditions and
technological advancements since the Rule was adopted in 2000, such as
an increase in the speed of trading, have decreased the relevance of
some of the information contained in Rule 605 reports.\603\
---------------------------------------------------------------------------
\603\ See supra notes 12-16 and accompanying text for further
discussion.
---------------------------------------------------------------------------
(a) Scope of Reporting Entities Under Current Rule 605 Reporting
Requirements
The current scope of entities that are required to report under
Rule 605 does not include broker-dealers that only route customer
orders externally, rather than executing customer orders internally,
because they do not meet the definition of market center. As a result,
it is difficult for market participants to use the execution quality
statistics that are currently available to compare execution quality
across these broker-dealers. Furthermore, to the extent that firms that
operate two separate market centers co-mingle execution quality
information about multiple market centers in Rule 605 reports, this
would make it difficult for market participants to assess the execution
quality of each market individually.
(1) Broker-Dealers
Currently, broker-dealers that are not market centers are not
required to prepare Rule 605 reports,\604\ which the Commission
believes limits market participants' ability to assess and compare the
execution quality that broker-dealers obtain for their customers.
---------------------------------------------------------------------------
\604\ A broker-dealer may currently be subject to Rule 605
reporting requirements to the extent that the broker-dealer is
acting as or operates a market center. However, such reports are
required to cover only the orders that the broker-dealer handled
within its capacity as a market center. See supra notes 179-180 and
accompanying text.
---------------------------------------------------------------------------
Rule 605 and Rule 606 operate together to allow investors to
evaluate what happens to their orders after the investors submit their
orders to a broker-dealer for execution.\605\ If a market center's Rule
605 reports are representative of the aggregate execution quality that
any given broker-dealer receives from that market center, then a
customer of a broker-dealer can use that broker-dealer's Rule 606
reports to identify the venues to which the broker-dealer regularly
routes orders for execution and use Rule 605 reports to get information
on aggregate order
---------------------------------------------------------------------------
\605\ See supra note 141 and accompanying text.
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[[Page 3838]]
execution quality at those market centers.\606\ However, if broker-
dealers receive different execution quality from a given market center,
combining Rule 606 and Rule 605 data would not be informative about the
execution quality of individual broker-dealers' average execution
quality. This is because, since a market center's Rule 605 report is
aggregated across all of its broker-dealer customers, it is not
possible to determine how execution quality varies across broker-
dealers at a particular market center.\607\
---------------------------------------------------------------------------
\606\ See supra section VII.C.1.(b) for a discussion of broker-
dealers' current reporting requirements under Rule 606.
\607\ For example, consider two broker-dealers, Broker-Dealer 1
and Broker-Dealer 2, which both route orders to a market center
(``Market Center A'') according to these broker-dealers' Rule 606
reports. Assume that the orders routed by Broker-Dealer 1 receive
consistently below-average execution quality from the wholesaler,
while the orders routed by Broker-Dealer 2 receive consistently
above-average execution quality. If a customer of Broker-Dealer 1
were to examine Market Center A's Rule 605 report to get a sense of
the average execution quality that their Broker-Dealer achieves for
their orders, the customer would see only the execution quality
statistics aggregated across Broker-Dealers 1 and 2, which would
likely reveal that Market Center A offers about average levels of
execution quality. However, this would not reveal the worse
execution quality that Broker-Dealer 1, and therefore the customer
of Broker-Dealer 1, is receiving from the market center.
---------------------------------------------------------------------------
To explore this idea, an analysis was performed examining whether
wholesalers, which know the identities of the broker-dealers who route
orders to them, provide different execution quality to different
broker-dealers because of differences in characteristics of their order
flows: specifically, adverse selection risk. All else equal, it is
generally more profitable for any liquidity provider, including
wholesalers, to execute against orders with lower adverse selection
risk, due to the reduced risk that prices will move against the
liquidity provider.\608\ Therefore, wholesalers may provide better
execution quality to retail brokers whose order flow exhibits lower
adverse selection risk, e.g., in order to attract further order flow
from that retail broker. Accordingly, a sample of CAT data \609\
between January 1, 2022 and March 31, 2022 in NMS common stocks and
ETFs was evaluated to see if execution quality \610\ that retail
brokers received from wholesalers differed based on the adverse
selection risk of the broker-dealers' order flow,\611\ as measured
using price impact.\612\ Retail brokers were grouped into quintiles
based on the weighted average percentage price impact of their order
flow.
---------------------------------------------------------------------------
\608\ See, e.g., David Easley, Nicholas M. Kiefer & Maureen
O'Hara, Cream-skimming or profit-sharing? The curious role of
purchased order flow, 51 J. Fin. 811 (1996).
\609\ This Commission analysis uses CAT data to examine the
execution quality of marketable orders in NMS Common stocks and ETFs
that belonged to accounts with a CAT account type of ``Individual
Customer'' and that originated from a broker-dealer MPID that
originating orders from 10,000 or more unique ``Individual
Customer'' accounts during January 2022. The number of unique
``Individual Customer'' accounts associated with each MPID was
calculated as the number for unique customer account identifiers
with an account customer type of ``Individual Customer'' that
originated at least one order during the month of January 2022.
Fifty-eight (58) broker-dealer MPIDs were associated with retail
brokers originated orders from 10,000 or more unique Individual
Customer accounts in January 2022. Account type definitions are
available in Appendix G to the CAT Reporting Technical
Specifications for Industry Members (https://catnmsplan.com/), under
the field name ``accountHolderType.'' Account types represent the
beneficial owner of the account for which an order was received or
originated, or to which the shares or contracts are allocated.
Possible types are: Institutional Customer, Employee, Foreign,
Individual Customer, Market Making, Firm Agency Average Price, Other
Proprietary, and Error. An Institutional Customer account is defined
by FINRA Rule 4512(c) as a bank, investment adviser, or any other
person with total assets of at least $50 million. An Individual
Customer account means an account that does not meet the definition
of an ``institution'' and is also not a proprietary account.
Therefore, the CAT account type ``Individual Customer'' may not be
limited to individual investors because it includes natural persons
as well as corporate entities that do not meet the definitions for
other account types. The Commission restricted that analysis to
MPIDs that originated orders from 10,000 or more ``Individual
Customer'' accounts in order to ensure that these MPIDs are likely
to be associated with retail brokers to help ensure that the sample
is more likely to contain marketable orders originating from
individual investors.
\610\ Measures of execution quality in this analysis include the
percentage effective half-spread and the average E/Q ratio.
Percentage effective half-spread is the weighted average of the
percentage effective half spread (measured as (execution price--NBBO
midpoint at time of order receipt)/NBBO midpoint at time of order
receipt). E/Q ratio is the weighted average of the ratio of each
transaction's effective spread divided by its quoted spread at the
time of order receipt. Time of order receipt is defined as the time
the wholesaler first receives the order. The NBBO is based on
consolidated market data feed. Weighted averages are calculated by
calculating the share weighted value at the individual stock level
over the sample (i.e., weighting at the stock level based on the
number of shares executed for transactions in the individual stock)
and then weighting across stocks based on their total dollar
transaction volume during the sample period (i.e., using the stock's
total dollar trading volume as the weight when averaging the share
weighted average stock values).
\611\ The analysis employed filters to clean the data and
account for potential data errors. Retail brokers' fractional share
orders with share quantity less than one share were excluded from
the analysis. The analysis included market and marketable limit
orders that were under $200,000 in value and that originated from
one the 58 retail broker MPIDs and were received by a market center
that was associated with one of the six wholesalers CRD numbers
(FINRA's Central Registration Depository number) during some point
in the order's lifecycle. Orders that were received by the
wholesaler or executed outside of normal market hours were excluded.
Orders were also excluded if they had certain special handling codes
so that execution quality statistics would not be skewed by orders
being limited in handling by special instructions (e.g., pegged
orders, stop orders, post only orders, etc.) Orders identified in
CAT as Market and Limit orders with no special handling codes or one
of the following special handling codes were included in the
analysis: NH (not held), CASH (cash), DISQ (display quantity), RLO
(retail liquidity order), and DNR (do not reduce). These special
handling codes were identified based on their common use by retail
brokers and descriptions of their special handling codes. The
marketability of a limit order was determined based on the
consolidated market data feed NBBO at the time a wholesaler first
receives the order. Limit orders that were not marketable were
excluded. The dollar value of an order was determined by multiplying
the order's number of shares by either its limit price, in the case
of a limit order, or by the midpoint of the consolidated market data
feed NBBO at the time the order was first received by a wholesaler,
in the case of a market order. The analysis includes NMS Common
Stocks and ETFs (identified by security type codes of `A' and `ETF'
in NYSE TAQ data) that are also present in CRSP data from CRSP 1925
US Indices Database and CRSP 1925 US Stock Database, Ctr. Rsch. Sec.
Prices, U. Chi. Booth Sch. Bus. (2022). Price improvement, effective
spreads, realized spreads, quoted spreads, and price impacts were
winsorized if they were greater than 20% of a stock's VWAP during a
stock-week.
\612\ By measuring the difference between the transaction price
and the prevailing market price some fixed period of time after the
transaction (e.g., one minute), price impact measures the extent of
adverse selection costs faced by a liquidity provider. For example,
if a liquidity provider provides liquidity by buying shares from a
trader who wants to sell, thereby accumulating a positive inventory
position, if the liquidity provider wants to unwind this inventory
position by selling shares in the market, they will incur a loss if
the price has fallen in the meantime. In this case, the price impact
measure will be positive, reflecting the liquidity provider's
exposure to adverse selection costs. In this analysis, percentage
price impact is the weighted average of the percentage one minute
price impact half spread (measured as (NBBO midpoint one minute
after execution--NBBO midpoint at time of order receipt)/NBBO
midpoint at time of order receipt). See supra note 610 for a
definition of the time of order receipt and information about how
weighted averaged were calculated in this analysis.
---------------------------------------------------------------------------
Table 3 shows that the execution quality that retail brokers
received from wholesalers systematically decreases as the adverse
selection risk of their order flow increases, such that retail brokers
with orders with higher average adverse selection risk systematically
receive worse execution quality in the form of higher average
percentage effective half-spreads and higher average E/Q ratios (i.e.,
lower price improvement) as
[[Page 3839]]
compared to broker-dealers with orders with lower average adverse
selection risk.\613\ This highlights that wholesalers provide different
execution quality to different retail brokers, in this case depending
on the adverse selection risk of their orders. This is likely to have a
large effect on the execution quality received by retail brokers, as an
analysis of Rule 606 data found that retail brokers route more than 87%
of the individual investor orders that they handle to wholesalers.\614\
However, since a wholesaler's Rule 605 report is aggregated across all
of its broker-dealer customers, this variation in execution quality
across retail brokers cannot be determined by matching its Rule 605
report to broker-dealers' routing information from their Rule 606
reports.
---------------------------------------------------------------------------
\613\ This analysis uses data from prior to the implementation
of the MDI Rules and specific numbers may differ following the
implementation of the MDI Rules. In particular, for stocks with
prices over $250, quoted spreads and price improvement statistics
are expected to narrow because they will be measured against a
narrower NBBO. The effects on effective spread, price impact, and
realized spread statistics in these stocks is uncertain, because
they are measured against the NBBO midpoint, and the Commission is
uncertain how this will be affected. See supra section
VII.C.1.(d)(2). However, the Commission does not anticipate that the
existence of a negative relation between the retail brokers' adverse
selection risk and the execution quality that they receive from
wholesalers described here would be affected by the implementation
of the MDI Rules.
\614\ These numbers are based on an analysis of the percentage
of market orders, marketable limit orders, non-marketable limit
orders, and other orders that 46 retail brokers route to different
types of venues in Q1 2022 based on their Rule 606 reports.
Consistent with Rule 606, routing statistics are aggregated together
in Rule 606 reports based on whether the stock is listed in the S&P
500 index. The 46 broker-dealers were identified from the 58 retail
brokers identified according to the procedure described in supra
note 609. This analysis uses the retail broker's 606 report if they
publish one, or the Rule 606 report of their clearing broker if they
did not produce a Rule 606 report themselves (the sample of 46
broker-dealer Rule 606 reports include some broker-dealers that were
not included in the CAT retail analysis because some clearing broker
Rule 606 reports are included). Some broker-dealers reported
handling orders only on a not held basis and did not have any Rule
606 reports. Because Rule 606 only include percentages of where
their order flow is routed and not statistics on the number of
orders, the reports are aggregated together using a weighting factor
based on an estimate of the number of non-directed orders each
broker-dealer routes in each security type each month. The number of
non-directed orders is estimated separately for S&P 500 and non-S&P
500 stocks by dividing the number of non-directed market orders
originating from a retail broker in each stock type in a given
month, which is estimated from CAT data, by the percentage of market
orders as a percent of non-directed orders in the retail broker's
Rule 606 report for that stock type in the same month (the weight
for a clearing broker consists of the aggregated orders from the
introducing brokers in the CAT analysis that utilize that clearing
broker). The resulting statistics show that broker-dealers routed
87.3% of orders in S&P 500 stocks and 87.9% of orders in non-S&P 500
stocks to wholesalers, as compared to 9.1% and 8.5%, respectively,
to national securities exchanges.
Table 3--Average Wholesaler Execution Quality Received by Retail Broker Quintiles, January-March 2022
----------------------------------------------------------------------------------------------------------------
Percentage Percentage
Broker-dealer quintile price impact effective half- E/Q ratio
(bps) spread (bps)
----------------------------------------------------------------------------------------------------------------
1.............................................................. -1.04 2.86 0.43
2.............................................................. 0.48 1.87 0.46
3.............................................................. 0.79 2.15 0.48
4.............................................................. 1.32 3.48 0.61
5.............................................................. 3.85 7.24 0.88
----------------------------------------------------------------------------------------------------------------
Table 3: Average Wholesaler Execution Quality Received by Retail Broker Quintiles, January-March 2022. This
table summarizes how execution quality varies in NMS Common Stocks and ETFs based on a retail broker MPID's
price impact by grouping 58 retail broker MPIDs identified according to the procedure described in supra note
609 in NMS Common Stocks and ETFs into quintiles based on their average price impact. Each retail broker
MPID's price impact is determined by share weighting its average percentage price impact half spread within an
individual NMS common stock or ETF and then averaging across stocks using the weighting of the dollar volume
the retail broker executed in each security (dollar volume weighted); this measure of price impact is then
used to sort retail broker MPIDs into quintiles. Within each quintile, average percentage price impacts,
percentage effective half-spreads, and E/Q ratios are calculated as described in supra notes 610 and 612. See
supra note 609 for dataset description and supra note 611 for details on the sample and filters used in this
analysis. This analysis uses data from prior to the implementation of the MDI Rules and specific numbers may
differ following the implementation of the MDI Rules. See supra note 613 and section VII.C.1.(d).
(2) Reporting Entities That Operate SDPs
When a market center also operates a SDP, co-mingling SDP activity
with other market center activity may obscure or distort information
about the market center's execution quality in their Rule 605 reports,
making it more difficult for market participants to observe the
execution quality of each separate trading venue. SDPs are sometimes
called ``ping pools,'' \615\ reflecting that institutional investors
use these venues to ``ping'' (i.e., submit a small order in search of
hidden liquidity) SDPs, often using Immediate or Cancel (IOC) orders.
IOC orders typically have different execution profiles than other types
of orders, including lower fill rates.\616\ Combining information on
orders submitted to a market center's SDP along with its other orders
will therefore effect a downwards skew on the market center's fill
rates, and analogously an upward skew on the SDP's fill rates. This may
particularly be the case for wholesalers who combine the orders
submitted to their SDP with orders that are internalized or executed on
a riskless principal basis,\617\ since SDP activity represents a
significant portion of their trading volume.\618\ Also, since the
information on executions in SDPs largely reflects institutional
orders, combining information on SDP orders along with other orders
would tend to obscure information that is particularly relevant for
institutional investors or broker-dealers handling institutional
investors' orders in assessing differences across these market centers.
To the extent that institutional investors are less able to observe and
compare differences in execution quality across market centers as a
result, this may reduce incentives for these market centers to compete
for institutional investor orders on the basis of execution quality.
---------------------------------------------------------------------------
\615\ See, e.g., Annie Massa, Trader VIP Clubs, `Ping Pools'
Take Dark Trades to New Level, Bloomberg, (Jan. 16, 2018, 5:00
a.m.), available at https://www.bloomberg.com/news/articles/2018-01-16/trader-vip-clubs-ping-pools-take-dark-trades-to-new-level#xj4y7vzkg.
\616\ See infra section VII.C.2.(c)(7) for discussion of
differences between marketable IOC order executions and the
executions of other marketable order types.
\617\ See infra section VII.C.2.(c)(8) for a discussion on how
the treatment of wholesalers' riskless principal trades in Rule 605
reports may also obscure information on execution quality.
\618\ See infra note 769 and accompanying text, describing that
the combined trading volume of the affiliated SDPs of the two most
active wholesalers accounted for over 4% of total U.S. consolidated
trading volume in 2021.
---------------------------------------------------------------------------
(b) Coverage of Orders Under Current Rule 605 Reporting Requirements
The Commission believes that current Rule 605 reporting
requirements exclude execution quality information about some order
sizes and types that are relevant to market participants.
To estimate the percentage of shares that are currently excluded
from Rule 605 reporting requirements and the driving factor behind
their exclusions (i.e., whether they are excluded based on their
submission time, type, or size), data from the Tick Size Pilot B.I
Market
[[Page 3840]]
Quality dataset,\619\ which had much broader reporting requirements
than Rule 605,\620\ was analyzed for a period from April 2016 to March
2019. As a first step, approximately 25% of orders are estimated to be
excluded from Rule 605 requirements as they are flagged as having
special handling requests. A breakdown of the remaining submitted share
volume (i.e., after excluded special handling orders) is presented in
Figure 2, and shows that around 2.2% of shares are currently excluded
from Rule 605 reporting requirements due to having effective times
outside of regular trading hours. A further 51.6% of shares are
excluded because they were of an order type that is currently excluded
from Rule 605 reporting requirements.\621\ An additional 11.3% of the
remaining order volume are excluded from Rule 605 coverage because of
the exclusion of orders less than 100 shares and larger-sized orders.
This leaves only around a third of share volume that is currently
eligible to be included in Rule 605.\622\
---------------------------------------------------------------------------
\619\ See Securities Exchange Act Release No. 72460 (June 24,
2014), 79 FR 36840 (June 30, 2014) (Order Directing the Exchanges
and the Financial Industry Regulatory Authority To Submit a Tick
Size Pilot Plan) (``Tick Size Pilot Plan''). The Tick Size Pilot B.I
Market Quality dataset contains information for approximately 2,400
small cap stocks for a period from April 2016 to March 2019. As the
Tick Size Pilot data only collected data for small cap stocks,
results using this dataset are not necessarily representative of all
stocks.
\620\ See Appendix B and C Requirements and Technical
Specifications, available at https://www.finra.org/sites/default/files/Appendix_B_C_Reporting_Requirements_version2.pdf. Order types
that are included in the Tick Size Pilot dataset that are not
covered by Rule 605 include Resting Intermarket Sweep orders, Retail
Liquidity Providing orders, Midpoint Passive Liquidity orders, Not
Held orders, Clean Cross orders, Auction orders, and orders that
became effective when an invalid NBBO was in effect. Order sizes
included in the Tick Size Pilot dataset that are not covered by Rule
605 include orders for between 1-99 shares and orders for 10,000+
shares. See also Tick Size Pilot Program, Appendix B and C
Statistics Frequently Asked Questions, available at https://www.finra.org/sites/default/files/Tick-Size-Pilot-Appendix-B-and-C-FAQ.pdf (``Tick Size Pilot FAQs''), answer to Question 2.1.
Furthermore, the Tick Size Pilot dataset includes separate
statistics for orders submitted outside of regular trading hours
(trading sessions E and BE). See Tick Size Pilot FAQs, answer to
Question 4.11.
\621\ Of the shares excluded on the basis of order type, the
largest percentage (73.6%) are excluded because they are not-held
orders.
\622\ An additional percentage of this order flow is also
excluded from coverage due to the exclusion of stop-loss orders and
non-exempt short sales, but these are not one of the listed order
types in the Tick Size Pilot dataset and therefore it is not
possible to exclude them. See Appendix B and C Requirements and
Technical Specifications, available at https://www.finra.org/sites/default/files/Appendix_B_C_Reporting_Requirements_version2.pdf.
---------------------------------------------------------------------------
BILLING CODE 8011-01-P
Figure 2: Rule 605 Coverage, by Submission Time, Order Type, and Order
Size, April 2016-March 2019
[GRAPHIC] [TIFF OMITTED] TP20JA23.002
In order to examine changes in Rule 605 coverage, the Commission
compared the number of executed shares in one market center's Rule 605
reports between October 2003 and February 2021 to data on that market
center's execution volume retrieved from TAQ.\623\ Figure 3 shows that
an estimated 50% of shares executed during regular market hours were
included in Rule 605 reports as of February 2021,\624\ and shows that
this number has been on a slightly downward trend since around mid-
2012.\625\
---------------------------------------------------------------------------
\623\ The number of shares traded on NYSE was collected from the
intraday TAQ Consolidated Trade files for the period from October
2003 to February 2021 for the entire universe of TAQ securities.
Trades outside of regular trading hours were excluded. This dataset
includes trades at the opening and closing auction. Due to that fact
that odd-lot trades are only included in TAQ from December 2013
onwards, the Commission excluded odd-lot trades from the dataset to
avoid a mechanical decrease in coverage following their inclusion
into the dataset. Rule 605 data for the same period was provided by
IHS Markit.
\624\ The Commission focused on the data from one market center
(NYSE) because of the availability of a long time series for NYSE
Rule 605 data. The Commission selected NYSE due to its large market
share and ease of identifying this market center in both Rule 605
and TAQ data. Note that these results are not necessarily
representative of all market centers and the results for other
market centers may be different.
\625\ The implementation of the MDI Rules may result in a change
in the flow of orders across trading venues, which may result in
numbers that are different from those reported here. See supra
section VII.C.1.(d)(2) for further discussion. However, the
Commission does not believe that the MDI Rules would significantly
affect the proportion of exchange volume that is covered by Rule 605
reporting requirements.
---------------------------------------------------------------------------
[[Page 3841]]
Figure 3: Rule 605 Coverage Compared to TAQ, for the NYSE, October
2003-February 2021
[GRAPHIC] [TIFF OMITTED] TP20JA23.003
Figure 3 shows that Rule 605 coverage has varied significantly over
time, likely the result of market and regulatory events that may have
affected the usage of orders types that are excluded from or included
in the definition of a covered order. For example, equity markets have
seen an increase in the usage of ISOs after Regulation NMS \626\ and an
increase in participation in national securities exchanges' closing
auctions,\627\ both of which likely have decreased Rule 605 coverage
over time.\628\
---------------------------------------------------------------------------
\626\ See infra note 1021 and corresponding text. Marketable
ISOs submitted at prices worse than the NBBO are excluded from Rule
605 reporting requirements.
\627\ See, e.g., Vincent Bogousslavsky & Dmitriy Muravyev, Who
trades at the Close? Implications for Price Discovery and Liquidity
(working paper Dec. 16, 2021), available at https://ssrn.com/abstract=3485840 (retrieved from SSRN Elsevier database), showing
that closing auctions accounted for 7.5% of daily volume in 2018, up
from 3.1% in 2010. The definition of ``covered orders'' that are
subject to Rule 605 reporting requirements excludes orders for which
customers requested special handling, including orders to be
executed at a market opening price or a market closing price. See 17
CFR 242.600(b)(22).
\628\ Other market and regulatory changes that may have impacted
Rule 605 coverage over time include the increased use of automated
orders (e.g., NYSE switching from a floor-based trading model to a
hybrid model), which may have increased coverage during the period
of 2003-2007 due to an increase in the number of ``held'' orders
(see 2018 Rule 606 Amendments Release, 83 FR 58338), and changes in
the use of block orders. Note that the use of odd-lots and orders
for less than one share have also changed substantially over time,
but these orders types are excluded from our analysis of TAQ data.
---------------------------------------------------------------------------
The following sections will discuss the various facets of Rule 605
reporting requirements that lead to the exclusion of orders from
reporting requirements and the extent to which these orders may be
relevant for an assessment of execution quality, including excluded
order sizes, ISOs, stop orders, non-exempt short sale orders, away-
from-the-quote limit orders, and orders submitted outside of regular
trading hours.
(1) Orders Less Than 100 Shares and Larger-Sized Orders
Currently, orders of certain sizes are excluded from Rule 605
reporting requirements, including orders for less than 100 shares and
larger-sized orders.\629\ Taken together, data on the usage of orders
of these sizes implies that a large percentage of orders and trades is
currently excluded from Rule 605 reporting requirements on the basis on
order size, thus limiting the extent to which reporting entities
compete for customers on the basis of execution quality.
---------------------------------------------------------------------------
\629\ See 17 CFR 242.605(a)(1). See also supra note 40 and
corresponding text for a definition of the current order size
categories included in Rule 605 reporting requirements.
---------------------------------------------------------------------------
(a) Orders Less Than 100 Shares
Due to the Rule's current exclusion of orders that are sized
smaller than 100 shares, which excludes all odd-lot orders and, in some
cases, round lot orders where a round lot is less than 100 shares, the
Commission believes that Rule 605 reports are missing information about
an important segment of order flow.
The rise in the use of odd-lot orders is a phenomenon that has been
well-
[[Page 3842]]
documented in modern markets.\630\ An analysis of data from the SEC's
MIDAS analytics tool \631\ confirms that the use of odd-lots has
increased substantially as a percentage of total on-exchange trades
within the past decade. Figure 4 plots monthly averages of the odd-lot
rate (the number of odd-lot trades as a percentage of the total on-
exchange trades) across stock price deciles, showing that the relative
number of odd-lot trades has increased dramatically between 2012 and
2022, for high-priced stocks in particular.\632\ Specifically, the
figure shows that the odd-lot rate increased from around 0.6% to 2.32%
for the lowest-price stocks (Decile 1), and from 10.6% to 40.9% for the
highest-priced stocks (Decile 10).
---------------------------------------------------------------------------
\630\ See, e.g., supra note 273 and accompanying text,
describing how market participants have stated that odd-lots make up
a majority of all trades. Until the round lot definition adopted
pursuant to the MDI Rules is implemented, round lots continue to be
defined in exchange rules. For most NMS stocks, a round lot is
defined as 100 shares. Following the implementation of the MDI
Rules, for stocks with prices greater than $250, a round lot will be
defined as consisting of between 1 and 40 shares, depending on the
tier. See supra note 577 for a definition of these tiers.
\631\ See dataset Summary Metrics by Decile and Quartile, SEC,
available at https://www.sec.gov/marketstructure/downloads.html. The
data is available between January 2012 and March 2022.
\632\ The number of odd-lot trades may be higher following the
implementation of the MDI Rules due to the availability of odd-lot
quotes in consolidated market data, which may result in numbers that
are different from those reported here. For stocks priced above
$250, the change in the definition of round lots may in result in
fewer odd-lot trades, as more trades will be incorporated into the
definition of round lots. See supra section VII.C.1.(d)(2) for
further discussion.
---------------------------------------------------------------------------
Figure 4: Odd-Lot Rates by Stock Price Deciles, January 2012-March 2022
[GRAPHIC] [TIFF OMITTED] TP20JA23.004
There is evidence that these high percentages are not only the case
for odd-lot trades, but for odd-lot orders as well. Using data from
January to March 2021, a recent academic working paper found that the
rate of orders sized between 1 and 100 shares ranges from 5.6% of all
submitted orders for less than 500 shares in the lowest-priced stocks,
to 46.9% of all such orders in the highest-priced stocks.\633\ This is
supported by an analysis of the distribution of order sizes using order
submission data from MIDAS for a sample of 80 stocks during the month
of March 2022.\634\ Confirming results from Figure 4 examining the time
series of odd-lot order rates, Figure 5 shows that odd-lot orders make
up a significant percentage of orders (18.2%), although these orders
are only a small percentage of total submitted share volume
(2.8%).\635\
---------------------------------------------------------------------------
\633\ See Bartlett, et al. The authors divide their sample of
stocks into five price-based buckets, with stocks in the lowest-
priced group defined as those priced at $20.00 or less, and stocks
in the highest-priced group priced at $250.00 or more.
\634\ This dataset consists of NMLO submission data collected
from MIDAS and includes the posted orders and quotes on 11 national
securities exchanges, for a sample of 80 stocks, across all trading
days in March 2022. For more details on this dataset, see https://www.sec.gov/marketstructure/midas-system. The sample of stocks is
chosen to be a representative sample in terms of market
capitalization and price (calculated using price and shares
outstanding data from CRSP on the last trading day in February 2021,
from CRSP 1925 US Stock Database, Ctr. Rsch. Sec. Prices, U. Chi.
Booth Sch. Bus. (2022)). Note that the MIDAS dataset only includes
displayed orders, and includes some order types that are currently
excluded from Rule 605 reports, such as short sale orders and orders
with special handling requests, as it is not possible to distinguish
these orders in MIDAS.
\635\ This data only includes information about NMLOs, and
therefore information about the sizes of market orders and
marketable limit orders is not available.
---------------------------------------------------------------------------
Figure 5: Distribution of NMLOs Across Order Size Buckets, March 2022
[[Page 3843]]
[GRAPHIC] [TIFF OMITTED] TP20JA23.005
Market commentators have attributed this rise in odd-lot trading to
a variety of factors. For example, an increase in the number of high-
priced stocks caused order sizes to decrease in these stocks, where
trading in larger order sizes is more expensive.\636\ Another factor is
a rise in algorithmic trading, which chops orders into many smaller
orders. Broker-dealers that handle institutional orders often make use
of odd-lot orders as a result of trading algorithms that split larger
parent orders into smaller child orders to reduce the market impact of
their trades.\637\ High frequency traders also use inside the spread
odd-lot orders as a means of probing for hidden liquidity or detecting
forthcoming order flow. Academic papers have found evidence that high
frequency traders and other institutional investors make up a
substantial fraction of odd-lot trades.\638\ Another potential reason
for the increase in odd-lot trading is the increasing presence of
trading by individual investors, who tend to use smaller order
sizes.\639\ Therefore, by not capturing information related to these
orders, Rule 605 reports are missing information about potentially
important segments of order flow from both individual and institutional
investors.
---------------------------------------------------------------------------
\636\ See, e.g., Phil Mackintosh, ``Odd Facts About Odd-Lots,''
(Apr. 2021), available at https://www.nasdaq.com/articles/odd-facts-about-odd-lots-2021-04-22.
\637\ See infra section VII.C.3.(a)(1)(b), discussing the
practice of broker-dealers handling institutional parent orders as
not held orders and splitting them up into child orders.
\638\ See, e.g., Hardy Johnson, Bonnie F. Van Ness & Robert A.
Van Ness, Are all odd-lots the same? Odd-lot transactions by order
submission and trader type, 79 J. Banking & Fin. 1(2017); Maureen
O'Hara, Chen Yao & Mao Ye, What's not there: Odd lots and market
data, 69 J. Fin. 2199 (2014).
\639\ See, e.g., Bartlett et al. (2022); Matthew Healey, An In-
Depth View Into Odd Lots, Chi. Bd. Options Exch. (Oct. 2021),
available at https://www.cboe.com/insights/posts/an-in-depth-view-into-odd-lots/.
---------------------------------------------------------------------------
(b) Orders Less Than a Share
Due to the Rule's current exclusion of fractional orders that are
smaller than one share,\640\ the Commission believes that Rule 605
reports are missing information about an increasingly important segment
of individual investor order flow. Similar to the increase in odd-lots,
one reason for the increase in the use of fractional shares is the
increasing presence of trading by individual investors, who tend to use
smaller order sizes.\641\ The past few years have seen increasing
attention paid to fractional shares, as more and more retail brokers
are offering this functionality.\642\ The Commission understands that
there are at least two different ways that retail brokers handle
fractional trades: first, they can rely on their clearing firm, which
will often ``round up'' the fractional part of the order and deposit
the residual in an internal ``fractional inventory account''; and
second, they can execute fractional trades against their own
inventory.\643\
---------------------------------------------------------------------------
\640\ Note that orders greater than one share can also be
fractional. If the fractional order is for more than just a single
share (e.g., 2.5 shares), the broker-dealer may internalize the
fractional component (0.5 shares) and reroute the whole component (2
shares) to a market center for execution.
\641\ See, e.g., Kevin L. Matthews, What are Fractional Shares
and How do They Work?, Bus. Insider (Sept. 21, 2022), available at
https://www.businessinsider.com/personal-finance/fractional-shares.
\642\ See, e.g., Rick Steves, Fractional Shares: Experts Weight
in Amid Exploding Retail Trading Volumes, Fin. Feeds (June 7, 2021,
8:25 a.m.), available at https://financefeeds.com/fractional-shares-experts-weigh-in-amid-exploding-retail-trading-volumes/, which shows
that trading volume increased substantially (in one case, more than
1,400%) for brokers after they introduced the use of fractional
shares.
\643\ See, e.g., Robert P. Bartlett, Justin McCrary & Maureen
O'Hara, A Fractional Solution to a Stock Market Mystery (working
paper July 20, 2022), available at https://ssrn.com/abstract=4167890
(retrieved from SSRN Elsevier database). Note that, as fractional
shares fall below the smallest order size category in current Rule
605, a broker-dealer that currently exclusively executes fractional
shares would be a market center, but would not be required to file
Rule 605 reports.
---------------------------------------------------------------------------
An estimation of the percentage of orders that are currently
excluded from Rule 605 reporting requirements because they are smaller
than one share is difficult, as these orders are executed off-exchange
and therefore not included in public datasets. However, an analysis
using data from CAT \644\ confirms that
[[Page 3844]]
levels of fractional trading are mostly the result of individual
investor trading: in March 2022, there were 31.67 million orders for
less than one share that eventually received an execution, the
overwhelming majority (92%) of which were submitted by accounts
attributed to ``Individual Customers.'' \645\ While these orders only
represented a small fraction (around 1.4%) of total executed orders,
they represented a much higher fraction (10.4%) of executions received
by individual investors.\646\ Therefore, by not capturing information
related to these orders, Rule 605 reports are missing information about
an important segment of individual investor trades.
---------------------------------------------------------------------------
\644\ This dataset contains CAT records capturing introducing
and trading activity in March 2022, including fractional NMS orders
that were eventually executed on- and off-exchange. As individual
fractional orders are often aggregated into a single representative
order before routing and execution, staff looked at the information
specific to the originating customer orders (designated as MENO
orders events in CAT) that were eventually executed, and,
separately, examined the information specific to the executions of
the orders (designated as MEOT for off-exchange or EX and EOT for
on-exchange events in CAT) that could be linked to the fractional
MENOs either directly or via a representative order.
\645\ See supra note 609 for a definition of account types in
CAT.
\646\ In terms of notional volume, executed fractional orders
make up around 0.17% of total executed dollar volume and 1.4% of
individual investor executed dollar volume.
---------------------------------------------------------------------------
(c) Larger-Sized Orders
Due to the Rule's current exclusion of orders that are larger than
10,000 shares,\647\ the Commission believes that Rule 605 reports are
missing information about another important segment of order flow. The
Commission understands that practices have evolved such that most
broker-dealers that service institutional investors use SORs to break
up these customers' large parent orders into smaller-sized child
orders.\648\ As shown in Figure 6, which plots the number of shares
associated with trades that are for 10,000 or more shares as a percent
of total executed shares,\649\ the rate of larger-sized trades declined
from more than 25% in late 2003 to 11.3% as of March 2022. This decline
is likely the result of the increased use of SORs, though other market
changes such as the overall increase in stock prices may play a part.
However, the rate of larger-sized trades has been increasing since
August 2011, when the rate of larger-sized trades was around 6.7%.
---------------------------------------------------------------------------
\647\ See supra note 281 and corresponding discussion describing
the exemptive relief provided by the Commission in 2001 for orders
with a size of 10,000 shares or greater.
\648\ See infra section VII.C.3.(a)(1)(b) further discussing the
practice of broker-dealers handling institutional parent orders as
not held orders and splitting them up into child orders.
\649\ This analysis uses data from intraday TAQ Consolidated
Trade files for the period from September 2003 to March 2022 for the
entire universe of TAQ securities. Plotted is the monthly number of
shares associated with trades that are for 10,000 shares or more,
divided by the total number of executed shares. The data is limited
to trades with sales conditions indicating regular trades, including
regular trades with no associated conditions, automatic executions,
intermarket sweep orders, and odd lot trades. See NYSE Daily TAQ
Client Specification, available at https://www.nyse.com/publicdocs/nyse/data/Daily_TAQ_Client_Spec_v3.3.pdf.
---------------------------------------------------------------------------
Figure 6: Larger-Sized Trades as a Percent of Total Executed Shares,
September 2003-March 2022
[GRAPHIC] [TIFF OMITTED] TP20JA23.006
BILLING CODE 8011-01-C
Furthermore, larger-sized orders make up a non-negligible percent
of order flow. Figure 5, which plots the distribution of NMLO sizes in
order submission data from MIDAS for the month of March 2022, shows
that, while NMLOs of 10,000 or more shares made up only 0.09% of order
flow in terms of number of orders, they made up nearly 7.8% of order
flow in terms of share volume. However, some, or possibly most, of
these larger-sized orders may be not held to the market, so would not
be required to be included in Rule 605 reports even without the
exemptive relief.\650\
---------------------------------------------------------------------------
\650\ See supra note 60 and accompanying text discussing broker-
dealers' requirements under Rule 606(b)(3) to provide individualized
reports of execution quality upon request for not held orders.
---------------------------------------------------------------------------
(2) Orders Submitted With Stop Prices
The Commission believes that the current exclusion of orders with
stop prices from the definition of ``covered order'' excludes orders
that are likely relevant for investors. A stop order, also referred to
as a stop-loss order, is an order to buy or sell a stock once the price
of the stock reaches the specified price, known as the stop price. When
the stop price is reached, a stop order becomes a market order, or a
limit order in the case of so-called stop limit
[[Page 3845]]
orders.\651\ The treatment of stop orders varies across broker-dealers
and market centers.\652\
---------------------------------------------------------------------------
\651\ See, e.g., SEC, Types of Orders, available at https://www.investor.gov/introduction-investing/investing-basics/how-stock-markets-work/types-orders and the definitions of stop order and stop
limit order in FINRA Rule 5350(a), available at https://www.finra.org/rules-guidance/rulebooks/finra-rules/5350. The stop
price can be the last sale price, or a quotation in the case of stop
on quote or stop limit on quote orders. The stop price may also be
permitted to increase or decrease by a predetermined amount or
formula in the case of trailing stop and trailing stop limit orders.
\652\ For example, one broker-dealer stated that some of the
market centers to which it routes orders may impose price limits to
prevent stop orders from being triggered by potentially erroneous
trades, and that these price limits vary by market center. See
Trading FAQs: Order Types, Fidelity, available at https://www.fidelity.com/trading/faqs-order-types. Another brokerage firm
states that, depending on to which market center a stop limit order
is presented, a stop limit order can be activated as a limit order
using either a transaction or quotation as the triggering event. See
Best Execution of Equity Securities, UBS (June 2021), available at
https://www.ubs.com/content/dam/static/wmamericas/bestexecution.pdf.
---------------------------------------------------------------------------
The Commission understands that stop orders resting on national
securities exchanges have been uncommon, and the vast majority of stop
orders are handled by broker-dealers.\653\ Some national securities
exchanges have eliminated this order type from their rule book.\654\
Furthermore, the use of stop orders has typically been associated with
individual investors,\655\ who use these orders to try to protect a
gain or to limit potential losses of a currently held position.\656\
Table 4 breaks down a sample of stop loss order volume by account type
and stop loss order type using CAT data for March 2022.\657\ The data
confirms that the use of stop orders by institutional investors is very
rare (only 0.23% of market and 0.0003% of limit orders are submitted
with stop prices), while their use is relatively more common for
individual investors, particularly for market orders, around 6.44% of
which are submitted with stop prices.
---------------------------------------------------------------------------
\653\ See, e.g., Memorandum from SEC Division of Trading and
Markets on Certain Issues Affecting Customers in the Current Equity
Market Structure (Jan. 26, 2016), available at https://www.sec.gov/spotlight/equity-market-structure/issues-affecting-customers-emsac-012616.pdf, citing NYSE Order Type Usage Chart illustrating that
stop orders, along with good-til-canceled, agency cross and manual
orders, accounted for only 0.19% of total matched volume for Q3 2015
and Q4 2015. See also How to Survive the Markets Without Stop-Loss
Orders, NASDAQ (Dec. 2, 2015), available at https://www.nasdaq.com/articles/how-survive-markets-without-stop-loss-orders-2015-12-02,
stating that stop orders represent around 2% of all orders placed on
national securities exchanges.
\654\ See, e.g., Securities Exchange Act Release No. 76649 (Dec.
15, 2015), 80 FR 79365 (Dec. 21, 2015) (SR-NYSE-2015-60) (``NYSE
Notice''); Securities Exchange Act Release No. 76655 (Dec. 15,
2015), 80 FR 79382 (Dec. 21, 2015) (SR-NYSEMKT-2015-103).
\655\ See, e.g., Annie Massa & Sam Mamudi, Black Rock Calls for
Halting Stock Market to Avoid Volatility, Bloomberg Bus. (Oct. 7,
2015), available at http://www.bloomberg.com/news/articles/2015-10-07/blackrock-calls-for-halting-the-stock-market-to-avoid-volatility
(citing industry concerns with ``the widespread use of stop orders
by retail investors'').
\656\ See, e.g., Memorandum from SEC Division of Trading and
Markets on Certain Issues Affecting Customers in the Current Equity
Market Structure (Jan. 26, 2016), available at https://www.sec.gov/spotlight/equity-market-structure/issues-affecting-customers-emsac-012616.pdf. Meanwhile, professional or institutional investors are
more likely to have the resources to be able to actively monitor
their orders, and are therefore less likely to use stop orders. See,
e.g., How to Survive the Markets Without Stop-Loss Orders, NASDAQ
(Dec. 2, 2015), available at https://www.nasdaq.com/articles/how-survive-markets-without-stop-loss-orders-2015-12-02.
\657\ See supra note 609 for dataset description. Stop orders
are identified using the reporting requirements for stop orders in
the CAT Reporting Technical Specifications for Industry Members. See
CAT Reporting Technical Specifications for Industry Members,
Consolidated Audit Trail, 64 (July 29, 2022), available at https://www.catnmsplan.com/sites/default/files/2022-07/07.29.2022_CAT_Reporting_Technical_Specifications_for_Industry_Members_v4.0.0r16_CLEAN_0.pdf.
Table 4--Stop Order Volume by Account and Order Types, March 2022
----------------------------------------------------------------------------------------------------------------
Types of stop orders (% of total stop orders)
Orders with ---------------------------------------------------------------
Investor and order type stop prices (% Stop on quote/ Trailing stop/
of total Stop/ stop stop limit on trailing stop Total
orders) limit quote limit
----------------------------------------------------------------------------------------------------------------
Institutional:
Market...................... 0.23 49.4 0.5 11.3 61.3
Limit....................... 0.0003 37.8 0.4 0.5 38.7
Individual:
Market...................... 6.44 68.3 9.0 10.3 87.6
Limit....................... 0.03 10.1 1.7 0.6 12.4
----------------------------------------------------------------------------------------------------------------
Table 4: Stop Order Volume by Account and Order Types, March 2022. This table shows the percentage of orders
that are submitted with stop prices (as a percentage of total orders) separately for accounts associated with
institutional and individual investor types and for market and limit orders, using a sample of CAT data for
all NMS stocks from March 2022. Also shown is a breakdown of stop order submission volume according to six
common types of stop orders. See supra note 657 for information on the dataset and identification of stop
orders.
(3) Non-Exempt Short Sale Orders
Commission staff has taken the position that staff would view all
non-exempt short sale orders as special handling orders.\658\ As a
result, these orders are currently not included as part of Rule 605
statistics, which may exclude a large portion of orders that are likely
relevant for market participants.
---------------------------------------------------------------------------
\658\ See 2013 FAQs.
---------------------------------------------------------------------------
Non-exempt short sale orders are orders that are subject to price
restrictions under Rule 201 of Regulation SHO,\659\ which contains a
short sale circuit breaker that, when triggered by a price decline of
10% or more from a covered security's prior closing price, imposes a
restriction on the price at which the covered security may be sold
short (i.e., must be above the current national best bid). Once
triggered, the price restriction will apply to short sale orders in
that security for the remainder of the day and the following day,
unless the short sale order is ``short exempt.'' \660\ Since a non-
exempt short sale that is subject to a price restriction is only
allowed to take place at least one tick above the NBB, these could be
``orders to be executed on a particular type of tick or bid,'' which
would exclude them from the definition of ``covered orders.'' \661\ The
exclusion of tick-sensitive orders from Rule 605 reporting requirements
ensures that these orders do not skew execution quality statistics, as
the prevention of
[[Page 3846]]
these orders from executing at the best bid would likely lead to lower
execution quality statistics (e.g., negative price improvement and
higher effective spreads) as compared to other orders.
---------------------------------------------------------------------------
\659\ See supra note 246 for more information about Rule 201 of
Regulation SHO.
\660\ ``Short exempt'' orders include short sale orders from
market makers and short sales priced above the current national best
bid at the time of submission. See 17 CFR 242.201(c) and (d).
\661\ See supra section II.B.1.(b) for a discussion of the
definition of covered orders.
---------------------------------------------------------------------------
However, in the years since Rule 201's adoption, it has become
clear that Rule 201 price test restrictions are not often triggered.
Staff found that, between April 2015 and March 2022, a Rule 201 trigger
event only occurred on 1.7% of trading days for an average stock.\662\
Around 18% of Rule 201 triggers occur the day after a previous trigger
event, and around 46% occur within a week after a previous trigger
event. These statistics imply that Rule 201 triggers tend to be
relatively rare, and clustered around a few isolated events.
---------------------------------------------------------------------------
\662\ This analysis looked at the percentage of trading days
that experienced a Rule 201 trigger event for the period January
2012 to February 2021 for all listed stocks on NYSE or NASDAQ
exchanges and then averaged across stocks. The Commission restricted
its sample to common stocks identified in CRSP (share code 10 or
11), from CRSP 1925 US Stock Database, Ctr. Rsch. Sec. Prices, U.
Chi. Booth Sch. Bus. (2022). The Commission also excluded financial
stocks (SIC code 6000-6999), as financial stocks may have different
properties than other types of stocks, including characteristics
related to short selling (e.g., Markus K. Brunnermeier & Martin
Oehmke, Predatory Short Selling, 18 Rev. Fin. 2153 (2014)). Rule 201
circuit breaker data retrieved from ftp://ftp.nyxdata.com/NYSEGroupSSRCircuitBreakers/ and ftp://ftp.nasdaqtrader.com/SymbolDirectory/shorthalts/.
---------------------------------------------------------------------------
(4) Orders Submitted Pre-Opening/Post-Closing
When Rule 605 was first adopted, the Commission explained the
decision to exclude orders submitted outside of regular trading hours
by stating that there are substantial differences in the nature of the
market between regular trading hours and after-hours, and therefore
orders executed at these times should not be blended together.\663\
However, the current exclusion of all orders submitted outside of
regular market hours from the definition of ``covered order,'' \664\ in
addition to excluding orders that execute outside of regular hours,
also extends to orders that, while submitted outside of regular market
hours, are only eligible to execute during regular market hours. While
these orders represent only a small portion of order flow, they
represent a relatively high concentration of orders from individual
investors. Therefore, the current exclusion of all orders submitted
outside of regular trading hours from Rule 605 may lead to the
exclusion of an important segment of individual investor orders.
---------------------------------------------------------------------------
\663\ See Adopting Release, 65 FR at 75421.
\664\ See 17 CFR 242.600(b)(77).
---------------------------------------------------------------------------
When Rule 605 was first adopted, after-hours markets were still
mostly the purview of institutional investors, but a growing number of
broker-dealers had recently begun providing their retail customers with
the ability to have their orders directed to electronic communication
networks (ECNs) after the major markets close for the day. The growth
in the availability of after-hours trading for individual investors
raised concerns over, and heightened awareness of, the differences in
execution quality for after-hours trades, which tend to be much riskier
due to lower liquidity levels and higher volatility in after-hours
markets.\665\
---------------------------------------------------------------------------
\665\ See, e.g., Special Study: Electronic Communication
Networks and After-Hours Trading, SEC (June 2000), available at
https://www.sec.gov/news/studies/ecnafter.htm.
---------------------------------------------------------------------------
Along with an increase in access to after-hours trading, the late
1990s and early 2000s saw an increase in the prevalence of online
brokerages, in which individual investors in particular were given
newfound access to order entry systems. Early research into the rise of
online brokerages describes a shift from a system in which retail
brokers ``communicate buy/sell recommendations to clients over the
telephone'' (presumably during regular working hours), to a system in
which individual investors have ``round-the-clock access to trading
systems and account information.'' \666\ Logically, as investors make
use of the ``round-the-clock'' access offered by online brokerages, the
number of orders submitted outside of regular market hours has likely
increased over the preceding decades. However, not all orders submitted
after hours are eligible to trade in after-hours markets, which
continues to be the case even in today's market. For example, some
broker-dealers' platforms allow customers to submit orders at any time,
but unless the customer requests to trade during extended hours and the
security is eligible to trade as such, the order will only be executed
during regular market hours.\667\ Since these orders are not intended
to, and in many cases are not eligible to, execute outside of regular
trading hours, these orders may not be subject to the same concerns
that drove the Commission to exclude orders submitted outside of
trading hours from Rule 605 reporting requirements in the Adopting
Release.
---------------------------------------------------------------------------
\666\ Jennifer Wu, Michael Siegel & Joshua Manion, Online
Trading: An Internet Revolution, Sloan School of Management
Massachusetts Institute of Technology Research Notes, p. 4 (1999).
\667\ See, e.g., Extended Hours Overview, Charles Schwab,
available at https://www.schwab.com/public/schwab/nn/qq/about_extended_hours_trading.html; Extended-Hours Trading,
Robinhood, available at https://robinhood.com/us/en/support/articles/extendedhours-trading/.
---------------------------------------------------------------------------
To estimate the amount of orders that are submitted outside of
regular trading hours, data from the Tick Size Pilot B.I Market Quality
dataset \668\ was analyzed to break order volume down into different
trading sessions according to when the order was eligible to
trade.\669\ The Commission considers only those orders that have an
effective time during regular market hours to be eligible for Rule 605
reporting, and excludes orders that are otherwise excluded from current
Rule 605 reporting requirements, i.e., because they are an excluded
order type or size. The Commission found that a small fraction of
orders are effective outside of regular market hours (1.3%), while the
vast majority of orders (98.7%) are effective during regular market
hours.
---------------------------------------------------------------------------
\668\ See supra note 619 for dataset description.
\669\ These trading sessions include (1) regular hours only; (2)
extended hours only; (3) both regular and extended hours with an
effective time during regular market hours; and (4) both regular and
extended hours with an order effective time during extended hours.
See Tick Size Pilot Program Appendix B and C Frequently Asked
Questions, Q4.11, available at https://www.finra.org/sites/default/files/Tick-Size-Pilot-Appendix-B-and-C-FAQ.pdf.
---------------------------------------------------------------------------
At least some of these orders, while submitted outside of regular
market hours, execute during regular trading hours, e.g., because they
are NMLOs that are only eligible to execute during regular trading
hours.\670\ In order to estimate the extent to which this occurs, a
sample of CAT data \671\ was analyzed to examine submission volumes of
NMLOs submitted outside of regular trading hours that were designated
as only eligible to trade during regular trading hours,\672\ and
compared them to
[[Page 3847]]
the volumes and characteristics of NMLOs submitted during a sample 10-
minute time window from 9:40 a.m. to 10:40 a.m. This analysis confirms
that pre-open orders eligible to trade during regular trading hours
likely make up only a very small percentage of order volume,
representing only around 4.8% of the volume of orders submitted during
a single ten-minute period of the trading day. However, further
analysis reveals that these orders contain a high concentration of
individual investor orders. Specifically, pre-open share volume
contains a much larger fraction of individual investor shares (29.5%)
than the sample time window during regular trading hours (1.9%), at
least for off-exchange market centers for which individual investor
orders could be identified.\673\ This is consistent with the idea that
at least some of this order flow represents orders that are submitted
by individual investors outside of market hours, i.e., via online
brokerage accounts, but not necessarily with the intention to engage in
after-hours trading.
---------------------------------------------------------------------------
\670\ Note that most retail brokers do not permit market orders
during extended hours trading. See, e.g., Extended Hours Overview,
Charles Schwab, available at https://www.schwab.com/public/schwab/nn/qq/about_extended_hours_trading.html; Extended-Hours Trading,
Robinhood, available at https://robinhood.com/us/en/support/articles/extendedhours-trading/.
\671\ The sample consists of 390 stocks for the period of March
2021. Note that this sample of NMLOs collected from CAT may include
NMLOs that would not be included in Rule 605 reports, if they never
touch the NBBO at any point during their lifespan. Characteristics
include whether the order was submitted to an exchange or off-
exchange market center, distance from the prevailing quote midpoint
(or, in the case of pre-open orders, from the open price) in basis
points (bps), and order size in terms of number of shares. For off-
exchange orders, the Commission is also able to characterize whether
the order was initially submitted by an individual investor.
\672\ The definition of marketability for the purposes of this
analysis for pre-open orders is determined using the NBBO that is
first disseminated after the time of order receipt, such that orders
to be executed at a market opening price are excluded. See supra
note 231 and accompanying text for more information about defining
the marketability of orders submitted outside of regular market
hours.
\673\ As the account type (i.e., individual or institutional)
data field is only available upon order origination and is not
transferred to the executing market center, staff was not able to
differentiate individual investors in the CAT data for exchanges.
---------------------------------------------------------------------------
(c) Information Required by Current Rule 605 Reporting Requirements
In addition to decreasing the coverage of Rule 605, subsequent
market changes since the initial adoption of Rule 605 may have also
decreased the relevance of some of the metrics included in Rule 605
reports. This section will discuss how market changes may have
affected, or will likely affect in the near future, aspects of several
such metrics, including the definition of round lots for order size
categories, the granularity of metrics related to time-to-execution,
and the use of a five-minute time horizon for realized spreads.
(1) Order Size Categories
The Commission believes that defining order size categories in
terms of numbers of shares has led these order size categories to be
less informative about differences in execution qualities across
differently-sized orders. To illustrate, consider that some Regulation
NMS rules exclude orders or trades that are sized above $200,000, as
these orders typically warrant different treatment than smaller
orders.\674\ For a $50 stock, a $200,000 order would be equivalent to
around 4,000 shares, meaning that typically-sized orders (i.e., orders
that are not excluded from the previously described Regulation NMS
rules) below $200,000 (and above $500, given that orders below 100
shares are excluded) are split between three order size categories: 100
to 499 shares, from 500 to 1999 shares, and from 2000 to 4999 shares.
Market participants are therefore able to use these order size
categories to compare across orders of different sizes. However, for a
$500 stock, a $200,000 order would only be equivalent to 400 shares.
Therefore, for the purposes of Rule 605 reporting, nearly all
typically-sized orders in this high-priced stock are either grouped in
the smallest order size category (100 to 499 shares \675\), or, if they
would fall below the smallest order size category of 100 shares,
excluded altogether from reporting requirements.\676\ As all orders
tend to be clustered into a single category, market participants are
unable to use these categories to compare across orders of different
sizes in higher-priced stocks. Similarly, at least one market
participant argues that the definition of the current order size
categories in terms of number of shares together with the exclusion of
orders of less than 100 shares,\677\ has led to the exclusion of more
orders with low dollar values as the average stock price
increases.\678\
---------------------------------------------------------------------------
\674\ See, e.g., Rule 606(a)(1) of Regulation NMS (requiring
reports on the routing of customer orders) and Rule 600(b)(25) of
Regulation NMS (defining ``customer order'' to exclude an order with
a market value of $200,000 or more); Rule 604(b)(4) of Regulation
NMS (providing an exception for orders of block size from required
limit order display) and Rule 600(b)(12) of Regulation NMS (defining
``block size'' as, in part, an order for a quantity of stock having
a market value of at least $200,000).
\675\ See 17 CFR 242.605(a)(1). See also supra note 40 and
corresponding text for a definition of the current order size
categories included in Rule 605 reporting requirements.
\676\ In addition, even prior to the implementation of the MDI
Rules, a small number of NMS stocks have a round lot size smaller
than 100. See supra note 266.
\677\ See supra section VII.C.2.(b)(1)(a) for a discussion of
the exclusion of orders that are less than 100 shares from current
Rule 605 reporting requirements.
\678\ See Phil Mackintosh, Modern Retail Needs Modern Rules,
NASDAQ (May 27, 2021, 11:54 a.m.), available at https://www.nasdaq.com/articles/modern-retail-needs-modern-rules-2021-05-27/.
---------------------------------------------------------------------------
Furthermore, the Commission's 2020 adoption of the MDI Rules
included a new definition of ``round lot'' that causes some round lots
to be excluded from reporting requirements, absent an update to Rule
605's order size categories.\679\ Specifically, the current size
categories as defined under Rule 605, which exclude orders with fewer
than 100 shares, exclude a portion of round lots for stocks with prices
greater than $250.
---------------------------------------------------------------------------
\679\ See supra note 577 for a definition of these tiers.
---------------------------------------------------------------------------
(2) Non-Marketable Limit Order Categories
The Commission preliminarily believes that the current
categorization of NMLOs may include orders whose executions are more
likely to depend on their limit prices and price movements in the
market, and exclude orders whose executions are more likely to depend
on their handling by the market center. This could lead to the
excessive exclusion of limit orders whose execution quality may be
relevant to both individual and institutional investors.\680\
---------------------------------------------------------------------------
\680\ Both institutional and individual investors likely make
use of NMLOs. One academic study, using data on retail orders
between 2003 and 2007 from two OTC market centers, estimated that
NMLOs made up around 39% of individual investor order flow. See Eric
K. Kelley & Paul C. Tetlock, How Wise are Crowds? Insights from
Retail Orders and Stock Returns, 68 J. Fin. 1229 (2013). Other
academic papers suggest that NMLO usage by institutional investors
may also be high. See, e.g., Amber Anand, Sugato Chakravarty &
Terrence Martell, Empirical Evidence on the Evolution of Liquidity:
Choice of Market Versus Limit Orders by Informed and Uninformed
Traders, 8 J. Fin. Mkt. 288 (2005); Ron Kaniel & Hong Liu, So what
orders do informed traders use?, 79 J. Bus. 1867 (2006).
---------------------------------------------------------------------------
When proposing to exclude away-from-the-quote NMLOs with a limit
price more than ten cents away from the NBBO, the Commission reasoned
that the execution quality statistics for these types of orders may be
less meaningful because their executions depend more on the order's
limit price and price movement in the market than on handling by the
market center.\681\ Meanwhile, the current ``near-the-quote'' limit
order category \682\ is meant to include limit orders that are
submitted away from the NBBO, but that still have a relative likelihood
of being executed (hence the minimum distance requirement from the
NBBO). However, it is important to note that the likelihood of
execution of both greatly depends on the movement of the NBBO. An order
submitted even within 10 cents of the NBBO may never receive an
opportunity to be executed if that order never touches the NBBO (e.g.,
if prices were to move away from that order immediately after
submission), and an order that is submitted further than 10 cents may
indeed eventually execute if prices move towards the order.
---------------------------------------------------------------------------
\681\ See Proposing Release, 65 FR 48406 (Aug. 8, 2000) at
48414.
\682\ See 17 CFR 242.600(b)(14).
---------------------------------------------------------------------------
Figure 7 breaks down a sample of MIDAS NMLO submission data from 80
stocks in March 2022 \683\ into NMLO
[[Page 3848]]
types, including away-from-the-quote, near-the-quote, and at-the-quote
NMLOs, along with several categories of inside-the-quote NMLOs
depending on their distance from the midpoint (below-the-midpoint, at-
the-midpoint, and beyond-the-midpoint).\684\ The figure shows that
away-from-the-quote NMLOs represent nearly a quarter of all non-
marketable share volume.
---------------------------------------------------------------------------
\683\ See supra note 634 for a description of the dataset.
\684\ Results may be different following the implementation of
the MDI Rules. Specifically, the NBBO is anticipated to narrow for
stocks priced above $250 as a result of the new definition of round
lots, which would likely decrease the number of inside-the-quote
NMLOs and increase the number of quotes at or outside of the quotes
for these stocks. See supra section VII.C.1.(d)(2) for further
discussion.
---------------------------------------------------------------------------
BILLING CODE 8011-01-P
Figure 7: Order Submission Share Volume by NMLO Type, March 2022
[GRAPHIC] [TIFF OMITTED] TP20JA23.007
Figure 8 presents data on the fill rates of NMLO orders, broken
down by NMLO type, using the same sample of MIDAS NMLO submission
data.\685\ The figure shows that near-the-quote and away-from-the-quote
NMLOs appear very similar in terms of fill rates (0.6% and 0.18%,
respectively), particularly compared to other types of NMLOs (e.g.,
inside-the-quote NMLOs have an average fill rate of around 2.7% to
5.1%). The fact that near-the-quote and away-from-the-quote NMLOs have
similar fill rates is consistent with the possibility that the current
exclusion of NMLOs priced more than 10 cents away from the NBBO is
based on a threshold that does not optimally differentiate between
orders that have a meaningful chance to execute.\686\ Meanwhile, orders
that never have a meaningful opportunity to execute (e.g., because they
never touch the NBBO) may be included in Rule 605 statistics. To get an
idea of the extent to which such orders are currently included in Rule
605 statistics, note that, according to Figure 8, more than 99% of
near-the-quote NMLOs do not execute, which, according to Figure 7,
represents around 36% of total submission volume. While it is possible
that some of these orders did not execute because of their handling by
the market center, it is unlikely that this is case for all of them,
and likely that some of the lack of fills was the result of other
factors, such as price movements or cancellations by the
submitter.\687\
---------------------------------------------------------------------------
\685\ The distribution of orders into various NMLO categories
may change following the implementation of the MDI Rules. See supra
note 684 and section VII.C.1.d)(2). However, it is not clear how a
change in the distribution of orders into various NMLO categories
would affect the average fill rates of these NMLO categories.
\686\ Commenters supported including NMLOs further away from the
quote in Rule 605 reports but noted the difficulty of providing
meaningful execution quality statistics for such orders. See supra
notes 296-297 and accompanying text.
\687\ See infra section VII.E.2.(b) for a discussion of how NMLO
orders that are cancelled quickly after submission may impact fill
rates.
---------------------------------------------------------------------------
Figure 8: Fill Rates of NMLOs, March 2022
[[Page 3849]]
[GRAPHIC] [TIFF OMITTED] TP20JA23.008
Furthermore, defining the threshold for inclusion in Rule 605
reporting requirements in nominal terms (i.e., 10 cents) means that
NMLO coverage varies depending on the stock price: high-price stocks
with smaller relative tick sizes have less NMLO coverage, since 10
cents represents a relatively tighter band around the NBBO.\688\ This
is shown in Figure 9, which breaks down the NMLO submission volumes in
Figure 8 by both order type and average share prices. The figure shows
that away-from-the-quote NMLOs represent 24.4% of total NMLO share
volumes for the group of stocks with the highest share prices, but only
8.4% for the group of stocks with the lowest share prices. Excluding
large portions of relevant NMLOs results in less reliable market
quality measures; this may especially be the case for high-priced
stocks, thus making comparisons between market centers less reliable
for these stocks.
---------------------------------------------------------------------------
\688\ Results may be different following the implementation of
the MDI Rules. Specifically, NMLO coverage for stocks priced above
$250 may decrease even further, as the narrowing of the NBBO for
these stocks would result in even tighter price bands. See supra
section VII.C.1.(d)(2) for further discussion.
---------------------------------------------------------------------------
Figure 9: Order Submission Share Volume by NMLO Type and Stock Price
Quartiles, March 2022
[[Page 3850]]
[GRAPHIC] [TIFF OMITTED] TP20JA23.009
(3) Beyond-the-Midpoint Limit Orders
Currently, Rule 605 reports may not accurately reflect how the
execution quality of inside-the-quote NMLOs may vary across market
centers. The Commission preliminarily understands that some inside-the-
quote limit orders may have different execution quality characteristics
than other types of NMLOs, and that this may vary across market
centers. In particular, the Commission preliminarily understands that
some market centers, such as some wholesalers, treat ``beyond-the-
midpoint'' limit orders (i.e., NMLOs that are priced more aggressively
than the midpoint) like marketable limit orders and will offer price
improvement to these orders. However, because they are not a marketable
order type (i.e., they do not fully cross the spread), some statistics
are not currently calculated for inside-the-quote limit orders,
including price improvement statistics and effective spreads.
In order to examine this possibility, Table 5 presents results from
an analysis of the execution quality of beyond-the-midpoint NMLOs
compared to other order types, including market, marketable limit, and
other types of inside-the-quote NMLOs, using a sample of orders
executed by the six most active wholesalers from CAT data for the
period of Q1 2022.\689\ The results show that beyond-the-midpoint NMLOs
executed by wholesalers tend to have much faster time-executions and
higher fill rates than other types of inside-the-quote NMLOs, and are
also somewhat more likely to be given price improvement. Grouping
beyond-the-midpoint orders together with other NMLOs obscures the
differences in these market centers' treatment of these types of
orders, including potential differences in price improvement.
---------------------------------------------------------------------------
\689\ See supra note 609 for dataset description. This dataset
is from prior to the implementation of the MDI Rules and the
distribution of orders into various NMLO categories, including
beyond-the-midpoint orders, may change following the implementation
of the MDI Rules. See supra note 684 and section VII.C.1.(d)(2).
However, it is not clear how a change in the distribution of orders
into various NMLO categories would affect the average fill rates and
time-to-execution of these NMLO categories. The percent of price-
improved orders may also change, depending on how wholesalers adjust
their price improvement practices in stocks with narrower spreads.
However, it is unclear how the percentage of price-improved beyond-
the-midpoint NMLOs would change relative to other types of NMLOs.
Table 5--Execution Quality Characteristics of Beyond-the-Midpoint NMLOs Executed by Wholesalers, Q1 2022
----------------------------------------------------------------------------------------------------------------
Average time- Median time-to- Price-improved
Order type to-execution execution Fill rates (%) orders (%
(seconds) (seconds) total orders)
----------------------------------------------------------------------------------------------------------------
Market.......................................... 21.19 0.04 91.0 78.1
Marketable Limit................................ 233.95 3.22 94.0 55.9
Beyond-the-Midpoint NMLOs....................... 1503.31 145.49 94.1 4.6
[[Page 3851]]
At-the-Midpoint and Below-the-Midpoint NMLOs.... 4189.13 1480.60 81.7 1.1
----------------------------------------------------------------------------------------------------------------
Table 5: Execution Quality Characteristics of Beyond-the-Midpoint NMLOs Executed by Wholesalers, Q1 2022. This
table shows execution quality metrics for different order types handled by the top six wholesalers using CAT
data during the period of Q1 2022. See supra note 609 for dataset description. This analysis uses data from
prior to the implementation of the MDI Rules and results may be different following the implementation of the
MDI Rules. See supra note 689 and section VII.C.1.d)(2).
(4) Time-to-Execution
The rapid increase in execution speeds in modern markets has
decreased the usefulness of time-to-execution information that is
currently required in Rule 605 reports.\690\ Currently, time-to-
execution information is required in Rule 605 reports in two ways:
first, for market and marketable limit orders, the share-weighted
average time-to-executions for orders executed with price improvement,
at the quote, and with price dis-improvement, calculated based on
timestamps recorded in seconds; and second, for all orders, the number
of shares executed within certain pre-defined time-to-executions
categories.\691\
---------------------------------------------------------------------------
\690\ See supra note 133 and accompanying text discussing
concerns raised by commenters about the current provisions in Rule
605 for time-to-execution information.
\691\ See supra note 343 for a definition of these time-to-
execution categories.
---------------------------------------------------------------------------
First, calculating average time-to-execution statistics using
timestamps recorded in terms of seconds does not reflect changes in
market speeds. Figure 10 uses data from the SEC's MIDAS analytics tool
\692\ to plot the percentage of on-exchange NMLOs that, conditional on
being executed,\693\ are fully executed within one second or less from
the time of submission between Q4 2012 and Q1 2022. The figure shows
that this percentage has increased over time across different market
capitalization groups, and that in Q1 2022 more than half (51.6%) of
executed NMLOs are executed in less than one second in large market cap
stocks. Therefore, while timestamps expressed in seconds may have been
appropriate for the markets when Rule 605 was first adopted, they are
likely to miss much of the variation in time-to-execution across market
centers in today's markets.
---------------------------------------------------------------------------
\692\ See dataset Conditional Cancel and Trade Distributions,
SEC, available at https://www.sec.gov/marketstructure/downloads.html. If the order is not fully executed, it is treated as
canceled at the close. See Quote Life Report Methodology, SEC,
available at https://www.sec.gov/marketstructure/quote-life-report-methodology.
\693\ I.e., Figure 10 plots the number of fully executed NMLOs
executed within one second relative to the total number of fully
executed on-exchange NMLOs. Note that, in contrast, Figure 8 plots
the number of executed NMLO shares divided by the total number of
submitted NMLO shares.
---------------------------------------------------------------------------
Figure 10: Percentage of NMLOs Executed Within One Second, Q1 2012-Q4
2022
[GRAPHIC] [TIFF OMITTED] TP20JA23.010
[[Page 3852]]
Second, given that many orders are executed on a sub-second basis,
the current time-to-execution buckets prescribed by Rule 605 are not
able to fully capture variations in time-to-executions across order
types.\694\ To illustrate this, Figure 11 groups on-exchange NMLO
executions collected from MIDAS for the period of March 2022 \695\ into
time-to-execution buckets that correspond to those currently defined in
Rule 605. The figure shows that, while the distribution of orders looks
reasonable for away-from-the-quote and near-the-quote NMLOs, for which
executions are relatively evenly distributed across the time-to-
execution categories, these categories do not capture much
differentiation for other NMLO types, particularly for those that take
place inside the quote. For inside-the-quote NMLOs, 84.2% to 85.7% of
orders are grouped in the shortest time-to-execution bucket (from 0 to
less than 10 seconds), depending on the distance to the midpoint, while
the category corresponding to the longest time-to-execution bucket
defined by Rule 605 (5 to 30 minutes) has only 1.1% to 1.3% of
executions. Therefore, these time-to-execution categories likely do not
fully capture variations in the execution times of these orders across
reporting entities.
---------------------------------------------------------------------------
\694\ See supra note 343 for a definition of these time-to-
execution categories.
\695\ See supra note 634 for data description. Note that this
dataset includes only NMLOs submitted to exchanges that do not
immediately execute and are subsequently posted to the limit order
book. The results of this analysis may not reflect the execution
quality of inside-the-quote NMLOs that execute immediately, e.g.,
against hidden liquidity on the limit order book. Furthermore, this
dataset is from prior to the implementation of the MDI Rules and the
distribution of orders into various NMLO categories may change
following the implementation of the MDI Rules. See supra note 684
and section VII.C.1.(d)(2). However, it is not clear how a change in
the distribution of orders into various NMLO categories would affect
the average time-to-execution of these NMLO categories.
---------------------------------------------------------------------------
Figure 11: Distribution of NMLO Execution Times, March 2022
[GRAPHIC] [TIFF OMITTED] TP20JA23.011
MIDAS data includes only orders and quotes that are posted on
national securities exchanges' LOBs and trades that are executed
against those orders,\696\ and as such it is not possible to view the
submission times (and thus calculate the time-to-execution of) market
and marketable limit orders using MIDAS data. As a result, the above
analysis is only able to consider the time-to-execution of on-exchange
NMLOs. In order to estimate the time-to-execution of both on- and off-
exchange orders, including market and marketable limit orders, the
Commission used the Tick Size Pilot B.I Market Quality data from April
2016 until March 2019.\697\
---------------------------------------------------------------------------
\696\ See supra note 634. MIDAS data includes information about
off-exchange trade executions, but not information about any off-
exchange order submissions, so it is also not possible to use MIDAS
data to calculate the time-to-execution of off-exchange orders.
\697\ See supra note 619 for data description. Note that, as the
Tick Size Pilot only collected data for small cap stocks, these
execution times are not necessarily representative of all stocks.
For example, larger market cap stocks are typically more liquid and
likely execute faster. Also, as this is an older data set (April
2016 until March 2019), it may be that market speeds have changed
since this time. However, as it is likely that market speeds have
only gotten faster since this time period, it could represent a
lower bound on execution times and therefore still give an idea of
how relevant the current Rule 605 time-to-execution buckets are for
market and marketable limit orders. Lastly, this dataset also
includes off-exchange orders, while the MIDAS data only includes on-
exchange orders, which could result in different execution times
between the two datasets. Furthermore, this dataset is from prior to
the implementation of the MDI Rules and the distribution of orders
into various NMLO categories may change following the implementation
of the MDI Rules. See supra note 684 and section VII.C.1.(d)(2).
However, it is not clear how a change in the distribution of orders
into various NMLO categories would affect the average time-to-
execution of these NMLO categories.
---------------------------------------------------------------------------
[[Page 3853]]
Figure 12 shows the distribution of time-to-execution statistics for
market and marketable limit orders, along with the three categories of
non-marketable limit orders currently required in Rule 605 reports
(i.e., inside-the-quote, at-the-quote, and near-the-quote). Note that
the time-to-execution categories defined in the Tick Size Pilot dataset
are more granular than those in Rule 605.
Figure 12: Distribution of Order Execution Times, April 2016-March 2019
[GRAPHIC] [TIFF OMITTED] TP20JA23.012
Echoing the results using MIDAS data in Figure 11, Figure 12 shows
that, for at-the-quote and near-the-quote limit orders, executions are
reasonably well distributed across the different time-to-execution
buckets and there is positive volume in the longer time-to-execution
buckets that are included in both the Rule 605 and Tick Size Pilot
categorizations (30 to 59 seconds, 60 to 299 seconds, and 5 to 30
minutes). However, similar to the results for inside-the-quote NMLOs,
for market and marketable limit orders, execution times are mostly
bunched up at the faster end of their time buckets; in fact, the vast
majority of these orders are executed in under one second, falling
within the shortest Rule 605 category of shares executed from 0 to 9
seconds. Likewise, the longer time-to-execution buckets that are
included in both the Rule 605 and Tick Size Pilot categorizations are
virtually empty. Therefore, as with inside-the-quote NMLOs, current
Rule 605 time-to-execution categories are missing information about
potential differences across reporting entities in terms of the
execution times of the market and marketable limit orders that they
handle, which limits the usefulness of time-to-execution information
for investors.\698\
---------------------------------------------------------------------------
\698\ Academic literature suggests that time-to-execution
information would be especially useful for institutional investors
with short-lived private information, who profit from trading
against other, slower institutions. See, e.g., Ohad Kadan, Roni
Michaely & Pamela C. Moulton, Trading in the Presence of Short-Lived
Private Information: Evidence from Analyst Recommendation Changes,
53 J. Fin. Quantitative Analysis 1509 (2018). Time-to-execution
information would also benefit institutions that engage in market
making, as one study shows these institutions are likely to rely on
speed to reduce their exposure to adverse selection and to relax
their inventory constraints. See Jonathan Brogaard, Bjorn
Hagstr[ouml]mer, Lars Nord[eacute]n & Ryan Riordan, Trading Fast and
Slow: Colocation and Liquidity, 28 Rev. Fin. Stud. 3407 (2015).
---------------------------------------------------------------------------
(5) Effective and Realized Spreads
The Commission believes that current requirements in Rule 605
related to measures of effective and realized spreads may lead to
uninformative or incomplete information.
First, because of the increase in the speed at which markets
operate,\699\ the requirement to use a five-minute benchmark to
calculate realized spreads \700\ may limit the ability of the Rule 605
realized spreads to measure what they are intended to measure, i.e.,
the adverse selection risk associated with providing liquidity at a
market center. Liquidity providers face adverse selection risk when
they accumulate inventory, for example by providing liquidity to more
informed traders, because of the risk of market prices moving away from
market makers before they are able to unwind their positions.\701\
Realized spreads are calculated by comparing an order's transaction
price to the NBBO midpoint five minutes later (i.e., an estimate of the
average expected trade price). Smaller (or even negative) realized
spreads reflect that market prices have moved away from market makers,
which is usually a reflection of order flow with
[[Page 3854]]
greater adverse selection risk. Therefore, all else being equal, if a
market center reports favorable execution quality measures but a low or
negative realized spread, this would reflect that the market center is
still providing liquidity even during adverse market conditions.
---------------------------------------------------------------------------
\699\ See supra section VII.C.2.(c)(4) for a discussion of
evidence of increased market trading speeds.
\700\ See 17 CFR 242.600(b)(9). See also supra note 359 and
accompanying text for a further discussion of the definition of the
realized spread.
\701\ For example, if a liquidity provider provides liquidity to
an informed trader, who is selling its shares because it knows that
the share price is about to drop, the market maker will accumulate a
long position in the stock. If the market maker were to immediately
try to unwind this position in the market, the share price may have
already dropped and the market maker will have to sell at a lower
price than what it paid for the shares.
---------------------------------------------------------------------------
Selecting an appropriate time horizon to calculate the realized
spread must strike a balance between too short, which could distort the
measures by transitory price impact, and too long, which could measure
noise \702\ or the cumulative impact of subsequent market changes which
are unrelated to the order's execution quality. An ideal measurement
horizon would be one that aligns with the amount of time an average
liquidity provider holds onto the inventory positions established from
providing liquidity, which is not easily observable. A number of
academic studies argue that the five-minute horizon is too long for a
high-frequency environment.\703\ As one paper puts it, ``five minutes
is a `lifetime', and so is not a meaningful time frame in which to
evaluate trading.'' \704\ Another paper shows that realized spreads
will generally increase as the time horizon that they are calculated
over is shortened, highlighting that realized spreads are highly
dependent on the time horizon over which they are calculated.\705\
---------------------------------------------------------------------------
\702\ The term ``noise'' is used throughout in the statistical
sense and refers to unexplained or unrelated variability in
observations that degrades the efficiency of computed statistics or
estimators.
\703\ See, e.g., O'Hara 2015; O'Hara et al.; Conrad and Wahal.
\704\ See O'Hara 2015. The author argues that the use of a five-
minute time horizon to calculate realized spreads leads to spreads
that are nearly always negative, which is inconsistent with their
interpretation as returns to market-making. The implication is that
the five-minute time horizon is too noisy.
\705\ See Conrad and Wahal.
---------------------------------------------------------------------------
In order to see how using different time horizons for calculations
of realized spreads can affect comparisons across market centers, using
TAQ data for a sample of 400 stocks in February 2021,\706\ the
Commission calculated the average realized spreads across 15 different
market centers, measured using six different time horizons: 1 second, 5
seconds, 10 seconds, 15 seconds, 1 minute, and 5 minutes. The results
are presented in Figure 13, and support the findings from the empirical
literature, that the choice of time horizon is non-trivial and realized
spreads are generally increasing as the time horizon decreases.\707\
---------------------------------------------------------------------------
\706\ Using CRSP data from the last trading day in February
2021, the Commission selected 400 stocks, 100 each from 4 size
quartiles: under $100 million, $100 million to $1 billion, $1
billion to $10 billion, and over $10 billion. Within each market cap
group, the Commission split the stocks into 4 quartiles based on
price and selected 25 stocks from each price quartile evenly spaced
within the quartile. The Commission manually replaced 3 stocks in
the smallest size quartile with a price and sized matched stock
because they had very little trading volume. The Commission limited
its analysis to trades during regular market hours without an
irregular sale condition. Analysis derived based on data from CRSP
1925 US Stock Database, Ctr. Rsch. Sec. Prices, U. Chi. Booth Sch.
Bus. (2022).
\707\ This analysis uses data from prior to the implementation
of the MDI Rules and results may be different following the
implementation of the MDI Rules. Specifically, the NBBO midpoint in
stocks priced higher than $250 could be different under the MDI
Rules than it otherwise would be, resulting in changes in the
estimates for statistics calculated using the NBBO midpoint, such as
realized spreads. While specific numbers might change, the
Commission does not expect the relative variation in realized
spreads across different time horizons to change as a result of the
implementation of MDI. See supra section VII.C.1.(d)(2) for further
discussion.
---------------------------------------------------------------------------
Figure 13: Average Realized Spreads by Market Center and Time Horizon,
February 2021
[GRAPHIC] [TIFF OMITTED] TP20JA23.013
BILLING CODE 8011-01-C
[[Page 3855]]
These differences can have implications for comparisons across
market centers as well. As shown in Figure 13, while Market Centers 8
and 9 have positive realized spreads using the shortest time horizon,
their spreads are mostly negative at longer time horizons. As a result,
an assessment of whether these market centers have higher or lower
realized spreads (i.e., more or less adverse liquidity conditions) as
compared to, say, Market Center 6, depends on the time horizon used.
Therefore, the choice of interval can not only affect the
interpretation of realized spreads as a measure of liquidity
conditions, but also affect comparisons across market centers.
From the results of this analysis, it is unclear whether the choice
of any specific measurement horizon results in realized spreads more
accurately measuring adverse selection risk, as the ``ideal''
measurement horizon is not easily observable. However, given the higher
frequency of trading today, it is likely that the use of a five-minute
horizon for realized spreads limits the extent to which these measures
are able to capture adverse selection risk, making it more difficult to
compare conditions for liquidity providers across market centers.
Second, reporting entities are currently not required to include
information about the effective spreads of NMLOs in Rule 605 reports,
which means that neither individual nor institutional investors have
access to information about this dimension of execution quality for
their NMLOs. The effective spread is calculated by comparing the trade
execution price to the midpoint of the prevailing NBBO at the time of
order receipt, which is used as an estimate of the stock's value.\708\
For market and marketable limit orders, the effective spread captures
how much more than the stock's estimated value a trader has to pay for
the immediate execution of its order. For NMLOs, instead of capturing a
cost of immediacy, the effective spread captures how much the limit
order provider expects to earn (i.e., pay less than or receive more
than the stock's estimated value, depending on whether its order is to
buy or sell) from the execution of its limit order.\709\ This measure
of the expected benefits to liquidity provision contains information
that may otherwise be useful to investors, but is currently missing in
Rule 605 reports.\710\
---------------------------------------------------------------------------
\708\ See, e.g., Bjorn Hagstr[ouml]mer, Bias in the Effective
Bid-Ask Spread, 142 J. Fin. Econ. 314 (2021). See infra section
VII.E.3.(c)(3) discussing potential issues with using the midpoint
to calculate effective spreads.
\709\ The interpretation of effective spreads for NMLOs is
different from that of realized spreads. Effective spreads capture
what liquidity providers expect to earn from providing liquidity,
assuming that prices do not change before the liquidity provider is
able to unwind its position and realized its profit. Meanwhile,
realized spreads capture what it actually earns, taking into account
that the market price may have moved against the liquidity provider
before it could unwind its position. See supra note 701 and
accompanying text. Therefore, while the effective spread measures
the expected benefits to liquidity provision, the realized spreads
measure its riskiness.
\710\ Both individual and institutional investors provide
liquidity through the use of NMLOs. See supra note 680.
---------------------------------------------------------------------------
Lastly, the fact that Rule 605 reports only contain information on
average realized and average effective spreads in terms of dollar
amounts makes it difficult for market participants to account for
differences in share prices when comparing across market centers.\711\
While spreads in dollar terms can be useful for participants because
they can reflect a cost of (or benefit to) trading in terms that are
easy to interpret, it is also the case that, since the effective spread
is a per-share cost, the real costs to investors captured by the
effective spread can be very different, depending on the stock
price.\712\ All else being equal, spread measures tend to be higher in
dollar terms for higher-priced stocks. As different reporting entities
handle and/or transact in different mixes of stocks, this may make it
difficult for market participants who may want to compare reporting
entities' overall price performance or their performance for baskets of
stocks to aggregate across effective spreads.\713\
---------------------------------------------------------------------------
\711\ In theory, market participants could also control for
differences in share prices by matching up stock-level information
from Rule 605 reports to, e.g., information on the stock's average
stock price from that month. However, this would require market
participants who wish to control for differently-priced stocks to go
through the extra step of gathering and matching stock price
information to Rule 605 data, which may be an unreasonable
expectation, particularly for individual investors with limited
resources. Furthermore, while a monthly average might well capture
the prevailing stock price for any given execution for a stock with
low price volatility, it might not be a good representation of the
prevailing stock price for executions in stocks with high price
volatility.
\712\ To illustrate, consider an investor that wants to acquire
a $10,000 position in a $250 stock with an effective spread of
$0.01; the investors will have to pay about $0.40 to purchase 40
shares of the stock. Now consider an investors who wants to acquire
a $10,000 position in a $2.50 stock with an effective spread of
$0.01; the investor would have to pay around $4.00 to acquire 400
shares. In other words, even though the dollar effective spread was
the same, it was ten times more expensive for the investor to
accumulate a position worth the same dollar amount in the lower-
priced stock.
\713\ While the main purpose of Rule 605 is to facilitate
comparisons across reporting entities on the basis of execution
quality within a particular security, the Commission understands
that access to aggregated information is useful for market
participants. The proposed amendment to require reporting entities
to prepare summary reports that aggregate execution quality
information for S&P 500 stocks, along with all NMS stocks, would
give market participants access to aggregate effective spreads for
one commonly used basket of stocks. Meanwhile, per-stock percentage
spread information would enhance market participants' ability to
aggregate effective spread information across baskets of stocks
other than the S&P 500.
---------------------------------------------------------------------------
Also, measuring spreads in absolute terms may lead to comparisons
across reporting entities that do not take into account potential
differences in the timing of order flow, particularly for stocks whose
prices vary significantly over the course of the monthly reporting
period. For example, say that a stock's price increased dramatically
over the course of a month from $2.50 to $250 and that, by chance,
Market Center A executed more order flow for that stock at the
beginning of the month, while Market Center B executed more order flow
for that stock at the end of the month. In its Rule 605 report for that
month, Market Center A showed an average effective spread of $0.01,
while Market Center B showed an average effective spread of $0.10.
Measured in dollar terms, Market Center B would seem to have offered
worse execution prices than Market Center A, since it is associated
with higher effective spreads. However, relative to the stock price,
Market Center B would actually have the offered the better prices (a
percentage effective spread of 0.04%) compared to Market Center A (a
percentage effective spread of 0.4%).\714\ This illustrates that a
market center's spread measures may be higher in dollar terms, but not
necessarily because it offered worse execution performance; instead,
these differences in spread measures may simply reflect changes in the
stock's dollar price and the timing of market center's order flow.
---------------------------------------------------------------------------
\714\ To illustrate how the percentage effective spread can
reflect different costs in real terms, consider if one customer
acquired a $10,000 stake in the stock at the beginning of the month
(i.e., $10,000/$2.50 = 4,000 shares); a per-share effective spread
of $0.01 means that the customer's cost of acquiring the position
would have been $40. Meanwhile, another customer acquired a $10,000
stake at the end of the month (i.e., $10,000/$250 = 40 shares); a
per-share effective spread of $0.10 means that the customer's cost
would have been only $4.
---------------------------------------------------------------------------
(6) Price and Size Improvement
The current measure of price improvement required for Rule 605
reports may not succeed in always capturing price improvement relative
to the best available prices. Currently, market centers are required to
report price improvement as the difference between the trade price and
the NBBO.
[[Page 3856]]
However, a recent academic working paper shows that odd-lots offer
better prices than the NBBO 18% of the time for bids and 16% of the
time for offers.\715\ If an order executes against a resting odd-lot
with a price better than the NBBO, the execution would result in
positive price improvement according to the current Rule 605 reporting
requirements. In cases where this occurs, this positive price
improvement is the result of an inadequate benchmark price being used,
and not the same as if the market center were to actively offer the
order at a price better than the best available market price, which is
what price improvement is typically intended to measure.
---------------------------------------------------------------------------
\715\ See Bartlett et al. (2022). The authors found that this
percentage increases monotonically in the stock price, for example,
for bid prices, increasing from 5% for the group of lowest-price
stocks in their sample, to 42% for the group of highest-priced
stocks.
---------------------------------------------------------------------------
Furthermore, such positive price improvement may actually reflect
price dis-improvement, once all available displayed liquidity is taken
into account. For example, if a market center internalizes an order
with $0.05 of price improvement relative to the NBBO, but odd-lots are
available on another market center at prices that are $0.10 better than
the NBBO, the market center would post a price improvement measure of
$0.05, even though the investor could have received a better price if
the market center had routed the order to execute against the available
odd-lot liquidity instead of internalizing the order. As a result,
current measures of Rule 605 may overstate the amount of price
improvement offered by some market centers.
Information about price improvement is different from information
about whether orders received an execution of more than the displayed
size at the quote, i.e., ``size improvement.'' The price improvement
metrics currently required by Rule 605 do not necessarily capture a
market center's ability to fill orders beyond the liquidity available
at the NBBO.\716\ For example, consider a situation in which the market
is $10.05 x $10.10 with 100 consolidated shares available at the NBO of
$10.10 and 100 consolidated shares available at the next best ask price
of $10.15. Say that a trader submits a marketable buy order for 200
shares to a market center, which fills the entire order at the best ask
price of $10.10. The market center's Rule 605 statistics would reveal a
price improvement metric of $0 for this order, despite the fact that
the trader saved money by avoiding having to walk the book, which would
have resulted in a total price of (100 * $10.10) + (100 * $10.15) =
$2,025. As a result of the market center's ability to offer this ``size
improvement,'' the trader saved an average of $10.125 $- $10.10 =
$0.025 per share. This information about execution quality is not
reflected in the market center's price improvement statistics.
---------------------------------------------------------------------------
\716\ An analysis of data from the Tick Size Pilot B.II Market
and Marketable Limit Order dataset reveals that nearly 7% of orders
had sizes greater than the liquidity available at the NBBO between
April 2016 and March 2019. See infra note 723 for data description.
See also supra note 406 and accompanying text. This analysis uses
data from prior to the implementation of the MDI Rules and results
may be different following the implementation of the MDI Rules.
Specifically, the MDI Rules could result in a smaller number of
shares at the NBBO for stocks in higher-priced round lot tiers,
increasing the number of orders with sizes greater than the NBBO.
See supra section VII.C.1.(d)(2) for further discussion.
---------------------------------------------------------------------------
As the Commission stated in the Adopting Release, the average
effective spread captures some information about size improvement.\717\
The effective spread is calculated by comparing the trade execution
price with the midpoint of the NBBO, rather than with the NBBO itself.
In this way, it captures the full range of available liquidity at a
market center and not merely the displayed orders that determine the
NBBO. The effective spread will be larger for orders that are larger
than liquidity available at the NBBO and are required to walk the book.
Therefore, generally speaking, a market center that offers greater size
improvement will tend to have a lower average effective spread (i.e.,
these measures will be negatively correlated).\718\ However, as this
measure contains information about both size and price, it may be
difficult to disentangle information about size improvement from
information about price improvement when interpreting average effective
spreads.\719\ Therefore, investors that particularly value the ability
of market centers to offer size improvement, such as investors trading
in larger order sizes, would not currently be able to use the metrics
currently contained in Rule 605 reports to easily discern which market
center would better handle their order according to this dimension of
execution quality.\720\
---------------------------------------------------------------------------
\717\ See Adopting Release, 65 FR 75414 (Dec. 1, 2000) at 75425.
\718\ For example, assume that a trader submits a marketable buy
order for 100 shares to a $10.05 x $10.10 market with 100
consolidated shares available at the NBO of $10.10 and 100
consolidated shares available at the next best ask price of $10.15.
In this case, the effective spread would be 2 * ($10.10 - $10.075) =
$0.05, reflecting that the trader had to pay an average of $0.05
more per share than the NBBO midpoint. Now consider the situation in
which the trader instead submits a marketable buy order for 200
shares to a market center (``Market Center A'') that walks the order
up the book. In this case the effective spread will be twice as
high, 2 * ($10.125 - $10.075) = $0.10. This higher effective spread
reflects the need for Market Center A to use volume beyond the best
quote to fill the order. If, on the other hand, instead of walking
the 200-share order up the book, a market center (``Market Center
B'') fills the entire buy order at the current NBO of $10.10; the
effective spread would only be $0.05. The ability of Market Center B
to execute an order for more than the displayed size at the quote is
therefore reflected in an effective spread that is lower than that
of Market Center A.
\719\ To illustrate, consider the example in supra note 718,
but, instead of 200 shares, the trader's order was for 100 shares
and Market Center A executed the order with an average price dis-
improvement of $0.025; the effective spread for Market Center A
would similarly be $0.10. Furthermore, consider a situation in which
the market is wider at $10.12 x $10.02 and Market Center B executes
the 100-share order with an average price improvement of $0.025 per
share, while Market Center A executes it without any price
improvement. Both of these cases would lead to the same effective
spreads (an effective spread of $0.10 for Market Center A, and an
effective spread of $0.05 for Market Center B) as the above-
described scenario in which Market Center B offered size improvement
and Market Center A did not, but for situations in which the order
size is less than or equal to the displayed size at the quote.
\720\ For example, compare the example of Market Center B
offering size improvement to a 200-share order in note 718, supra,
to the example of Market Center B offering price improvement to a
100-share order in note 719, supra. A trader that tends to submit
200-share orders would want to know a market center's ability to
offer the first scenario, while a trader that tends to submit 100-
share orders would want to know the market center's ability to offer
the second scenario. However, in both examples the Rule 605 report
would show an effective spread statistic of $0.05 for orders in the
order size category of 100-499 shares, which means that these
traders would not be able to use this statistic to discern a market
center's execution quality according to the dimension of execution
quality that they find most valuable.
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(7) Marketable IOCs
The Commission preliminarily believes that grouping marketable IOCs
together with other marketable limit orders may lead to a downward skew
on the execution quality metrics (specifically, derived estimates of
fill rates) for market centers that handle a large amount of IOCs,
which would hinder the extent to which these metrics could be used to
accurately compare execution quality across market centers. At least
one commenter to the 2010 Concept Release on Equity Market Structure
pointed out that IOCs may have a different submitter profile
(typically, institutional investors) and different execution quality
characteristics than other types of orders.\721\ Furthermore, an
analysis using CAT data \722\ of retail orders received at larger
retail brokers during June 2021 indicate that approximately only 0.02%
of individual investor
[[Page 3857]]
orders are submitted with an IOC instruction.
---------------------------------------------------------------------------
\721\ See supra note 326 and accompanying text.
\722\ See supra note 609 for dataset description.
---------------------------------------------------------------------------
To examine whether IOC orders have different execution quality
characteristics than other types of orders, an analysis was performed
using data from the Tick Size Pilot B.II Market and Marketable Limit
Order dataset,\723\ which includes a flag indicating whether a market
or marketable limit order has been marked as IOC. The results are
presented in Table 6 and show that IOCs indeed may have different
execution quality, as they typically have much lower fill rates (3.22%)
than other market and marketable limit orders (15.94%), particularly
for larger-sized orders. Therefore, the inclusion of IOCs along with
other types of market and marketable limit orders may skew the
execution quality of these other orders types, particularly since IOCs
make up more than 90% of market and marketable share volume.
---------------------------------------------------------------------------
\723\ See Tick Size Pilot Plan. This dataset contains
information for approximately 2,400 small cap stocks for a period
from April 2016 to March 2019. Orders with special handling codes
are discarded, as are orders marked as short sales (``SS''). Note
that, as the Tick Size Pilot collected data only for small cap
stocks, these time-to-executions are not necessarily representative
of all stocks. For example, larger market cap stocks may be traded
more actively by institutional investors, and therefore would likely
have higher IOC volumes.
Table 6--Immediate-or-Cancel (IOC) Share Volume, October 2018-October 2019
----------------------------------------------------------------------------------------------------------------
IOC volume (%
of share Fill rate (IOC) Fill rate (non-
volume) IOC)
----------------------------------------------------------------------------------------------------------------
Market Centers Other than Wholesalers:
Less than 100 shares..................................... 88.1 39.6 15.4
100 to 499 shares........................................ 88.9 14.8 11.5
500 to 1,999 shares...................................... 84.6 5.4 6.5
2,000 to 4,999 shares.................................... 89.3 3.0 8.1
5,000 to 9,999 shares.................................... 91.6 1.3 7.5
10,000 or more shares.................................... 92.8 0.3 3.8
Wholesalers:
Less than 100 shares..................................... 33.6 30.1 67.1
100 to 499 shares........................................ 70.7 13.4 48.1
500 to 1,999 shares...................................... 66.6 5.6 95.0
2,000 to 4,999 shares.................................... 54.8 4.3 93.7
5,000 to 9,999 shares.................................... 59.0 2.1 84.5
10,000 or more shares.................................... 83.8 0.3 60.7
All Market Centers and Order Sizes........................... 90.04 3.22 15.94
----------------------------------------------------------------------------------------------------------------
Table 6: Immediate-Or-Cancel (IOC) Share Volume, October 2018-October 2019. This table shows the percentage of
market and marketable limit orders submitted with IOC instructions, along with the fill rates of those orders,
using data from the Tick Size Pilot B.II Market and Marketable Limit Order dataset. See supra note 723 for
data description. This dataset contains an ``IOC'' flag, which is equal to ``Y'' if the order is an IOC order.
The Commission excluded orders outside of regular trading hours and identified retail wholesaler orders as
orders originating from seven trading center codes that the Commission understands to be retail wholesalers.
This is especially likely to be the case for wholesalers. The
Commission understands that IOC orders received by wholesalers are
typically institutional orders that are pinged in the wholesalers' SDPs
to see if any contra-side volume is available. This is supported by
Table 6, which shows that the differences between fill rates for IOC
and non-IOC orders are particularly stark for these market centers:
While wholesaler fill rates range between 60% and 95% for non-IOC
orders, they are mostly below 30% for IOC orders, and even smaller for
larger order sizes, dropping to just 0.3% for orders for 10,000 shares
or more. This is again consistent with the idea that wholesalers' IOC
orders may represent institutional orders that are routed to their
SDPs. Co-mingling SDP activity with other market center activity may
obscure differences in execution quality or distort the general
execution quality metrics for the market center.\724\ Similarly,
grouping together IOC orders along with other types of market and
marketable orders could impose a significant downwards skew on the fill
rates, in particular for larger order sizes and orders handled by
wholesalers. This may impact market centers' incentives to achieve
better execution quality for marketable orders.\725\
---------------------------------------------------------------------------
\724\ See supra section VII.C.2.(a)(2) for further discussion of
co-mingling SDP activity with other market center activity.
\725\ For example, if a market center's Rule 605 reports reveals
low fill rates for market orders simply because it handles a large
amount of marketable IOCs, it may not be incentivized to improve its
fill rates for other types of market orders since the higher fill
rates of these orders would be obscured by the low fill rates of
marketable IOCs.
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(8) Riskless Principal Orders
The Commission believes that current reporting of riskless
principal transactions \726\ leads to the duplicative reporting of
these orders, and creates uncertainty about how many orders are
internalized by off-exchange market centers, particularly wholesalers.
---------------------------------------------------------------------------
\726\ See supra note 416 and accompanying text for a definition
and discussion of riskless principal transactions.
---------------------------------------------------------------------------
In a riskless principal transaction, a market center routes a
principal order to a second market center, typically an exchange or
ATS, in order to fulfill a customer order; upon execution at the second
market center, the first market center executes the customer
transaction on the same terms as it received from the principal
execution at the second market center. Currently, for the purposes of
Rule 605 reporting, both the first and second market centers in this
example would report the riskless principal transaction as having been
executed at the market center under Rule 605(a)(1)(i)(D), rather than
as a part of the cumulative number of shares of covered orders executed
at any other venue under Rule 605(a)(1)(i)(E).\727\
---------------------------------------------------------------------------
\727\ See supra note 417 and accompanying text. In contrast, for
the purposes of SIP reporting, the away market center is required to
report the principal transaction to the tape, while the receiving
market center would post a non-tape (regulatory or clearing-only)
report to reflect the offsetting riskless customer transaction. When
the initial leg of the transaction takes place on and is reported
through an exchange, members are instructed not to report the
customer transaction for public dissemination purposes, as that
would result in double (tape) reporting of the same transaction. See
Trade Reporting Frequently Asked Questions, answers to Questions
302.2 and 302.4, available at https://www.finra.org/filing-reporting/market-transparency-reporting/trade-reporting-faq.
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[[Page 3858]]
The Commission believes that, particularly in the case of riskless
principal transactions that are handled by wholesalers, grouping
transactions that are handled on a riskless principal basis together
with other orders executed at the market center under Rule
605(a)(1)(i)(D) may obscure information about the extent to which
wholesalers internalize orders. Wholesalers primarily choose between
two options to execute the individual investor orders that they handle:
they either internalize orders by executing orders against their own
capital, or they execute orders on a riskless principal basis.\728\
While wholesalers' internalized orders are not exposed to competition
from other interested parties quoting on external market centers, their
riskless principal executions expose individual investor orders to
trading interest from market participants other than the wholesaler,
which has potential implications for differences in execution quality
between these two order types. Currently, both types of orders would be
categorized together as orders executed at the market center under Rule
605(a)(1)(i)(D), so market participants would not be able to tell from
Rule 605 reports whether a wholesaler internalizes the majority of its
individual investor order flow, or executes the majority as riskless
principal. Thus, key information that would be useful for investors
(particularly individual investors, whose orders are overwhelmingly
handled by wholesalers \729\) when interpreting and comparing
information about wholesalers' execution quality is currently missing
from Rule 605 reports.
---------------------------------------------------------------------------
\728\ See infra section VII.C.3.(b)(1) for further discussion of
the market for trading services, which includes wholesalers.
\729\ See supra note 614 for results from an analysis of retail
brokers' routing practices.
---------------------------------------------------------------------------
(d) Accessibility of Current Rule 605 Reports
Rule 605 currently requires market centers to post their monthly
reports on an internet website that is free of charge and readily
accessible to the public.\730\ There is currently no system or
requirement in place for the centralized posting of Rule 605 reports,
which results in search costs for market participants. In order to
collect a complete or mostly complete set of Rule 605 reports to, for
example, select the reporting entity offering the best execution
quality in a given stock, a market participant would need to perform
the following tasks, for each of the estimated 236 reporting entities
that are currently required to prepare Rule 605 reports: \731\ first,
search the internet for the website(s) of the reporting entity; second,
find the area of the reporting entity's website(s) that links to its
Rule 605 report; and third, find the correct link and download the
appropriate report (or multiple reports, if the information for
multiple months is desired).
---------------------------------------------------------------------------
\730\ See 17 CFR 242.605(a)(2) (requiring market centers to make
their Rule 605 reports ``available for downloading from an internet
website that is free and readily accessible to the public. . . .'').
\731\ See supra section VI.C for a discussion of the estimated
number of reporting entities under the proposed amendments.
---------------------------------------------------------------------------
The process of collecting Rule 605 reports may be simplified by the
NMS Plan's requirement that each market center must designate a single
Participant to act as the market center's Designated Participant, who
is tasked with maintaining a comprehensive list of the hyperlinks
provided by its market centers.\732\ Furthermore, certain reporting
entities' use of third-party vendors to prepare and/or collect Rule 605
reports may also simplify the process of collecting Rule 605 reports,
as these vendors typically maintain a centralized repository of the
reports that they handle.\733\ However, because an individual vendor or
Designated Participant may only offer a subset of Rule 605 reports or
hyperlinks to reports, which may not be a representative sample of
reports, it is still the case that collecting the complete or even a
mostly comprehensive set of Rule 605 reports could entail search
costs.\734\ In order to collect a complete set of reports, market
participants may still need to search the websites of and collect
reports from multiple vendors or Designated Participants.
---------------------------------------------------------------------------
\732\ See Section VIII of the Rule 605 NMS Plan. For a
description of ``Designated Participant'' as defined in the Plan,
see supra note 47.
\733\ See, e.g., Disclosure of SEC--Required Order Execution
Information, S&P Global, available at https://vrs.vista-one-solutions.com/sec605rule.aspx.
\734\ For these reasons and others, EMSAC has suggested
considering a centralized location for 605 reports. See EMSAC
Recommendations Regarding Rule 605 and 606, SEC, 4, available at
https://www.sec.gov/spotlight/emsac/emsac-recommendations-rules-605-606.pdf (stating that ``To further improve standardization and the
consistency of reporting, the SEC could consider centralizing report
creation in an unbiased and trusted source such as FINRA.''). The
Commission also notes that FINRA has proposed requiring members to
submit Rule 606(a) order routing reports to FINRA for publication on
the FINRA website. See Report from FINRA Board of Governors Meeting,
FINRA (Mar. 2022), available at https://www.finra.org/media-center/newsreleases/2022/report-finra-board-governors-meeting-march-2022
(describing proposed amendments to centrally host SEC Rule 606(a)
reports).
---------------------------------------------------------------------------
3. Markets for Brokerage and Trading Services for NMS Stocks Under
Current Rule 605 Disclosure Requirements
(a) Brokerage Services for NMS Stocks
(1) Current Structure of the Market for Brokerage Services
Based on information from broker-dealers' FOCUS Report Form X-17A-5
Schedule II, there were 3,498 registered broker-dealers as of Q2 2022.
A portion of these broker-dealers focus their business on individual
and/or institutional investors in the market for NMS stocks.\735\ These
include both carrying broker-dealers, who maintain custody of customer
funds and securities, and introducing broker-dealers, who accept
customer orders and introduce their customers to a carrying broker-
dealer that will hold the customers' securities and cash.\736\ The
Commission estimates that there are approximately 153 broker-dealers
that carry at least one customer trading in NMS stocks and
options,\737\ and 1,110 broker-dealers that introduce at least one
customer trading in NMS stocks and options.\738\
---------------------------------------------------------------------------
\735\ Some broker-dealers service only the accounts of other
brokers, which are excluded from the definition of customers. See
supra note 140 for a definition of ``customer.''
\736\ See supra note 174 for a description of introducing and
carrying broker-dealers. Some firms operate a hybrid introducing/
carrying broker-dealer by introducing on a fully disclosed basis to
a carrying broker-dealer those customers that trade securities for
which the broker-dealer is not prepared to provide a full range of
services. See, e.g., Securities Exchange Act Release No. 70073 (Aug.
21, 2013), 78 FR 51910 (Aug. 21, 2013) at 51911, 51949, and 51968.
\737\ This number is based on the number of broker-dealers that
report carrying at least one customer on their 2021 FOCUS Schedule I
reports.
\738\ This number is based on estimates using broker-dealers
FDIDs identified in CAT data during the 2021 calendar year. As CAT
data only includes information about NMS stocks and options, broker-
dealers that introduce or carry customers trading in other assets
classes are not included in these numbers. See infra note 1008 for a
discussion of the data and methodology for identifying introducing
broker-dealers.
---------------------------------------------------------------------------
When a customer places an order in an NMS stock with a broker-
dealer, the broker-dealer acts as an agent on behalf of that customer,
who generally wants to receive the best possible execution of their
order.\739\ These broker-dealers can generally decide how to route that
order for execution to an exchange, a wholesaler, or an ATS, where the
trade
[[Page 3859]]
may be executed or potentially routed further. The high level of
fragmentation of NMS stock trading \740\ means that broker-dealers have
a variety of choices for order routing and execution, and the venue
that a broker-dealer chooses may have a tangible effect on the
execution quality of an order.
---------------------------------------------------------------------------
\739\ Some investors may not value order-level execution quality
in all cases. For example, it is the Commission's understanding that
when an institutional customer submits a large order to be executed
on behalf of one account (e.g., a single mutual fund or pension
fund), it expects the broker-dealer that handles and executes such
large order to do so in a manner that ensures best execution is
provided to the ``parent'' order. See infra section
VII.C.3.(a)(1)(b) for further discussion.
\740\ See infra section VII.C.3.(b)(1) for a breakdown of
trading in NMS stocks across various types of trading venues.
---------------------------------------------------------------------------
A broker-dealer has a legal duty to seek best execution of customer
orders. The duty of best execution predates the federal securities laws
and is derived from an implied representation that a broker-dealer
makes to its customers.\741\ The duty is established from ``common law
agency obligations of undivided loyalty and reasonable care that an
agent owes to [its] principal.'' \742\ This obligation requires that a
``broker-dealer seek to obtain for its customer orders the most
favorable terms reasonably available under the circumstances.'' \743\
---------------------------------------------------------------------------
\741\ See, e.g., Newton v. Merrill, Lynch, Pierce, Fenner &
Smith, Inc., 135 F.3d 266, 270 (3d Cir.), cert. denied, 525 U.S. 811
(1998).
\742\ See id.
\743\ See id. See also Securities Exchange Act Release No.
37619A (Sept. 6, 1996), 61 FR 48290 (Sept. 12, 1996) (``Order
Execution Obligations Adopting Release''). A Report of the Special
Study of Securities Markets stated that ``[t]he integrity of the
industry can be maintained only if the fundamental principle that a
customer should at all times get the best available price which can
reasonably be obtained for him is followed.'' See SEC Report of the
Special Study of Securities Markets, H.R. Doc. No. 95, 88th Cong.,
1st Sess. Pt. II, 624 (1963) (``Special Study'').
---------------------------------------------------------------------------
Investors may incur switching costs when changing broker-dealers,
such as the cost of withdrawing or transferring funds and potential
administrative fees. Switching broker-dealers could also involve time
delays resulting in lost investment opportunities or revenues and other
opportunity costs.\744\ Furthermore, some customers that rely on
broker-dealers' non-execution-related services, such as providing
recommendations, holding customers' funds and securities and/or
providing analyst research, may find it more costly to switch broker-
dealers, as these services would be more difficult to transfer across
broker-dealers. However, the Commission understands that some broker-
dealers, including some that cater to individual investors, will
compensate new customers for transfer fees that their outgoing broker-
dealer may charge them, which would result in lower (or even zero)
switching costs.\745\ The Commission understands that some investors,
particularly institutional investors, are likely to use multiple
broker-dealers,\746\ which would tend to lead to lower switching costs
as a customer that is unhappy with one broker-dealer could simply use
one of their other broker-dealers to handle those orders.
---------------------------------------------------------------------------
\744\ See, e.g., Understanding the Brokerage Account Transfer
Process, FINRA, available at https://www.finra.org/investors/learn-to-invest/brokerage-accounts/understanding-brokerage-account-transfer-process.
\745\ See, e.g., Scott Connor, Thinking about Switching to TD
Ameritrade? Transferring is Easier than You Might Think, TD
Ameritrade (Oct. 17, 2019), available at https://tickertape.tdameritrade.com/investing/how-to-switch-brokers-17755
(``If your broker does charge you a transfer fee, TD Ameritrade will
refund you up to $100.'').
\746\ For example, one academic paper finds that institutional
investors tend to break up larger orders and spread them out across
multiple broker-dealers, as a strategy to avoid information leakage.
See, e.g., Munhee Han & Sanghyun (Hugh) Kim, Splitting and
Shuffling: Institutional Trading Motives and Order Submissions
Across Brokers (working paper Sept. 30, 2020), available at https://ssrn.com/abstract=3429452 (retrieved from SSRN Elsevier database).
---------------------------------------------------------------------------
The Commission understands that the structure of the market for
brokerage services can broadly be separated into two distinct markets--
brokerage services for individual investors on the one hand, and
brokerage services for institutional investors on the other--that
differ somewhat in terms of their market structure.
(a) Brokerage Services for Individual Investors
As of the end of 2021, there were approximately 1,037 registered
broker-dealers that originated orders on behalf of individual investors
in the market for NMS stocks.\747\ Unlike institutional investors,
individual investors generally use a single broker to handle their
orders. Retail brokers can broadly be divided into ``discount'' brokers
and ``full-service'' brokers.\748\ Competition between discount brokers
for the business of individual investors in particular has recently
resulted in many new entrants and a decline in commissions to zero or
near zero.\749\ Instead of commissions on certain transaction, these
discount brokers earn revenue through other means, including, among
other products and services, interest on margin accounts and from
lending securities, as well as broker-wholesaler arrangements involving
PFOF paid by the wholesaler to the retail broker. Discount broker-
dealers can distinguish themselves by the accessibility and
functionality of their trading platform, which can be geared towards
less experienced or more sophisticated investors, and by providing more
extensive customer service as well as tools for research and education
on financial markets.
---------------------------------------------------------------------------
\747\ This number is estimated using the CAT data described
infra in note 1008. Individual investor accounts are identified in
CAT as accounts belonging to the ``Individual Customer'' account
type, defined as accounts that do not meet the definition of FINRA
Rule 4512(c) and are also not proprietary accounts. See supra note
609 for more information about account types in CAT.
\748\ Note that there is not necessarily a precise delineation
between full-service and discount brokers. Discount brokers
generally provide execution-only services, typically at a reduced or
zero commission rate. Full-service brokers (as they are commonly
called) typically charge commissions in exchange for a package of
services, including execution, incidental investment advice, and
custody. See, e.g., Interpretive Rule Under the Advisers Act
Affecting Broker-Dealers, Advisers Act Release No. 2652 (Sept. 24,
2007), notes 2 and 20.
\749\ See, e.g., Samuel Adams & Connor Kasten, Retail Order
Execution Quality under Zero Commissions, (working paper Jan. 7,
2021), available at https://ssrn.com/abstract=3779474 (retrieved
from SSRN Elsevier database), describing how ``on October 1st, 2019,
Charles Schwab announced that they would cut commissions from $4.95
per trade to zero on all retail trades starting on October 7th.
Within hours, TD Ameritrade followed by announcing they would cut
commissions to zero from $6.95 beginning on October 3rd. By January
3rd, Vanguard, Fidelity, and E*TRADE had joined the trend in
offering free equity trades for retail investors.''
---------------------------------------------------------------------------
(b) Brokerage Services for Institutional Investors
As of the end of 2021, there were approximately 909 registered
broker-dealers that originated institutional orders in the market for
NMS stocks.\750\ One feature that distinguishes the market for
institutional brokerage services is that a significant portion of
institutional investor orders are generally ``not held'' orders.\751\ A
broker-dealer has time and price discretion in executing a not held
order, and institutional investors in particular rely on such
discretion for various reasons including minimizing price impact.\752\
Due to the large size of institutional trading interests, broker-
dealers will often split orders when handling their orders, often
through the use of SORs. Specifically, a broker-dealer or its SOR will
split up a ``parent'' order into multiple ``child'' orders, with the
goal of executing the child orders in a way that achieves the
[[Page 3860]]
best execution for the parent order.\753\ For example, a broker-dealer
may not execute a child order at the best price, if doing so could
result in a larger price impact and increases the overall cost of
working a parent order. For this reason, most institutional parent
orders are handled by broker-dealers on a not held basis, which would
exclude these orders from Rule 605 execution quality disclosure
requirements.\754\ However, since 2018, broker-dealers are required by
Rule 606(b)(3) to provide individualized reports of execution quality
of not held orders upon request.\755\
---------------------------------------------------------------------------
\750\ This number is estimated using the CAT data described in
infra note 1008. Institutional investor accounts are identified in
CAT as accounts belonging to the ``Institutional Customer'' account
type, defined as accounts that meet the definition in FINRA Rule
4512(c). See supra note 609 for more information about account types
in CAT.
\751\ See supra note 538 discussing an analysis showing that
institutional investors are more likely than individual investors to
use not held orders.
\752\ See 2018 Rule 606 Amendments Release, 83 FR 58338 nn.60-61
and corresponding text. Meanwhile, a broker-dealer must attempt to
execute a held order immediately, which typically better suits
individual investors who seek immediate executions and rely less on
broker-dealer order handling discretion.
\753\ See Tyler Beason & Sunil Wahal, The Anatomy of Trading
Algorithms, (working paper Jan. 21, 2021), available at https://ssrn.com/abstract=3497001 (retrieved from SSRN Elsevier database).
\754\ Note that some child orders may be held orders and thus
would be required to be included in Rule 605 reports.
\755\ See supra note 60 and accompanying text discussing broker-
dealers requirements under Rule 606(b)(3) to provide individualized
reports of execution quality upon request for not held orders.
---------------------------------------------------------------------------
(2) Competition Between Broker-Dealers on the Basis of Execution
Quality
Broker-dealers compete with one another along a variety of
dimensions,\756\ including the execution quality that they offer, and
make their execution quality known in a variety of ways. For example,
at least one broker-dealer published execution quality reports using
the FIF template,\757\ and furthermore some broker-dealers disclose
their own execution quality metrics on their websites.\758\ Broker-
dealers may seek to improve their competitive position on the basis of
execution quality by, for example, investing in the speed and quality
of their routing technology. Broker-dealers may also compete on the
basis of execution quality by reevaluating their routing strategies to
increase the extent to which they route orders to the market centers
offering better execution quality.
---------------------------------------------------------------------------
\756\ For example, broker-dealers may compete by charging lower
commissions for trading, or by offering a wider range of services or
functionalities, such as trading in additional asset classes such as
options.
\757\ See supra note 554.
\758\ See supra note 506 for examples.
---------------------------------------------------------------------------
As discussed above,\759\ when making routing decisions, some
broker-dealers may face conflicts of interest that misalign their
interests with their customers' interest in receiving better execution
quality. These conflicts of interest could result, for example, from
broker-dealer affiliations with market centers. Some broker-dealers
operate or are otherwise affiliated with ATSs, which implies a possible
conflict of interest relative to their customers' best interests in
that these broker-dealers may give preference to routing orders to
their own ATSs, where they typically pay lower transaction fees, even
if their customer would have received better execution quality if the
order were routed to another trading venue. At least one academic study
has shown that broker-dealers that route orders to their ATSs obtain
worse execution quality.\760\ Similarly, presence of liquidity fees and
rebates on some market centers may incentivize broker-dealers to make
routing decisions based on where they can receive the highest rebate
(or pay the lowest fee), rather than where they can receive better
execution quality on behalf of their customer.\761\ For example, a
recent research paper analyzed the relation between maker-taker fee
schedules and order routing, and found a negative relation between take
fees and limit order execution quality.\762\ Another potential conflict
of interest, particularly with regard to individual investor order
flow, includes the receipt of PFOF, which may result in broker-dealers
routing orders to wholesalers as a result of the terms of the PFOF
arrangements.\763\
---------------------------------------------------------------------------
\759\ See supra section VII.C.2.(a)(1).
\760\ See Amber Anand, Mehrdad Samadi, Jonathan Sokobin & Kumar
Venkataraman, Institutional Order Handling and Broker-Affiliated
Trading Venues, 34 Rev. Fin. Studies 3364 (2021).
\761\ See, e.g., Robert H. Battalio, Shane A. Corwin, & Robert
H. Jennings, Can Brokers Have It All? On the Relation Between Make-
Take Fees and Limit Order Execution Quality, 71 J. Fin. 2193 (2016).
\762\ See id. The authors ``document a strong negative relation
between take fees and several measures of limit order execution
quality. Based on this evidence, [they] conclude that the decision
of some national brokerages to route all nonmarketable limit orders
to a single exchange paying the highest rebate is not consistent
with the broker's responsibility to obtain best execution for
customers.''
\763\ The study by Schwarz et al. (2022) in supra note 529 does
not find a relationship between the amount of PFOF a retail broker
receives and the amount of price improvement their customers' orders
receive. However, the authors noted that the variation in the
magnitude of price improvement they saw across retail brokers was
significantly greater than the amount of PFOF the retail broker
received, which could indicate their sample was not large enough to
observe a statistically significant effect.
---------------------------------------------------------------------------
If information asymmetries, such as those resulting from
insufficient public information about broker-dealer execution
quality,\764\ prevent investors from observing differences in execution
quality across broker-dealers, this would limit the extent to which
broker-dealers would need to keep these conflicts of interest in check
and compete on the basis of execution quality.
---------------------------------------------------------------------------
\764\ See supra section VII.C.2.(a)(1) discussing broker-
dealers' current execution quality reporting requirements.
---------------------------------------------------------------------------
(b) Trading Services for NMS Stocks
(1) Current Structure of the Market for Trading Services
Trading services for NMS stocks are highly fragmented among
different types of market centers.\765\ Table 7 shows that in Q1 of
2022, NMS stocks were traded on 16 national securities exchanges and
off-exchange at 32 NMS Stock ATSs and at over 230 other FINRA members,
including 6 wholesalers that internalize the majority of individual
investor marketable orders.\766\ National securities exchanges execute
approximately 60% of total share volume in NMS stocks, while off-
exchange market centers execute approximately 40% of total share
volume.\767\ The majority of off-exchange volume is executed by
wholesalers, who execute almost one quarter of total share volume
(23.9%) and about 60% of off-exchange volume. Some OTC market makers,
such as wholesalers, operate SDPs through which they execute
institutional orders in NMS stocks against their own inventory.\768\
SDPs accounted for approximately 4% of total trading volume in Q1
2022.\769\ As of June 2022, the Commission estimates that there are
currently 236 market centers to which Rule 605 applies.\770\
---------------------------------------------------------------------------
\765\ Some academic studies attribute the highly fragmented
nature of this market to implementation of Regulation NMS. See,
e.g., Maureen O'Hara & Mao Ye, Is Market Fragmentation Harming
Market Quality?, 100 J. Fin. Econ. 459 (2011); Amy Kwan, Ronald
Masulis & Thomas H. MacInish, Trading Rules, Competition for Order
Flow and Market Fragmentation, 115 J. Fin. Econ. 330 (2015).
\766\ See Concept Release on Equity Market Structure, 75 FR
3594, 3598-3560 (Jan. 21, 2010) (for a discussion of the types of
trading centers); see also Form ATS-N Filings and Information,
available at https://www.sec.gov/divisions/marketreg/form-ats-n-filings.htm. These wholesalers were determined based on marketable
order routing information from retail broker Rule 606(a)(1) reports.
\767\ This analysis uses data from prior to the implementation
of the MDI Rules. The implementation of the MDI Rules may result in
a change in the flow of orders across trading venues, which may
result in numbers that are different from those reported here.
However, the Commission is uncertain of the magnitude of these
effects. See supra section VII.C.1.(d)(2) for further discussion.
\768\ See Rosenblatt Securities (2022), US Equity Trading Venue
Guide. Wholesalers and OTC market makers can execute orders
themselves or route orders to be executed on other venues. An SDP
always acts as the counterparty to any trade that occurs on the SDP.
See, e.g., Where Do Stocks Trade?, FINRA (Dec. 3, 2021), available
at https://www.finra.org/investors/insights/where_do_stocks_trade">https://www.finra.org/investors/insights/where_do_stocks_trade.
\769\ See Rosenblatt Securities (2022), US Equity Trading Venue
Guide.
\770\ See supra section VI.C for a discussion of this estimate.
Some market centers may not be required to prepare Rule 605 reports,
for example, if they do not handle any covered orders.
[[Page 3861]]
Table 7--NMS Stock Traded Share Volume Percentage by Market Center Type
----------------------------------------------------------------------------------------------------------------
Off-exchange
Share volume (% share volume (%
Market center type Venue count of total of total off-
volume) exchange)
----------------------------------------------------------------------------------------------------------------
NMS Stock ATSs................................................ 32 10.2 25.2
National Securities Exchanges................................. 16 59.7 ...............
Wholesalers................................................... 6 23.9 59.4
Other FINRA Members........................................... 232 6.3 15.6
----------------------------------------------------------------------------------------------------------------
Table 7: NMS Stock Traded Share Volume Percentage by Market Center Type. This table reports the percentage of
all NMS stock executed share volume and the percentage of NMS stock share volume executed off-exchange for
different types of market centers for Q1 2022, including lists the number of venues in each market center
category. Exchange share volume and total market volume are based on CBOE Market Volume Data on monthly share
volume executed on each exchange available at: https://cboe.com/us/equities/market_statistics/historical_market_volume/. NMS Stock ATS, wholesaler and FINRA member share volume are based on monthly data
from FINRA OTC (Non-ATS) Transparency Data Monthly Statistics, available at: https://otctransparency.finra.org/otctransparency/OtcData otctransparency/OtcData; and FINRA ATS Transparency Data Monthly Statistics, available at: https://otctransparency.finra.org/otctransparency/AtsBlocksDownload. This analysis uses data from prior to the
implementation of the MDI Rules and specific numbers reported may be different following the implementation of
the MDI Rules. See supra note 767 and section VII.C.1.(d)(2).
These market centers, among other things, match traders with
counterparties, provide a framework for price negotiation and provide
liquidity to those seeking to trade, to supply investors with execution
services at efficient prices. Market centers' primary customers are the
broker-dealers that route their own orders or their customers' orders
for execution at the trading center, and market centers compete with
each other for these customers on a number of dimensions, including
execution quality.
Broker-dealers may face switching costs from changing the primary
trading venues to which they route orders. For example, the extent to
which broker-dealers may have long-term contractual arrangements to
route orders to specific market centers would hamper their ability to
switch trading venue. The common practice across national securities
exchanges of setting fee and rebate schedules where specific tiers are
determined by execution volume \771\ may also make it difficult of
broker-dealers to transfer order flow between market centers. Volume-
based tiering gives broker-dealers an incentive to concentrate orders
on a given exchange, not because that exchange may offer the best
execution quality but because doing so can allow a broker-dealer to
execute sufficient volume on the exchange to qualify for a better tier
and receive a lower fee or higher rebate. In addition, for national
securities exchanges, upfront connectivity fees associated with
establishing a connection to a new exchange could also discourage
switching.
---------------------------------------------------------------------------
\771\ Some national securities exchanges typically currently use
volume calculated on a monthly basis to determine the applicable
threshold or tier rate. See, e.g., fee schedules of NASDAQ PSX,
available at https://listingcenter.nasdaq.com/rulebook/phlx/rules/Phlx%20Equity%207 (as of July 2022) (calculating fees based on
``average daily volume during the month''); and Cboe EDGA, EDGA
Equities Fee Schedules, available at https://www.cboe.com/us/equities/membership/fee_schedule/edga/ (as of Apr. 1, 2022)
(calculating fees based on ``average daily volume'' and ``daily
volume'' on a monthly basis).
---------------------------------------------------------------------------
While national securities exchanges cater to a broader spectrum of
investors, ATSs and OTC market makers, including wholesalers, tend to
focus more on providing trading services for either institutional or
individual investor order flow. For example, an analysis of retail
brokers' routing practices showed that a group of six wholesalers
handled more than 87% of the customer orders of retail brokers in Q1
2022.\772\ Meanwhile, SDPs are mainly used for institutional orders, to
avoid exposure to potentially more informed order flow on other trading
venues.\773\
---------------------------------------------------------------------------
\772\ See supra note 614 for more details about this analysis.
\773\ See, e.g., Yashar H. Barardehi, et al., Internalized
Retail Order Imbalances and Institutional Liquidity Demand (working
paper revised May 23, 2022), available at https://ssrn.com/abstract=3966059 (retrieved from SSRN Elsevier database).
---------------------------------------------------------------------------
(2) Competition Between Trading Venues on the Basis of Execution
Quality
Trading venues compete with one another on the basis of the
execution quality that they offer, as well as on the basis of other
potential factors.\774\ As discussed above, Rule 605 reports are
currently a useful proxy that investors and their broker-dealers can
use to assess and compare the execution quality that they can expect to
receive across market centers,\775\ and there is evidence that broker-
dealers factor in information about the execution quality of market
centers from Rule 605 reports when making their order routing
decisions. One academic study attributes a significant decline in
effective and quoted spreads following the implementation of Rule 605
to an increase in competition between market centers, who improved the
execution quality that they offered in order to attract more order
flow.\776\ Market centers may seek to improve their competitive
position on the basis of execution quality by, for example, investing
in the speed and quality of their execution technology.
---------------------------------------------------------------------------
\774\ For example, national securities exchanges may adjust fees
and rebates to incentivize broker-dealers to route more order flow
to them. The use of liquidity rebates have also allowed national
securities exchanges to compete with off-exchange market centers for
order flow by making it more expensive to offer price improvement
over the displayed NBBO. See Transaction Fee Pilot for NMS Stocks,
84 FR 5202 (Feb. 20, 2019) at 5255.
\775\ See supra section VII.C.1.(a).
\776\ See Zhao & Chung.
---------------------------------------------------------------------------
Market centers have less of an incentive to compete and innovate on
execution quality to the extent that broker-dealers route orders for
reasons other than execution quality. As discussed above, if
information asymmetries, such as those resulting from insufficient
public information about broker-dealer execution quality, prevent
investors from observing differences in execution quality across
broker-dealers, this would limit the extent to which broker-dealers
would need to compete on the basis of execution quality.\777\ Market
centers also have less of an incentive to compete on the basis of
execution quality to the extent that broker-dealers and other market
participants are less able to use Rule 605 reports to compare execution
quality across market centers, for example, as a result of erosions to
the information content of Rule 605 statistics due to changes in market
conditions,\778\ or to the extent that Rule
[[Page 3862]]
605 does not include some relevant order sizes or types.\779\
---------------------------------------------------------------------------
\777\ See supra section VII.C.3.(a)(2).
\778\ For example, market centers may be less incentivized to
compete on the basis of execution speed to the extent that, as a
result of rapid increases in the speed of trading, market
participants are less able to use time-to-execution measures from
Rule 605 reports to compare across market centers. See supra section
VII.C.2.(c)(4) for further discussion.
\779\ For example, market centers may be less likely to compete
on the basis of execution quality for orders of less than 100
shares, since these orders are not required to be included in Rule
605 reports. See supra section VII.C.2.(b)(1)(b) for further
discussion.
---------------------------------------------------------------------------
D. Economic Effects
The proposed amendments modifying the reporting requirements under
Rule 605 may result in numerous beneficial economic effects. These
economic effects would mainly derive from improvements in the
transparency of execution quality of broker-dealers and market centers,
which would promote competition among these reporting entities on the
basis on execution quality. However, the proposed amendments to Rule
605 may also result in initial and ongoing compliance costs to
reporting entities.
As discussed above, this section measures the economic effects of
the proposed amendments relative to a regulatory baseline that includes
the implementation of the MDI Rules.\780\ Furthermore, this section
reflects the Commission's assessment of the anticipated economic
effects, including potentially countervailing or confounding economic
effects from the MDI Rules.\781\ However, given that the MDI Rules have
not yet been implemented, they have not affected market practice and
therefore data that would be required for a comprehensive quantitative
analysis of the economic effects that includes the effects of the MDI
Rules is not available. It is possible that the economic effects
relative to the baseline could be different once the MDI Rules are
implemented. Where implementation of the above-described MDI Rules may
affect certain numbers, the description of the economic effects below
notes those effects.
---------------------------------------------------------------------------
\780\ See supra section VII.C.1.(d).
\781\ See supra section VII.C.1.(d)(2) for a discussion of the
Commission's anticipated economic effects of the MDI Rules as stated
in the MDI Adopting Release.
---------------------------------------------------------------------------
1. Benefits
The Commission believes that the proposed amendments would promote
increased transparency of order execution quality as a result of the
expansion and modernization of Rule 605 disclosure requirements, as
well as a requirement for reporting entities to prepare summary
reports, which would improve market participants' ability to use Rule
605 reports and the information contained therein to compare execution
quality across reporting entities. This in turn would lead to increased
competition between reporting entities on the basis of execution
quality, leading to improvements in the execution quality received by
investors as competition between reporting entities would be create
incentives to offer better execution quality in order to attract and
retain customers and order flow.
(a) Increase in Transparency and Access to Information About Execution
Quality
The Commission believes that the proposed amendments would promote
increased transparency of order execution quality, particularly for
larger broker-dealers who were not previously required to disclose
execution quality information under Rule 605, but also for all
reporting entities, whose execution quality information would be more
relevant and easier to access as a result of improvements to existing
Rule 605 disclosure requirements.
(1) Expanding the Scope of Reporting Entities
(a) Expanding Requirements for Larger Broker-Dealers
The proposed amendment expanding the scope of Rule 605 reporting
entities to include larger broker-dealers \782\ would increase
transparency into the differences in execution quality achieved by
these broker-dealers when they route customer orders to execution
venues.\783\ Broker-dealers that route customer orders have many
choices about where to route customer orders for execution,\784\ and
their routing decisions affect the execution quality that their
customers' orders receive.\785\ To ensure that they are directing their
orders to the broker-dealer(s) that are able to achieve better
execution quality, investors, along with other market participants,
have a vested interest in their ability to accurately assess the
execution quality that their broker-dealers are able to achieve.
However, in the current regulatory environment, the ability of some
customers to assess the execution quality that their broker-dealers are
providing for their held orders may be limited.\786\
---------------------------------------------------------------------------
\782\ See supra section III.A for further discussion of the
proposed amendments related to the expansion of Rule 605 reporting
entities to include larger broker-dealers.
\783\ The EMSAC and commenters generally supported expanding the
Rule's scope beyond market centers, including to broker-dealers. See
supra notes 103-119 and accompanying text. The Commission believes
that these effects would principally accrue to larger broker-
dealers, who would be required to prepare Rule 605 reports, but may
spill over to effect smaller broker-dealers as well. See discussion
in infra section VII.D.1.(d)(1).
\784\ See supra section VII.C.3.(b)(1), discussing fragmentation
in the market for trading services for NMS stocks.
\785\ See, e.g., supra note 529 and accompanying text,
describing a recent academic working paper finding significant
variations in execution quality across broker-dealers.
\786\ See supra section VII.C.2.(a)(1) for a discussion of
limitations to investors' abilities to use Rule 606 and Rule 605
reports to estimate the execution quality achieved by broker-
dealers. Note that institutional investors may have access to
alternative sources of information about execution quality. See
supra section VII.C.1.(c)(2) for a discussion.
---------------------------------------------------------------------------
As a result of the proposed amendments, customers of these broker
dealers, along with other market participants, would no longer need to
make inferences about these broker-dealers' execution quality based on
broker-dealer routing information from Rule 606 data combined with
market centers' execution quality information from Rule 605 data, but
would have access to direct information about the aggregate execution
quality achieved by these broker-dealers.\787\ Customers could then use
this information to compare across broker-dealers and select those
broker-dealers offering better execution quality. Furthermore, combined
with information about broker-dealers' payment relationships with
execution venues in quarterly reports prepared pursuant to Rule
606(a)(1), information about the aggregate execution quality obtained
by larger broker-dealers that are in the business of routing customer
orders would give market participants and other interested parties
access to key information that would facilitate their ability to
evaluate how these payment relationships may affect execution quality.
---------------------------------------------------------------------------
\787\ This effect would be enhanced by the requirement that
broker-dealers publish Rule 605 reports for their broker-dealer
activities separately from activities related to the market
center(s) that they may operate, which would allow investors to
access execution quality information that is exclusively related to
the firm's broker-dealer operations. See supra note 182 and
accompanying text.
---------------------------------------------------------------------------
Under the proposed amendments, larger broker-dealers would be
required to categorize the execution quality information required by
Rule 605 using the same categories that market centers would be
required to use, including by individual security, different types of
orders, and different order sizes. As with market centers, a particular
broker-dealer's order flow may be made up of a different mixture of
securities, order types, and order sizes, which may impact or constrain
that broker-dealer's
[[Page 3863]]
overall execution quality level.\788\ For example, Figure 14, which
uses a week of CAT data \789\ to break down broker-dealer order flow
into different order types, shows that broker-dealers indeed handle a
variety of order types, including both marketable and non-marketable
orders, for both their individual and institutional investor customers.
Giving market participants access to this information in Rule 605
reports would ensure that they are able to control for these
differences in order flow characteristics when assessing and comparing
execution quality information across broker-dealers.
---------------------------------------------------------------------------
\788\ See supra note 513 for an example of how differences in
order flow characteristics may impact inferences about execution
quality.
\789\ See supra note 609 for dataset description.
---------------------------------------------------------------------------
Figure 14: Broker-Dealer Order Volume by Order Type, January 3-7, 2022
[GRAPHIC] [TIFF OMITTED] TP20JA23.014
The proposed amendment for larger broker-dealers to report both the
number of shares executed at the receiving broker-dealer and the number
of shares executed at any other venue \790\ would ensure that Rule 605
reports capture the execution quality of all orders that larger broker-
dealers receive for execution as part of their customer-facing broker-
dealer function. The majority of executions resulting from a firm's
broker-dealer operations would likely be categorized as away-executed
shares in the Rule 605 reports associated with its broker-dealer
operations.\791\ While these shares would not be categorized as being
directly executed by the broker-dealer, it is likely that market
participants understand that execution quality can depend significantly
on the broker-dealers' order handling and routing practices.
---------------------------------------------------------------------------
\790\ See 17 CFR 242.605(a)(1)(i)(D) and (E). As discussed
herein, the Commission is proposing to modify Rule 605(a)(1)(i)(D)
to also cover the number of shares executed at the receiving broker
or dealer. See supra note 155 and accompanying text.
\791\ To the extent that a broker-dealer also acts as a market
center, any executions that it handles would be required to be
published in the Rule 605 report(s) that it files in its capacity as
a market center.
---------------------------------------------------------------------------
The proposed amendments would also require larger broker-dealers to
report the same execution quality information as market centers,
including information about execution prices, execution speeds, and
fill rates,\792\ as well as, as a result of the proposed amendments,
information about size improvement.\793\ The Commission acknowledges
that there are certain ways in which broker-dealers may systematically
differ from market centers in terms of their execution quality
statistics; for example, due to their need to reroute orders that they
receive for execution, broker-dealers are likely to have a longer
execution time as measured from the time of order receipt, as compared
to market centers who can execute orders immediately without the need
to reroute. However, these differences are generally well-known to
market participants, who would be able to account for these differences
in assessing execution quality. Furthermore, it is unlikely that market
participants would use information in Rule 605 reports to compare
broker-dealers to market centers, as information about the execution
quality of these two types of reporting entities is useful to different
market participants for fundamentally different purposes. In terms of
the principal-agent problems described in the Market Failure
section,\794\ information about execution quality for broker-dealers
solves a different principal-agent problem than information about
execution quality for market centers. Broker-dealers' Rule 605 reports
would be more likely to be used by broker-dealers' customers to compare
execution quality across broker-dealers to alleviate the principal-
agent problem that exists between broker-dealers and their customers.
In contrast, market
[[Page 3864]]
centers' Rule 605 reports would continue to be more useful for broker-
dealers to compare execution quality across market centers to alleviate
the principal-agent problem that exists between broker-dealers and the
market centers to which they route their customers' orders.
---------------------------------------------------------------------------
\792\ See supra section VII.C.1.(a) for a discussion of the
economic significance of the execution quality information currently
required by Rule 605 to be disclosed by market centers.
\793\ See proposed Rule 605(a)(1)(i)(F) and discussion in supra
section IV.B.4.(e).
\794\ See supra section VII.B.
---------------------------------------------------------------------------
The Commission is mindful that Rule 605's execution quality reports
contain a large volume of statistical data, and as a result it may be
difficult for individual investors to review and digest the reports. By
requiring larger brokers-dealers to report stock-by-stock order
execution information in a uniform manner, the current proposal would
make it possible for market participants and other interested parties
to make their own determinations about how to group stocks or orders
when comparing execution quality across broker-dealers. Requiring
larger broker-dealers to produce more detailed execution quality data
would also help ameliorate potential concerns about overly general
statistics, or about the specific categorization of orders and
selection of metrics in the summary reports, by allowing market
participants and other interested parties to conduct their own analysis
based on alternative categorizations of the underlying data. Should
certain market participants not have the means to directly analyze the
detailed statistics,\795\ independent analysts, consultants, broker-
dealers, the financial press, and market centers likely will continue
to respond to the needs of investors by analyzing the disclosures and
producing more digestible information using the data to the extent that
they currently do so.\796\ Furthermore, requiring all market centers
and larger broker-dealers to prepare summary reports with aggregated
execution quality information \797\ as well as Rule 605 reports would
strike a balance between ensuring that market participants have access
to detailed execution quality information, and providing an overview of
execution quality information that may be more accessible for some
market participants.\798\
---------------------------------------------------------------------------
\795\ See Adopting Release, 65 FR 75414 (Dec. 1, 2000) at 75419
(stating that most individual investors likely would not obtain and
digest the reports themselves). See also supra note 112 and
accompanying text (EMSAC committee member stating that retail
investors will not look at the Rule 605 reports); Angel Letter at 3
(commenter stating that Rule 605 data is too raw for most investors
to interpret); and See Consumer Federation II at 10 (commenter
stating that most retail investors may not use the disclosures
directly).
\796\ See, e.g., supra notes 545-547, describing the use of Rule
605 data in academic literature, in comment letters related to
Commission and SRO rulemaking, and the financial press.
\797\ See proposed Rule 605(a)(2).
\798\ Several EMSAC committee members argued in favor of
requiring broker-dealers to file Rule 605 reports rather than only
summary reports. See supra notes 112-114 and accompanying text.
---------------------------------------------------------------------------
(b) Specifying and Expanding Requirements for Market Centers
In addition to the proposed amendment expanding the scope of Rule
605 reporting entities to include larger broker-dealers, the Commission
believes that additional proposed modifications to the scope of
reporting entities would also promote increased transparency.
A proposed amendment specifies that broker-dealers that operate
ATSs must prepare Rule 605 reports for their ATSs that are separate
from the reports for their other trading activities.\799\ Another
proposed amendment requires that market centers operating SDPs post
separate reports for each entity.\800\ These amendments would address
directly what Rule 605 requires with respect to reporting by firms that
operate multiple market centers, thus increasing the transparency of
each reporting entity's execution quality and limiting the co-mingling
of information about multiple types of reporting entities into a single
report, which, to the extent that it occurs, may currently add noise to
or skew Rule 605 reports. For example, requiring market centers that
operate SDPs to report statistics separately for each line of business
would increase the transparency of the operating market centers' fill
rates by eliminating the downwards skew from including ``pinging''
orders submitted to the SDP into their Rule 605 reports.\801\ Market
participants would be better informed about the execution quality of
each reporting entity, which would facilitate comparisons across
reporting entities.
---------------------------------------------------------------------------
\799\ See proposed Rule 605(a)(1). See also supra note 214 and
accompanying text. See supra note 212 and accompanying text for
discussion of suggestions from the EMSAC and commenters related to
reporting requirements for ATSs.
\800\ See proposed Rule 605(a)(1). See also supra note 219 and
accompanying text.
\801\ See supra section VII.C.2.(a)(2) for a discussion of why
the co-mingling of wholesaler and SDP orders for the purposes of
Rule 605 reporting will effect a downwards skew on the fill rates
derived from the wholesalers' Rule 605 reports.
---------------------------------------------------------------------------
If the Order Competition Rule Proposal is adopted,\802\ the
proposed amendment requiring separate Rule 605 reports for qualified
auctions \803\ would also promote increased transparency. First, it
would allow for easier comparisons of how execution quality varies
across qualified auctions. Second, it would limit the extent to which
co-mingling qualified auction statistics with other orders executed on
a market center add noise to or skew that market center's Rule 605
report. For example, orders submitted to a qualified auction may be
more likely to receive price improvement, and may have systematically
different fill rates and time-to-executions, as compared to similar
orders executed in other trading mechanisms.\804\
---------------------------------------------------------------------------
\802\ See Order Competition Rule Proposal.
\803\ See proposed Rule 605(a)(1). See also supra note 203 and
accompanying text.
\804\ See supra section III.B for further discussion.
---------------------------------------------------------------------------
The proposed amendment expanding the order size categories required
by Rule 605 to include information about fractional shares \805\ would
also expand the scope of reporting entities to include an estimated 20
additional market centers \806\ that currently exclusively execute
fractional shares and that were previously not required to file Rule
605 reports due to fractional shares falling below the smallest order
size category in the current Rule 605. This would increase transparency
about the execution quality achieved by these market centers.
---------------------------------------------------------------------------
\805\ See proposed Rule 600(b)(19).
\806\ See supra note 486 for further discussion of this
estimate.
---------------------------------------------------------------------------
(2) Modifications to Rule 605 Disclosure Requirements
The Commission believes that, as a result of the proposed
amendments expanding and modernizing Rule 605 disclosure requirements,
the metrics contained in Rule 605 would be more informative about
execution quality, which would increase transparency into the
differences in execution quality achieved by reporting entities. These
improvements in transparency would stem from modifications aimed at
clarifying and expanding the scope of Rule 605 reporting entities,
modernizing the information required to be reported under Rule 605, and
improving the accessibility of the information contained in Rule 605
reports.
(a) Expanding the Definition of Covered Orders
The proposed amendments expanding the definition of covered orders
to include additional order types would increase transparency about the
execution quality that reporting entities achieve for these additional
order types, including orders submitted outside of regular trading
hours, orders submitted with stop prices, and non-exempt short sale
orders.\807\
---------------------------------------------------------------------------
\807\ Commenters have suggested various ways to expand or modify
the definition of covered order, including broadening its scope to
capture additional order types. See supra notes 122-125 and
accompanying text.
---------------------------------------------------------------------------
[[Page 3865]]
First, the proposed amendment expanding the definition of ``covered
orders'' to include NMLOs submitted outside of regular trading hours
that become executable during regular trading hours \808\ would lead to
a more complete picture of reporting entities' execution
characteristics.\809\ While an analysis using CAT data shows that pre-
open/post-close orders that are executable during regular hours are
likely only a small portion of total order flow, these orders have a
higher concentration of individual investor shares (29.5%) than the
sample time window during regular trading hours (1.9%).\810\ Therefore,
including information about the execution quality of these orders would
be very relevant for individual investors, who would be able to make
more informed decisions when choosing a broker-dealer if these orders
are included in broker-dealers' execution quality disclosures.
Likewise, broker-dealers would be able to make more informed decisions
about where to route NMLOs submitted outside of regular trading hours,
knowing that these orders are being factored into a market center's
overall statistics.
---------------------------------------------------------------------------
\808\ See proposed Rule 600(b)(30). See also supra note 230 and
accompanying text.
\809\ One commenter to the 2018 Rule 2016 Amendments and
petitioner for rulemaking recommending inclusion of orders submitted
prior to market open in Rule 605 reporting requirements. See supra
notes 123-125.
\810\ See analysis described in supra Section VII.C.2.(b)(4).
---------------------------------------------------------------------------
Second, the proposed amendment removing the exclusion of orders
with stop prices from the definition of ``covered orders'' \811\ would
increase transparency about the execution quality of this type of
order.\812\ This would be particularly beneficial for this order type,
as the handling of stop orders can vary significantly across broker-
dealers and across the market centers to which they route.\813\
Furthermore, the execution prices of stop orders are highly sensitive
to handling and execution practices, as these orders are more likely to
execute when the stock price is in decline and any delay in execution
will result in a larger loss (or smaller gain) for the investor. This
risk is particularly acute for stop orders that use market orders, as
the execution price an investor receives for this market order can
deviate significantly from the stop price in a fast-moving market where
prices change rapidly.\814\ As shown in Table 4, stop orders that
trigger the submission of market orders are the most common type of
stop orders used by individual investors (representing 87.7% of their
stop orders), who are more likely than institutional investors to
submit stop orders (i.e., 6.44% of individual investors' market orders
are submitted with stop prices vs. 0.23% of those of institutional
investors). Therefore, information about the execution quality of stop
orders would be particularly useful for individual investors, who could
use this information to identify and direct stop orders to those
broker-dealers with the practices and abilities that allow them to
achieve higher execution quality for these orders. As broker-dealers
would be incentivized to improve their handling of stop orders,\815\
they would be able to use information about the execution quality of
stop orders achieved by market centers to route stop orders to those
market centers with the practices and abilities that allow them to
achieve higher execution quality for these orders.\816\ Furthermore,
the proposed amendment to include stop orders as a separate order type
category rather than grouping them together with other order types
\817\ also would prevent them from skewing the execution quality of
other orders downwards, given that stop orders are more likely to
execute in adverse market conditions.
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\811\ See proposed Rule 600(b)(30) (eliminating the express
carve out of orders submitted with stop prices from the definition
of ``covered order''). See also supra note 243 and accompanying
text.
\812\ A petitioner stated that including stop orders within the
Rule's scope would provide a more complete view of the orders
certain broker-dealers may use when assessing the execution quality
market centers provide. See supra note 123 and accompanying text.
\813\ See supra note 652 and accompanying text for a discussion
of differential treatment of stop orders.
\814\ See, e.g., SEC Investor Bulletin: Stop, Stop-Limit, and
Trailing Stop Orders, (July 13, 2017), available at https://www.sec.gov/oiea/investor-alerts-bulletins/ib_stoporders.html. This
risk can be attenuated with the use of stop limit orders, which sets
a minimum price at which the stop order can be executed. However,
the limit price may prevent the stop limit order from executing if
the stock price falls below the limit price before the stop limit
order can execute.
\815\ See infra section VII.D.1.(b)(1)(a) for a discussion of
the proposed amendments' impact on competition between broker-
dealers on the basis of execution quality for stop orders.
\816\ As discussed in supra section VII.C.2.(b)(2), the
Commission understands that the handling of stop orders can vary
significantly across market centers.
\817\ See proposed Rule 600(b)(20) (defining ``categorized by
order type'' to include a category for ``executable orders submitted
with stop prices'') (emphasis added). See also discussion in supra
section IV.B.2.(a).
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Lastly, the proposal to clarify that non-exempt short sale orders
should be included in Rule 605 statistics \818\ would lead to a more
complete picture of reporting entities' execution characteristics, as
short sales make up a large portion of trades and by implication are
likely also a significant component of order flow.\819\ An analysis of
short volume data found that, between August 2009 and February 2021,
short selling was an average of 47.3% of trading volume for non-
financial common stocks.\820\ To the extent that the proportion of
short selling trade volume is comparable to the proportion of short
selling order volume, these data points show that short selling is
prevalent in equity markets. Therefore, the inclusion of non-exempt
short sale orders would result in reporting entities' execution quality
statistics reflecting more relevant orders for individual and
institutional investors, who both engage in short selling. While the
costs to maintain margin accounts and borrow stocks may prevent some
individual investors from participating in the short sale market, one
academic working paper found that, between January 2010 and December
2016, 6.36% of all off-exchange short selling \821\ could be attributed
to retail traders, and 10.92% of retail trading was made up of short
sales.\822\ Meanwhile, evidence suggests
[[Page 3866]]
that short selling by institutional investors is largely the purview of
hedge funds,\823\ which are estimated to make up around 85% of the
short selling market.\824\ One academic paper finds that short sellers'
choice of trading venue is highly dependent on its market design and
that, due to their information advantages, short sellers prefer trading
venues that offer high execution speeds over those that offer low
trading costs.\825\ Therefore, including information about the
execution quality that reporting entities achieve for short sale orders
into Rule 605 disclosures would be relevant for a variety of investors
who engage in short selling.
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\818\ See supra note 254 and accompanying text.
\819\ See also supra note 123 and accompanying text (petitioner
recommending inclusion of short sales in Rule 605).
\820\ Short volume data is provided by CBOE Group (CBOE BYX
Exchange, CBOE BZX Exchange, CBOE EDGA Exchange, CBOE EDGX
Exchange), FINRA (FNYX,FNSQ, FNQC), NASDAQ Group (Nasdaq BX, Nasdaq
PSX and Nasdaq Stock Market), and NYSE Group (New York Stock
Exchange, NYSE Arca, NYSE American, NYSE Chicago, and NYSE
National). See https://www.cboe.com/us/equities/market_statistics/short_sale/ (CBOE data); https://www.finra.org/finra-data/browse-catalog/short-sale-volume-data (FINRA data); https://nasdaqtrader.com/Trader.aspx?id=shortsale (NASDAQ data); ftp://ftp.nyxdata.com/ (NYSE data). Common stocks include those with a
CRSP share code of 10 or 11. Financial stocks (SIC code 6000-6999)
and stocks that do not have an active trading status in CRSP (trade
status = A) are excluded. Analysis derived based on data from CRSP
1925 US Stock Database, Ctr. Rsch. Sec. Prices, U. Chi. Booth Sch.
Bus. (2022). The daily level of short selling is calculated for each
stock as the daily number of shares sold short divided by the daily
trading volume, averaged across stocks, and finally averaged across
all days in the sample (August 3, 2009 to February 5, 2021). Note
that this number matches that of other studies. For example, Figure
F.1 in the Congressional Study on Short Sale Reporting shows that
the level of short selling as a percentage of trading volume grew
from 2007 to close to 50% by 2013. See Short Sale Position and
Transaction Reporting (June 5, 2014), available at https://www.sec.gov/files/short-sale-position-and-transaction-reporting%2C0.pdf.
\821\ One academic paper found that short selling by individual
investors made up a much smaller percentage of overall shorting
volume on NYSE (1% to 2%). The authors attribute the low number of
on-exchange retail shorting to brokerage routing decisions. See
Ekkehart Boehmer, Charles M. Jones & Xiaoyan Zhang, Which Shorts are
Informed?, 63 J. Fin. 491 (2008).
\822\ See Ekkehart Boehmer & Wanshan Song, Smart Retail Traders,
Short Sellers, and Stock Returns. Short Sellers, and Stock Returns
(working paper Oct. 23, 2020) available athttps://papers.ssrn.com/sol3/papers.cfm?abstract_id=3723096 (retrieved from SSRN Elsevier
database).
\823\ See Peter Molk & Frank Partnoy, Institutional Investors as
Short Sellers?, 99 B.U. L. Rev. 837, 839 (2019). Molk and Partnoy's
paper ``identif[ies] the regulatory and other barriers that keep key
categories of institutions[, specifically, mutual funds, insurance
companies, banks, sovereign wealth funds, endowments, and
foundations,] from acquiring significant short positions.'' Id. at
843. In addition, a Division of Economic and Risk Analysis White
Paper survey of all mutual fund Form N-SAR filings in 2014 found
that ``[w]hile 64% of all funds were allowed to engage in short
selling, only 5% of all funds actually did so.'' See Daniel Deli et
al., Use Of Derivatives By Registered Investment Companies, SEC 8
(2015), available at https://www.sec.gov/files/derivatives12-2015.pdf.
\824\ See Yawen Jiao, Massimo Massa & Hong Zhang, Short Selling
Meets Hedge Fund 13F: An Anatomy of Informed Demand, 122 J. Fin.
Econ. 544 (2016), citing a 2009 report from Goldman Sachs.
\825\ See Adam V. Reed, Mehrdad Samadi & Jonathan Sokobin,
Shorting in Broad Daylight: Short Sales and Venue Choice, 55 J. Fin.
Quantitative Analysis 2246 (Nov. 2020).
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(b) Modernizing the Required Information
(i) Categorization by Order Size
The proposed amendments modernizing the information required by
Rule 605 would promote increased transparency by increasing the
relevance of the information contained in Rule 605 reports, including
information about order size categories.\826\
---------------------------------------------------------------------------
\826\ The EMSAC and commenters have also suggested bringing
smaller and larger order sizes within scope. See supra notes 126-132
and accompanying text.
---------------------------------------------------------------------------
The proposed amendments expanding Rule 605's order size categories
to include information about a wider range of order sizes,\827\
including odd-lots, orders less than one share, and larger-sized
orders,\828\ would increase the extent to which Rule 605 captures
information about orders that are relevant to both individual and
institutional investors. Analyses showed that the inclusion of orders
for less than 100 shares into Rule 605 reporting requirements would
include up to an additional 18.2% of NMLOs (2.8% of NMLO share
volume),\829\ and the inclusion of fractional shares would include up
to an additional 10.4% of executions received by individual investors
into Rule 605 reports.\830\ Fractional shares would benefit from
increased transparency. While the Commission lacks information on the
execution quality of fractional shares, the execution quality of orders
for less than one share may vary across broker-dealers. In particular,
many market centers do not offer the functionality to accept or execute
such orders, and so their execution quality will depend on how the
broker-dealer handles these orders, such as internalizing such orders
or aggregating them together for the purpose of rerouting to market
centers.\831\ Lastly, the inclusion of information about larger-sized
orders would include up to an additional 7.8% of NMLO share
volume,\832\ which would likely mostly be relevant for institutional
investors, to the extent that some of these orders may not be split
into smaller child orders.\833\
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\827\ Commenters have suggested amending the scope of the Rule
to include odd-lot orders (see supra note 271 and accompanying
text), as well as larger-sized orders (see supra notes 283-285 and
accompanying text).
\828\ See proposed Rule 600(b)(20). Furthermore, see supra
section IV.B.1.(b)(2) for a discussion of the Commission's proposal
to rescind the exemptive relief for orders of 10,000 or more shares
and include these orders within the scope of Rule 605 reports.
\829\ See Figure 5 in supra section VII.C.2.(b)(1)(a). As
discussed in this section, odd-lots are submitted by both individual
and institutional investors.
\830\ See analysis in supra section VII.C.2.(b)(1)(b).
\831\ See supra note 643 and accompanying text.
\832\ See analysis in supra section VII.C.2.(b)(1)(c).
\833\ This effect on competition may be limited if most large
institutional orders are not held orders and would thus be excluded
from Rule 605 reporting requirements, and/or are broken up into
smaller child orders that are likely to be smaller and may already
be included in Rule 605 reporting requirement. See supra note 650
and accompanying text.
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In addition, the proposed amendments to define order size
categories in terms of number of round lots \834\ would increase the
transparency regarding distribution of order sizes that a reporting
entity handles, particularly for higher-priced stocks. The new MDI
Rules tie the definition of round lot to a stock's average closing
price during the previous month, with higher-priced stocks associated
with lower-sized rounds lots,\835\ to account for the fact that order
sizes will tend to be smaller in higher-priced stocks. Continuing the
example from section VII.C.2.(c)(1), under the new MDI Rules, a $500
stock would have a round lot size of 40 shares. Therefore, for a $500
stock, instead of all typically-sized orders below $200,000 \836\
(i.e., 400 shares, or 10 round lots) being clustered in a single order
size category, these orders would potentially be spread among four out
of six of the proposed order size categories: (i) less than a share;
(ii) odd-lot; (iii) 1 round lot to less than 5 round lots; (iv) 5 round
lots to less than 20 round lots. This would result in a more meaningful
categorization of orders that would better enable market participants
to compare execution qualities across orders of different sizes. As a
result, market participants would be better able to take into account
potential differences in the distribution of order sizes that reporting
entities typically handle for a given stock when comparing execution
quality metrics across reporting entities, making these metrics more
informative for making apples-to-apples comparisons of execution
quality across reporting entities.
---------------------------------------------------------------------------
\834\ See proposed Rule 600(b)(19).
\835\ See supra note 577 and accompanying text describing the
new definition of round lots.
\836\ This refers to the exclusion of orders greater than
$200,000 from some Regulation NMS rules. See supra note 674.
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(ii) Categorization by Order Type
The proposed amendments modifying the order type categories
required by Rule 605, including modifications to the coverage of NMLOs,
and including separate order type categories for beyond-the-midpoint
orders and marketable IOCs, would promote increased transparency by
increasing the relevance of the information contained in Rule 605
reports.
First, the proposed amendment to modify Rule 605's coverage of
NMLOs so that reporting entities are required to disclosure execution
quality information only for those NMLOs that become executable \837\
(i.e., eventually touch the NBBO) would facilitate comparisons between
market centers, by more accurately excluding NMLOs that do not receive
a meaningful opportunity to execute; for example because the price
moved away from the order and/or the order was cancelled before its
limit price was reached.\838\ On the other
[[Page 3867]]
hand, investors could expect a NMLO with a limit price equal to the
prevailing NBBO to have a reasonable chance of executing, even if the
limit price is more than $.10 away from the NBB or NBO at the time of
order receipt. This would facilitate comparisons between market centers
by ensuring that the execution quality statistics for NMLOs more
meaningfully capture a market center's performance in handling NMLOs,
rather than reflecting market conditions potentially outside of the
market center's control, such as movements of the NBBO.
---------------------------------------------------------------------------
\837\ See proposed Rule 600(b)(42) (defining ``executable'') and
proposed Rule 600(b)(20) (defining ``categorized by order type'' to
include categories for ``executable orders submitted with stop
prices'' and ``executable non-marketable limit orders'') (emphasis
added). See also supra notes 240-241 and 303-304.
\838\ See supra notes 296-297 and accompanying text for
discussion of commenters' suggestions regarding Rule 605 reporting
requirements for NMLOs.
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This is evident from an analysis comparing the fill rates of all
near-the-quote and away-from-the-quote NMLOs to the fill rates of
executable NMLOs, calculated using the sample of MIDAS data.\839\
Results are presented in Figure 15.\840\ While the fill rates of all
near-the-quote and away-from-the-quote NMLOs are very low and similar
to one another (0.2% and 0.6%, respectively), the fill rates of
executable near-the-quote and away-from-the-quote NMLOs are much
higher, and also very different from one another. In fact, at 32.9%,
the average fill rate of executable away-from-the-quote NMLOs is
relatively high, and actually much higher than the average fill rate of
executable near-the-quote orders (5.5%).\841\ This reflects that even
away-from-the-quote orders are likely to execute if prices move such
that they have a meaningful opportunity to execute.
---------------------------------------------------------------------------
\839\ See supra note 634 for a description of the dataset. Staff
found that, first, only a small percentage of NMLOs eventually touch
the NBBO: only 15.01% of near-the-quote NMLOs and 2.08% of away-
from-the-quote NMLOs were executable during their lifespan.
\840\ This analysis uses data from prior to the implementation
of the MDI Rules and results may be different following the
implementation of the MDI Rules. However, it is not clear how a
change in the distribution of orders into various NMLO categories
would affect the average fill rates of these NMLO categories. See
supra note 685 and section VII.C.1.(d)(2). Also, note that, by
definition, all at-the-quote and inside-the-quote NMLOs are
executable by definition of having a limit price equal to or better
than the NBBO, and so the fill rates of executable at-the-quote and
inside-the-quote NMLOs would be identical to those for all at-the-
quote and inside-the-quote NMLOs presented in Figure 8.
\841\ This is likely because many near-the-quote NMLOs are
cancelled before their limit prices are reached. In fact, examining
the distribution of cancellations of these orders reveals that 27.5%
of near-the-quote NMLO shares are cancelled within 100 milliseconds,
vs. only 13.5% of away-from-the-quote NMLOs.
---------------------------------------------------------------------------
BILLING CODE 8011-01-P
Figure 15: Fill Rates of Executable Away-From-the-Quote and Near-the-
Quote NMLOs, March 2022
[GRAPHIC] [TIFF OMITTED] TP20JA23.015
BILLING CODE 8011-01-C
Second, the proposed amendment to include a separate order type
category for beyond-the-midpoint limit orders \842\ would increase
transparency on how reporting entities handle these types of orders
(e.g., whether or not they offer these orders price improvement) and
reduce the extent to which including information about these orders
along with other types of NMLOs may skew the execution quality
statistics of other types of NMLOs. The Commission understands that
different reporting entities may treat beyond-the-midpoint
[[Page 3868]]
NMLOs differently from other types of NMLOs, and that as a result
beyond-the-midpoint NMLOs have systematically different execution
quality characteristics than other types of NMLOs, and even other types
of inside-the-quote NMLOs. For example, beyond-the-midpoint limit
orders may be offered price improvement at some market centers, such as
wholesalers, so the execution quality of these orders would be highly
dependent on to which type of market center the broker-dealer routes
such orders.\843\ Requiring reporting entities to report execution
quality statistics separately for beyond-the-midpoint orders would
reveal differences in reporting entities' handling of this type of
order.
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\842\ See proposed Rule 600(b)(20) (defining ``categorized by
order type'' to include a category for ``beyond-the-midpoint limit
orders''). See also supra note 312 and accompanying text.
\843\ See Table 5 in supra section VII.C.5.(c), showing that
beyond-the-midpoint orders handled by wholesalers tend to have
higher fill rates, faster execution time, and higher price
improvement relative to other types of NMLOs.
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Lastly, the proposed amendment assigning marketable IOCs to a
separate order type category so that they no longer would be commingled
with other order types \844\ would increase the transparency of
execution quality information, both for IOCs and for other types of
marketable orders.\845\ Assigning marketable IOCs to a separate order
type category would increase transparency about the execution quality
that reporting entities achieve for these types of orders. Supporting
the idea that IOCs tend to have different execution quality profiles
than other types of marketable orders, an analysis showed that IOCs on
average have much lower fill rates (3.22%) than other market and
marketable limit orders (15.94%), and that fill rates vary across
market centers and according to order characteristics such as
size.\846\ Information about the execution quality of IOCs would allow
broker-dealers handling these types of orders to be able to better
assess which market center on average offers better execution quality
to these types of orders. These broker-dealers could thus make more
informed decisions about where to route these orders. Furthermore, due
to their different execution profiles, removing IOCs from other
marketable order categories would cause the execution quality metrics
for other types of marketable orders to more accurately reflect
reporting entities' handling of other types of market orders.\847\ The
effect on the execution quality metrics of other types of marketable
orders would likely be significant, as an analysis of IOCs found that
they make up more than 90% of market and marketable share volume.\848\
---------------------------------------------------------------------------
\844\ See proposed Rule 600(b)(20) (defining ``categorized by
order type'' to include a category for ``marketable immediate-or-
cancel orders''). See also discussion in supra section IV.B.2.(c).
\845\ The EMSAC, as well as commenters on the 2010 Equity Market
Structure Concept Release and the 2018 Rule 606 Amendments,
suggested separating IOCs within the categorization by order type.
See supra note 324 and accompanying text.
\846\ For example, market centers other than wholesalers tend to
have higher fill rates for IOC odd-lots (39.6%) than non-IOC odd-
lots (15.4%), the opposite is true for wholesalers (30.1% vs.
67.1%). See Table 6 in supra section VII.C.5.(g).
\847\ See supra note 725 and accompanying text for an example of
how co-mingling IOCs with other order types could lower marker
centers' incentives to improve execution quality for other
marketable orders.
\848\ See Table 6 in supra section VII.C.5.(g) and corresponding
discussion.
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(iii) Timestamp Conventions
Several of the proposed amendments would promote increased
transparency by modifying the conventions used to calculate time-to-
execution information for the purposes of Rule 605 reporting, including
increasing the granularity of the timestamp, replacing the current
time-to-execution buckets in Rule 605 with statistics capturing
information about the distribution of time-to-execution, and modifying
the conventions for recording the time-to-execution of NMLOs.\849\
---------------------------------------------------------------------------
\849\ See supra notes 339-340, 358 and accompanying text
discussing suggestions from commenters related to the current
provisions in Rule 605 for timestamps.
---------------------------------------------------------------------------
First, the proposed amendment increasing the granularity of the
timestamp conventions used for the time of order receipt and time of
order execution from seconds to milliseconds \850\ would make the
current time-to-execution statistics in Rule 605, including the average
share-weighted time-to-execution of shares executed with positive price
improvement, without price improvement and also with negative price
improvement, more informative about the execution speeds offered by a
market center. Given the data and trading speeds enabled by modern
technology in which execution speeds measured in seconds are likely to
miss much of the variation in time-to-executions across reporting
entities in today's markets, particularly for market and marketable
orders,\851\ adding granularity to the timestamps used to calculate the
time-to-execution speed measures included in Rule 605 reports would
benefit market participants in their efforts to compare time-to-
executions across reporting entities.
---------------------------------------------------------------------------
\850\ See proposed Rule 600(b)(108) and (109). See also supra
notes 333-334 and accompanying text.
\851\ See supra section VII.C.2.(c)(4) for a discussion of how
the granularity of the time-to-execution categories currently
defined in Rule 605 has lost relevance over time.
---------------------------------------------------------------------------
Second, the proposal to eliminate the current time-to-execution
buckets \852\ would eliminate a method for presenting information about
time-to-executions that has lost relevance over time, as, for reasons
described above, these categories are not granular enough with respect
to variations in time-to-executions across reporting entities. Instead,
the Commission proposes requiring, in addition to average time to
execution statistics as currently included in Rule 605,\853\ both
share-weighted median and 99th percentile time-to-execution statistics
in order to provide information about the distribution of execution
speeds achieved by a reporting entity.\854\ Given that outliers could
skew the share-weighted average time to execution, information about
the distribution of execution speeds in addition to the average would
still be useful. However, time-to-execution buckets are of limited
utility, especially since time-to-execution buckets that are
appropriate for some order types, such as NMLOs, may not be granular
enough for other order types, such as market and marketable
orders.\855\ Statistics capturing the distribution of time-to-
executions would represent a more flexible and useful method for
capturing information about the time-to-executions of a variety of
order types.
---------------------------------------------------------------------------
\852\ See 17 CFR 242.605(a)(1)(i)(F), (G), (H), (I) and (J)
(detailing time-to-execution buckets of 0-9 seconds, 10 to 29
seconds, 30 to 59 seconds, 60 to 299 seconds and 5 to 30 minutes
after the time of order receipt).
\853\ See 17 CFR 242.605(a)(1)(ii)(D), (F), and (I), requiring
share-weighted average period from the time of order receipt to the
time of order execution for shares executed with price improvement,
at the quote, and outside the quote, respectively.
\854\ See proposed Rule 605(a)(1)(ii)(D), (E), (H), (I), (M),
and (N), and proposed Rule 605(a)(1)(iii)(D) and (E), requiring
share-weighted median and share-weighted 99th percentile time to
execution information. See also supra note 349 and accompanying
text.
\855\ See Figure 12 and corresponding discussion in section
VII.C.2.(c)(4), supra, describing an analysis showing that, for at-
the-quote and near-the-quote limit orders, executions are reasonably
well distributed across the different time-to-execution buckets but,
for market and marketable limit orders, time-to-executions are
mostly bunched up at the faster end of their time buckets.
---------------------------------------------------------------------------
Finally, the proposed amendments would measure time-to-execution
for NMLOs from the time that the order becomes executable, rather than
from the time of order receipt.\856\ This would ensure that this metric
would be more likely to capture the portions of execution speed that
are within a
[[Page 3869]]
reporting entity's control, rather than dependent on market
conditions.\857\
---------------------------------------------------------------------------
\856\ See proposed Rule 605(a)(1)(iii)(C), (D), and (E).
\857\ See supra note 513 for an example of how market conditions
can influence the time-to-execution of NMLOs.
---------------------------------------------------------------------------
(iv) Modifications to Information Required for All Types of Orders
The proposed amendments modernizing the information required for
all order types would promote increased transparency by increasing the
relevance of the information contained in Rule 605 reports. This holds
as well for the proposed amendments modifying the calculations of
average realized spreads, expanding existing requirements to report
average effective spreads, adding additional metrics such as percentage
realized and effective spreads, effective over quoted spreads, and size
improvement, and modifying the categorization of riskless principal
trades.
First, the proposed amendment to modify the time horizon used to
calculate the realized spread from a single horizon of five minutes to
two horizons of 15 seconds and 1 minute \858\ would increase the
relevance of this measure and allow it to more accurately reflect the
speed of modern markets.\859\ This would allow market participants to
better compare execution quality across market centers. Realized
spreads are meant to capture information about the adverse selection
risk associated with providing liquidity,\860\ and in this way are a
useful measure for evaluating reporting entities' order handling
practices during times of market stress or high adverse selection.
However, the current requirement to use a five-minute time horizon to
calculate realized spreads for the purposes of Rule 605 disclosures is
too long of a horizon to reflect the speed of modern markets, and
likely results in noisy measures of the realized spread.\861\ Instead,
the proposed time horizons of 15 seconds and 1 minute are more
appropriate time horizons given current trading speeds. Analysis found
that the proposed time horizons of 15 seconds and 1 minute capture most
of the information about realized spreads, in particular for the
largest stocks.\862\ This supports results from the academic
literature, as one paper similarly posits that the five-minute time
horizon should be replaced with a horizon of no more than 15 seconds
for large stocks and 60 seconds for small stocks.\863\
---------------------------------------------------------------------------
\858\ See proposed Rule 605(a)(1)(i)(G) and(I). See also supra
note 375 and accompanying text.
\859\ See supra note 377 discussing commenters' suggestions
regarding to Rule 605's provisions related to the realized spread.
\860\ See supra note 701 and accompanying text for a discussion
about what the realized spread is intended to measure.
\861\ See discussion in supra section VII.C.2.(c)(5).
\862\ See discussion of analyses in supra section IV.B.4.(a).
\863\ See Conrad and Wahal.
---------------------------------------------------------------------------
Second, the proposed amendment to require market centers to include
information about average effective spreads for NMLOs and orders
submitted with stop prices,\864\ in addition to market and marketable
limit orders, would increase transparency about the availability of
favorable executions for these types of orders. For NMLOs, the average
effective spread captures how much customers can expect to be
compensated for providing liquidity.\865\ If a market center is
offering lower (or, more precisely, more negative) effective spreads
for NMLOs on average, that means that the market center is able to
execute NMLOs even when the NBBO spread is wide, e.g., because it is
able to attract trading interest even during potentially adverse market
conditions.\866\ This can represent profitable trading opportunities
for providers of limit orders, who would otherwise need to raise (in
case of a buy limit order) or lower (in case of a sell limit order)
their limit prices in order to attract a counterparty. Therefore,
information about effective spreads for NMLOs would allow providers of
limit orders (and their broker-dealers) to make comparisons across
market centers based on the profitability of their limit order
strategies. For orders submitted with stop prices, the average
effective spread would reflect similar information to the extent that
these are NMLOs. For marketable orders submitted with stop prices,\867\
the average effective spread would capture information about how much
more than the stock's estimated value a trader has to pay for the
immediate execution of their order, similarly to how the effective
spread currently included in Rule 605 for market and marketable limit
orders can be interpreted.
---------------------------------------------------------------------------
\864\ See proposed Rule 600(b)(10). See also supra note 386 and
accompanying text.
\865\ See supra note 709 and accompanying text for more details
about interpreting effective spreads for NMLOs.
\866\ Note that the ability of market centers to execute NMLOs
at a wide spread is limited by the prohibited of trade-throughs of
protected quotes under Rule 611 of Regulation NMS.
\867\ See supra Table 4 for a break-down of orders submitted
with stop prices according to order type.
---------------------------------------------------------------------------
The proposed amendments would require the average effective spread
of a NMLO or an order submitted with a stop price to be calculated
using the midpoint as of the time of the order's executability, rather
than the time of order execution.\868\ Providing the average effective
spread would allow market participants to measure what liquidity
providers expect to earn, which is more informative about expectations
of the reporting entities' skill at handling and/or executing orders as
compared to a measurement of what liquidity providers actually earn,
which can be impacted by market conditions outside of a reporting
entities' control.\869\
---------------------------------------------------------------------------
\868\ See proposed Rule 600(b)(10). The time an order becomes
executable would be used for NMLOs, beyond-the-midpoint limit
orders, and orders submitted with stop prices.
\869\ Market participants can use the realized spread to
estimate what limit order providers actually earn from liquidity
provision. See supra note 709.
---------------------------------------------------------------------------
Third, the proposed amendment requiring reporting entities to
report average effective spreads and average realized spreads in
percentage terms,\870\ in addition to the current requirement to report
them in dollar terms,\871\ would allow market participants to evaluate
and compare the actual per-share dollar premium paid (or amount earned)
captured by the spread, and use average percentage measures to compare
aggregate spreads across broker-dealers that handle different mixes of
stocks and/or stocks with significant price volatility. Since average
spread measures represent a per-share cost, the real costs to (or
premiums earned by) investors captured by average spread measures can
be very different, depending on the stock price.\872\ Percentage
average spread measures, on the other hand, would better account for
these differences in stock prices.\873\ As different reporting entities
handle and/or transact in different mixes of stocks with varying
prices, including information about average percentage spreads would
make it possible for market participants who may want to compare
reporting entities' overall spread measures or their spread measures
for baskets of stocks to aggregate average spreads for a variety of
[[Page 3870]]
stocks with varying prices.\874\ This would facilitate a more apples-
to-apples comparison of both average effective and average realized
spreads across reporting entities.
---------------------------------------------------------------------------
\870\ See proposed Rule 605(a)(1)(i)(H), (J), and (L).
\871\ See 17 CFR 242.605(a)(1)(i)(K) and 17 CFR
242.605(a)(1)(ii)(A).
\872\ See supra note 712 and accompanying text for an example
showing that the total cost of accumulating the same position in
terms of dollar value in two stocks with the same per-share dollar
effective spread can differ significantly in terms of total
transaction costs if one stock is priced much lower than the other.
\873\ See example in supra note 712. While the $250 stock and
the $2.50 stock would have the same average effective spread, the
average percentage effective spreads of these stocks would be 0.004%
and 0.4%, respectively, which indicates that investors would face
higher costs from accumulating a position in the $2.50 stock than
they would from accumulating an equal-value position in the $250
stock.
\874\ While the main purpose of Rule 605 is to facilitate
comparisons across reporting entities on the basis of execution
quality within a particular security, the Commission understands
that access to aggregated information is useful for market
participants. The proposed amendment to require reporting entities
to prepare summary reports that aggregate execution quality
information for S&P 500 stocks, along with all NMS stocks, would
give market participants access to aggregate effective spreads for
one commonly used basket of stocks. Meanwhile, per-stock percentage
spread information would enhance market participant's ability to
aggregate effective spread information across baskets of stocks
other than the S&P 500.
---------------------------------------------------------------------------
Fourth, the proposed amendment requiring reporting entities to
include information on effective over quoted spreads \875\ would
increase market participants' access to information about price
improvement. The Commission understands that the effective over quoted
spread (E/Q) is a measure often used in industry practice.\876\ As
such, it represents a measure of price improvement that is likely to be
easily understood and interpreted by market participants. While E/Q can
already be calculated from data currently available in Rule 605
reports,\877\ extrapolating an average monthly quoted spread and using
that to calculate an average monthly E/Q produces a noisier E/Q measure
than an average E/Q calculated on a per transaction basis.\878\
Therefore, including this measure would improve upon the accessibility
of price improvement information contained in Rule 605 reports by
making more readily available a measure that is already used and well
understood by industry participants.
---------------------------------------------------------------------------
\875\ See proposed Rule 605(a)(1)(i)(M). See also supra note 401
and accompanying text.
\876\ See, e.g., About Us: Brokerage Built for You, Vanguard,
available at https://investor.vanguard.com/about-us/brokerage-order-execution-quality.
\877\ See supra note 399.
\878\ To see this, consider a market center that, in a given
month, executes two orders of sizes s1 and s2,
with effective spreads E1 and E2 and quoted
spreads Q1 and Q2. The true share-weighted
average E/Q would be [s1/(s1 + s2) x (E1/Q1)] + [s2/(s1 + s2) x (E2/
Q2)]. On the other hand, approximating the average E/Q from share-
weighted average effective and quoted spreads would yield [s1/(s1 Q1
+ s2 Q2) x E1] + [s2/(s1 Q1 + s2 Q2) x E2]. In other words, it
yields the weighted effective spread divided by a share-weighted
average quoted spread, rather than a share-weighted average of the
effective divided by quoted spread.
---------------------------------------------------------------------------
Fifth, the proposed amendment expanding Rule 605 reporting
requirements to include a measure of size improvement would provide
market participants with more information about an additional dimension
of execution quality that is currently not fully captured by Rule 605
statistics.\879\ The proposed amendment would require reporting
entities to report, for executions of covered shares, a benchmark
metric calculated as the consolidated reference quote size, capped at
the size of the order,\880\ which a market participant could compare to
the market center's reported number of shares executed at or better
than the quote.\881\ This would reflect the market center's ability to
offer size improvement, which would be particularly beneficial for
larger-sized orders, as these orders are the most likely to exceed the
liquidity available at the best quotes and therefore benefit the most
from size improvement.
---------------------------------------------------------------------------
\879\ Liquidity providers have expressed support for a size
improvement measure (see supra note 405) and have made suggestions
regarding measures (see supra notes 411-413).
\880\ See proposed Rule 605(a)(1)(i)(F). As discussed in supra
section IV.B.4.(e), this metric is meant to capture whether the
depth available at the best market prices is sufficient to fully
execute against a given order, or whether the order would need to
walk the book in order to fully execute.
\881\ Continuing the example from section VII.C.2.(c)(6), while
the market center's Rule 605 report would reveal a price improvement
metric of $0 for this order, the market center's benchmark metric
would reveal a consolidated reference quote size of 100 shares,
which a market participant could compare to the market center's
reported number of shares executed at or better than the quote,
which would reveal 200 shares.
---------------------------------------------------------------------------
If information about size improvement is already captured by
current Rule 605 statistics, the addition of the above-described
benchmark metric capturing size improvement would not necessarily
represent a benefit to transparency. To examine the extent to which a
size improvement measure calculated using this benchmark metric would
contain information that is different from measures currently required
by Rule 605, data from the Tick Size Pilot B.II Market and Marketable
Limit Order dataset \882\ was analyzed to calculate the average
correlation \883\ between price improvement, effective spreads, and the
size improvement share count divided by the benchmark share count
(``size enhancement rate'').\884\ As national securities exchanges and
off-exchange market centers differ in the extent to which they can
offer size and price improvement, staff performed this analysis
separately for these two different types of market centers.
---------------------------------------------------------------------------
\882\ See supra note 723 for dataset description. The Commission
limited this analysis to a randomly selected sample of 100 stocks
and for the time period of March 2019. This dataset was then merged
with MIDAS data to obtain the consolidated depth available at the
NBBO at the time of the market and marketable limit order
submissions, along with data on odd-lots and consolidated volume at
prices outside of the NBBO. This analysis uses data from prior to
the implementation of the MDI Rules and the specific numbers may be
different following the implementation of the MDI Rules. In
particular, for certain stocks, the NBBO quoted spread is expected
to narrow, the liquidity available at the NBBO may decrease, and the
NBBO midpoint may change, though the Commission is uncertain of the
direction of this effect. This may impact statistics that are based
on these values, including measures of price and size improvement
and effective spreads. See supra section VII.C.1.(d)(2). However, it
is unclear whether or how these effects would impact the
correlations between these measures documented in this analysis.
\883\ Correlation is calculated using the Pearson correlation
coefficient, which measures the linear correlation between two sets
of data, ranging from -1 to 1, with -1 representing perfect negative
correlation and 1 representing perfect positive correlation. To
construct a measure of average correlation, the Commission first
calculated the Pearson correlation coefficient for each pair of
execution quality metrics, for each market center--stock
combination. Then the Commission took the value-weighted average
correlation coefficient across all stocks for each market center,
using dollar volume as weights. Then the Commission averaged the
resulting correlation coefficients across market centers using an
equal-weighted average.
\884\ See section IV.B.4.(e) for a definition of the size
improvement share count, which captures the number of shares greater
than the depth available at the NBBO to which the market center was
able to offer the best displayed price. The size improvement share
count is divided by the proposed benchmark share count to obtain the
size enhancement rate to control for differences in market
conditions. For example, if Market Center A has 1,000,000 shares
executed at or better than the best displayed price and a benchmark
share count of 800,000, and Market Center B has 2,000,000 shares
executed at or better than the best displayed price and a benchmark
share count of 1,800,000, both market centers would have a size
improvement share count of 200,000, but Market Center A would be
offering the a higher rate of size improvement since they had fewer
shares available to them at the consolidated depth (i.e., a lower
benchmark share count). To capture this, the size improvement share
count is divided by the benchmark share count, such that Market
Center A would have a size enhancement rate of 200,000/800,000 = 25%
and Exchange B would have size enhancement rate of 200,000/1,800,000
= 11%. This difference recognizes that Exchange A and Exchange B
provided the same number of size improved shares but Exchange A had
lower consolidated depth available when it needed to execute.
---------------------------------------------------------------------------
Results are presented in Table 8 and show that, for both national
securities exchanges and off-exchange market centers, effective spreads
are modestly (negatively) correlated with price improvement, confirming
that effective spreads contain some of the same information as price
improvement measures. Likewise, at least for national securities
exchanges, effective spreads are modestly (negatively) correlated with
the size enhancement rate, confirming that effective spreads contain
some information about size improvement. However, this correlation is
nearly zero for off-exchange market centers, implying that effective
spreads are a poor measure of size improvement
[[Page 3871]]
particularly for these types of market centers.
Table 8--Average Correlation Between Measures of Price and Size
Improvement
------------------------------------------------------------------------
National
securities Off-exchange
Correlations exchanges market centers
(percent) (percent)
------------------------------------------------------------------------
Price Improvement and Effective Spreads. -25.7 -20.5
Size Enhancement Rate and Effective -12.0 0.1
Spreads................................
Price Improvement and Size Enhancement 31.3 5.9
Rate...................................
------------------------------------------------------------------------
Table 8: Average Correlation between Measures of Price and Size
Improvement. This table presents correlations between three measures
of price improvement and size improvement: price improvement,
calculated as the signed difference between the execution price and
the NBBO; the effective spread, calculated as twice the signed
difference between the execution price and the NBBO midpoint; and the
size enhancement rate, calculated as the size improvement share count
divided by the benchmark share count (see supra note 884 and
accompanying text for a detailed description of this measure). See
supra note 723 for dataset description and supra note 883 for
methodology. This analysis uses data from prior to the implementation
of the MDI Rules and results may be different following the
implementation of the MDI Rules. See supra note 882 and section
VII.C.1.(d)(2).
While price improvement and the size enhancement rate are
moderately correlated for national securities exchanges, implying that
information from these two measures overlaps to some extent, this
correlation is comparatively low for off-exchange market centers. The
fact that price improvement and the size enhancement rate are not
perfectly overlapping (i.e., are not perfectly correlated) implies that
each of these measures to some degree conveys different information
about execution quality, particularly for off-exchange market centers.
Therefore, including information that could be used to calculate a size
improvement measure such as the size enhancement rate into Rule 605
reporting requirements would provide market participants with more
information about an additional dimension of execution quality that is
not fully captured by current Rule 605 statistics.
Lastly, the proposed amendment specifying that market centers
should include riskless principal trades in the category of trades
executed away from the market center \885\ would increase transparency
about internalization by wholesalers, as information on the extent to
which wholesalers internalize order flow is currently obscured by the
inclusion of riskless principal trades into the category of trades
executed at, rather than away from, the market center.\886\ Market
participants would be more informed about potential differences in
execution quality between wholesalers that largely internalize order
flow as compared to those whose orders are subject to competition from
other interested parties quoting on external market centers.
---------------------------------------------------------------------------
\885\ See proposed Rule 605(a)(1)(i)(D). See also supra note 418
and accompanying text.
\886\ See supra section VII.C.2.(c)(8) for a discussion of how
classifying riskless principal trades in the category of executions
taking place at the market center may obscure the extent to which
wholesalers internalize order flow.
---------------------------------------------------------------------------
(v) Modifications to Information Required for Market, Marketable Limit,
Marketable IOC, and Beyond-the-Midpoint Limit Orders
Several of the proposed amendments would modernize the information
required for market, marketable limit, marketable IOC, and beyond-the-
midpoint limit orders, which would promote transparency by increasing
the relevance of the information contained in Rule 605 reports for
these types of orders, including information about time-to-execution
and price improvement.
First, the proposed amendment requiring reporting entities to
report, for shares executed with price improvement, executed at the
quote, or executed outside the quote, a wider range of time-to-
execution statistics, including the average,\887\ median,\888\ and 99th
percentile \889\ period from the time of order receipt to the time of
order execution, would increase transparency about the execution speeds
offered by a reporting entity. Given that outliers could skew the
share-weighted average time to execution, information about the
distribution of execution speeds in addition to the average would be
useful.\890\ Therefore, including a variety of statistics (mean, median
and 99th percentile) would help ensure that market participants have
sufficient information about the distribution of time-to-execution in
order to account for any outliers. This would facilitate comparisons
across reporting entities on the basis of execution speeds.
---------------------------------------------------------------------------
\887\ For shares executed with price improvement, executed at
the quote, or executed outside the quote, respectively, see proposed
Rules 605(a)(1)(ii)(C), 605(a)(1)(ii)(G), and 605(a)(1)(ii)(L).
\888\ For shares executed with price improvement, executed at
the quote, or executed outside the quote, respectively, see proposed
Rules 605(a)(1)(ii)(D), 605(a)(1)(ii)(H), and 605(a)(1)(ii)(M).
\889\ For shares executed with price improvement, executed at
the quote, or executed outside the quote, respectively, see proposed
Rules 605(a)(1)(ii)(E), 605(a)(1)(ii)(I), and 605(a)(1)(ii)(N).
\890\ Consider, for example, a reporting entity (``Reporting
Entity A'') that executes one hundred equally-sized orders with a
time-to-execution of 1 millisecond, but a single order at a time-to-
execution of 100,000 milliseconds (100 seconds), and compare to a
reporting entity (``Reporting Entity B'') that executes the same
size and amount of orders all at a time-to-execution of 1,001
milliseconds. Both reporting entities' average time-to-execution
statistic would be 1,001 milliseconds. However, comparing these two
statistics would not reveal that Reporting Entity A nearly always
offers a faster execution time than Reporting Entity B, except for a
single outlier. Median time-to-execution statistics, however, would
reveal that Reporting Entity A has a median time-to-execution of 1
millisecond, while Reporting Entity B has a median time-to-execution
of 1,001 milliseconds, which would allow for comparison accounting
for Reporting Entity A's outlier.
---------------------------------------------------------------------------
Second, the proposed amendment requiring, for marketable order
types (i.e., market, marketable limit, marketable IOC, and beyond-the-
midpoint limit orders), reporting entities to disclose price
improvement statistics using the best available displayed price as the
benchmark \891\ would give market participants access to price
improvement information relative to a benchmark price that more
accurately reflects liquidity available in the market. For example, if
a market center internalizes an order with $0.05 of price improvement
relative to the NBBO, but odd-lots are available on another market
center at prices that are $0.10 better than the NBBO, this measure
would reflect a price dis-improvement of $0.05. This would indicate
that the investor could have received a better price if the market
center had routed the order to execute against the available odd-lot
liquidity.
[[Page 3872]]
This would thus allow market participants (including broker-dealers) to
identify those market centers that execute orders at prices better than
the best available displayed price, taking into account all available
displayed liquidity.\892\
---------------------------------------------------------------------------
\891\ See proposed Rule 600(b)(14) (defining the ``best
available displayed price'') and proposed Rule 605(a)(1)(ii)(O)
through (S). See also supra section IV.5 for further discussion of
these amendments.
\892\ If only the NBBO is used as the benchmark for the proposed
price improvement statistic relative to the best available displayed
price, because, for example, odd-lots inside the NBBO are not
available or because information about the best odd-lot orders
available in the market inside the NBBO is not or is not yet
available in consolidated market data, then these additional price
improvement statistics would be the same as the price improvement
statistics currently included in Rule 605 and would not have
significant economic effects. See supra note 423.
---------------------------------------------------------------------------
(vi) Additional Required Information for Executable NMLOs, Executable
Stop Orders, and Beyond-the-Midpoint Limit Orders
The proposed amendments would increase the relevance of the
information contained in Rule 605 reports for executable NMLOs,
executable stop orders, and beyond-the-midpoint limit orders.
Specifically, the proposed amendment requiring reporting entities to
report the number of shares that executed while an executable NMLO was
in force \893\ would promote transparency regarding differences in the
execution probabilities of NMLOs between reporting entities.\894\
Market participants would be able to determine if a reporting entity is
unable to achieve an execution in an executable NMLO despite the fact
that a large number of shares are executing at that NMLO's limit price
elsewhere in the market, enabling investors and their broker-dealers to
make better informed routing decisions. Furthermore, the proposed
amendment requiring the reporting of the number of orders that received
either a complete or partial fill would provide important additional
information about the nature of a market center or broker-dealer's NMLO
and stop order executions--e.g., whether a high executed cumulative
count represents, on average, larger execution sizes or a higher count
of orders receiving executions.\895\
---------------------------------------------------------------------------
\893\ See proposed Rule 605(a)(1)(iii)(B). See also supra
section IV.B.6 for further discussion of this proposed amendment.
\894\ One commenter suggested a similar execution quality metric
called a ``non-marketable benchmark.'' See supra notes 442-443 and
accompanying text.
\895\ For example, say that a reporting entity discloses in its
Rule 605 reports that it received 100 orders sized 100 round lots or
greater in a stock with a 100-share round lot, with a and that these
orders had a cumulative number of shares of 1,000,000, and
furthermore that it executed 990,000 of those shares. Information on
the number of complete or partial fills would help to clarify
whether the reporting entity, e.g., executed 99 orders of 10,000
shares each, or a single order of 990,000 shares.
---------------------------------------------------------------------------
(3) Proposed Summary Execution Quality Reports
The proposed amendment requiring reporting entities to prepare
human-readable summary reports \896\ would facilitate comparisons
across reporting entities on the basis of execution quality by
increasing the accessibility of the information contained in Rule 605
reports.\897\ The data generated under Rule 605 is complex, and the raw
data may be difficult for some market participants to interpret and
aggregate. Summary reports would give market participants access to
standardized information that could be used to quickly compare across
reporting entities. This would be particularly useful for those
investors that may not have access to the resources to retrieve and
process the raw data in Rule 605 reports, such as some individual
investors.
---------------------------------------------------------------------------
\896\ See proposed Rule 605(a)(2). See also supra note 462 and
accompanying text.
\897\ In several contexts in which the Commission has received
general feedback on equity market structure, commenters have
suggested that the Commission require a simplified execution quality
report, particularly for retail investors. See supra notes 135-138
and corresponding text. Commenters have also suggested that the
Commission require broker-dealers to produce a summary report. See
supra notes 451-454.
---------------------------------------------------------------------------
However, as differences in execution quality can be driven by
differences between reporting entities other than differences in their
skills at handling and/or executing orders, such as differences in the
characteristics of their order flow,\898\ the Commission recognizes
that it is important to strike a balance between sufficient aggregation
of orders to produce statistics that are meaningful and sufficient
differentiation of orders to facilitate fair comparisons of execution
quality across reporting entities.\899\ The Commission believes that
the statistics required in the summary reports would strike this
balance.
---------------------------------------------------------------------------
\898\ See supra note 513 for an example of how differences in
order flow characteristics may impact inferences about execution
quality.
\899\ See, e.g., Adopting Release, 65 FR 75414 (Dec. 1, 2000) at
75423.
---------------------------------------------------------------------------
(b) Improvements in Execution Quality
The Commission believes that the proposed amendments would serve to
improve execution quality for both individual and institutional
investors, as these investors would be able to make better informed
decisions about where to route their orders to achieve better quality
executions. Execution quality would further improve, as the flow of
orders and customers to those reporting entities offering better
execution quality would promote increased competition on the basis of
execution quality, both in the market for brokerage services and in the
market for trading services. This would result in improvements to
overall levels of execution quality, as well as improvements to
particular components of execution quality, such as execution prices,
execution speeds, size improvement, and fill rates.
The magnitude of the improvements in order execution quality that
individual and institutional investors may experience may be lower when
the MDI Rules are implemented, because the availability of faster
consolidated market data with more data on odd-lot information, auction
information, and depth of book information from competing consolidators
could result in improved execution quality for customer orders if their
broker-dealers currently utilize SIP data and switch to consuming the
expanded consolidated market data. However, there is uncertainty with
respect to how these benefits would change because there is uncertainty
regarding how the price improvement wholesalers would provide retail
investors would change as well as uncertainty regarding how the NBBO
midpoint will change for stocks with prices above $250 when the MDI
Rules are implemented.\900\ The Commission believes that the Proposal
would still lead to improvements in individual and institutional
investor order execution quality, as well as improvements in price
discovery, relative to a baseline in which The MDI Rules are
implemented.
---------------------------------------------------------------------------
\900\ See supra section VII.C.1.(d)(2) for further details on
how the rules adopted in Market Data Infrastructure could affect the
NBBO.
---------------------------------------------------------------------------
(1) Increased Competition on the Basis of Execution Quality
The Commission believes that the proposed amendments would have the
general effect of increasing levels of execution quality, as both
broker-dealers and market centers would experience increased
competition on the basis of execution quality. The Commission expects
that these improvements in overall levels of execution quality would
likely be the result of improvements to broker-dealer routing practices
and improvements to market centers' execution practices, as well as
generally improvements in market participants' ability to use Rule 605
reports to compare information across reporting entities as a result of
better and more accessible data.
[[Page 3873]]
(a) Improvements to Broker-Dealer Routing Practices
The Commission believes that execution quality would improve as a
result of increased competition between broker-dealers on the basis of
execution quality.\901\ The proposed amendment expanding the scope of
Rule 605 reporting entities to include larger broker-dealers would
promote increased transparency regarding the execution quality achieved
by broker-dealers.\902\ Hence, market participants would be better able
to compare execution quality information across broker-dealers.
Customers could then use this information to compare across broker-
dealers and select those broker-dealers offering better execution
quality. The flow of customers to the broker-dealers that provide
better execution quality would improve the execution quality of
customers that route their orders to high-quality broker-dealers and
also increase the extent to which broker-dealers rely on execution
quality information when making their order routing decisions in order
to compete with other broker-dealers for customer order flow.
---------------------------------------------------------------------------
\901\ The Commission believes that these effects would
principally accrue to larger broker-dealers, who would be required
to prepare Rule 605 reports, but may spill over to effect smaller
broker-dealers as well. See discussion in infra section
VII.D.1.(d)(1).
\902\ See supra section VII.D.1.(a)(1)(a) for a discussion of
how the proposed amendment requiring larger broker-dealers to
publish Rule 605 reports would promote increased transparency about
the execution quality of larger broker-dealers.
---------------------------------------------------------------------------
Broker-dealers would increase their competitive position with
respect to execution quality by investing in or otherwise adjusting
their routing practices to increase the extent to which they route
orders to the market centers offering better execution quality and
limit the extent to which they route orders for other potential
reasons. For example, broker-dealers that face conflicts of interest
that would otherwise misalign their interests with their customers'
interest in receiving the best possible execution quality would be
better incentivized to manage these conflicts as a result of an
increase in their need to compete on the basis of execution
quality.\903\ Specifically, as the gains to broker-dealers of
conflicted routing practices would be more likely to be outweighed by a
loss of customer order flow, because they offer lower execution
quality, these broker-dealers would base more of their routing
decisions on the execution quality of market centers, rather than on
which market centers are more likely to benefit them (e.g., because of
higher PFOF or lower access fees).
---------------------------------------------------------------------------
\903\ See supra section VII.C.2.(a)(1) for a discussion of
potential conflicts of interest in broker-dealer routing decisions.
---------------------------------------------------------------------------
The magnitude of the improvements in order routing practices may be
lower when the MDI Rules are implemented, because the availability of
faster consolidated market data with more data on odd-lot information,
auction information, and depth of book information from competing
consolidators could result in improved order routing for customer
orders if their broker-dealers currently utilize SIP data and switch to
consuming the expanded consolidated market data.\904\ However, the
Commission believes that the proposed amendments would lead to
improvements in broker-dealer order routing decisions relative to a
baseline in which the MDI Rules are implemented.
---------------------------------------------------------------------------
\904\ See supra section VII.C.1.(d)(2) for further discussion.
---------------------------------------------------------------------------
(b) Improvements to Market Centers' Execution Practices
The Commission believes that execution quality would improve as a
result of increased competition between market centers on the basis of
execution quality. As a result of the proposed amendments' effects
increasing the transparency of reporting entities' execution quality,
including market centers,\905\ broker-dealers would be better informed
about the execution quality of market centers when making their routing
decisions. The flow of orders to those market centers that provide
better execution quality would improve the execution quality of those
broker-dealers (and their customers) that route their orders to these
higher-quality market centers, and also increase the extent to which
market centers must improve their execution practices in order to
better compete with other market centers to attract customer order
flow.
---------------------------------------------------------------------------
\905\ See supra section VII.D.1.(a)(2) for a discussion of how
the proposed modifications to Rule 605 disclosure requirements would
promote increased transparency about execution quality.
---------------------------------------------------------------------------
The flow of orders to market centers that provide better execution
quality would be further enhanced by improvements in broker-dealer
routing practices,\906\ resulting from an increase in the extent to
which broker-dealers \907\ compete on the basis of execution quality as
a result of the proposed amendments increasing the transparency of
larger broker-dealers' execution quality.\908\ Broker-dealers would be
more likely to account for market centers' execution quality, further
promoting the flow of orders to market centers offering better
execution quality. The flow of orders to those market centers offering
better execution quality could also result in further improvements in
execution quality for their customers, as liquidity externalities and
the consolidation of orders onto high-quality market centers would
increase the liquidity of these venues.\909\
---------------------------------------------------------------------------
\906\ See supra section VII.D.1.(b)(1)(a) for a discussion of
the effects of the proposed amendments on broker-dealer routing
practices.
\907\ The Commission believes that these effects would
principally accrue to larger broker-dealers, but may spill over to
effect smaller broker-dealers as well. See supra note 901.
\908\ See supra section VII.D.1.(a)(1)(a) for a discussion of
how the proposed amendment requiring larger broker-dealers to
publish Rule 605 reports would promote increased transparency about
the execution quality of larger broker-dealers.
\909\ However, liquidity externalities may have adverse effects
on the competition between market centers if they result in the exit
of some market centers. See infra section VII.D.1.(d)(4) for a
discussion.
---------------------------------------------------------------------------
Additionally, the proposed amendments modifying the scope of
reporting entities to specify that broker-dealers post separate Rule
605 reports for their ATSs and require that market centers operating
SDPs and qualified auctions post separate reports for each market
center would facilitate comparisons of execution quality across similar
types of market centers, by allowing market participants to be better
informed about the execution quality of each type of market
center.\910\ This would increase the extent to which these market
centers would compete on the basis of execution quality in order to
attract orders.
---------------------------------------------------------------------------
\910\ See supra section VII.D.1.(a)(1) for a discussion of how
the proposed amendments modifying the scope of reporting entities
would promote increased transparency about execution quality.
---------------------------------------------------------------------------
The magnitude of the improvements in execution practices may be
lower when the MDI Rules are implemented, because the availability of
faster consolidated market data with more data on odd-lot information,
auctions information, and depth of book information from competing
consolidators could result in more informed customer order routing by
broker-dealers that switch to consuming the expanded consolidated
market data, which could separately increase the flow of orders to
trading venues offering better execution quality.\911\ However, the
Commission believes that the proposed amendments would lead to
improvements in execution practices over and above the improvements
that might result from the implementation of the MDI Rules.
---------------------------------------------------------------------------
\911\ See supra section VII.C.1.(d)(2) for further discussion.
---------------------------------------------------------------------------
[[Page 3874]]
(c) Improvements to Information Used To Make Apples-to-Apples
Comparisons of Execution Quality
The Commission believes that competition between reporting entities
on the basis of execution quality would also be enhanced by the
proposed amendments modernizing the information included in Rule 605
reports used to make apples-to-apples comparisons of execution quality.
Some of the information required to be reported by Rule 605 does not
measure execution quality directly but serves the purpose of providing
context to execution quality metrics. This enables investors to make
better apples-to-apples comparisons across reporting entities whose
order flows consist of different mixes of securities, order sizes, and
order types,\912\ and to ascertain how entities may handle orders
during different market conditions.\913\ If market participants have
access to more (and/or more relevant) information that improves their
ability to compare execution quality across reporting entities, this
would further promote competition between reporting entities on the
basis of execution quality, resulting in improvements in execution
quality for investors. Such information includes the proposed
amendments expanding and modernizing order size and order type
categories,\914\ which permit market participants to control for
potential differences in the characteristics of reporting entities'
order flow, as well as the proposed amendments modifying the
calculation of realized spreads,\915\ which allows market participants
to control for potential differences in the extent to which reporting
entities handle orders during periods of adverse market conditions.
---------------------------------------------------------------------------
\912\ See supra note 513 for an example of how differences in
order flow characteristics may impact inferences about execution
quality.
\913\ See supra note 701 and accompanying text for a discussion
of how handling order flow during adverse market conditions affects
execution quality.
\914\ See supra sections VII.D.1.(a)(2)(b) and
VII.D.1.(a)(2)(c)(i)-(ii) for discussions of how the proposed
amendments expanding the coverage of orders, as well as modifying
the existing order type and size categories, respectively, would
promote increased transparency about execution quality.
\915\ See supra section VII.D.1.(a)(2)(c)(iv) for a discussion
of how the proposed amendments modifying the reporting requirements
for realized spreads, including expanding and modernizing the time
horizon used to calculate the average realized spread, as well as
including information about percentage average realized spreads,
would promote increased transparency about execution quality.
---------------------------------------------------------------------------
Furthermore, as market participants have access to more useful
information about the execution quality of particular order types and
sizes, the extent to which reporting entities would need to compete on
the basis of execution quality to attract these types of orders would
increase, and order flow would accumulate to the reporting entities
offering the highest execution quality for these types of orders. This
would in turn translate into improved execution quality for investors
for these types of orders. For example, as a result of the proposed
amendment expanding the order size categories to include information
about odd-lots, market participants' improved access to information
about a market center's offering of price improvement and timely
execution of odd-lots would improve both the price and speed at which
odd-lot orders are executed, which would be beneficial for both
institutional and individual investors.\916\
---------------------------------------------------------------------------
\916\ See supra section VII.C.2.(b)(1)(a) for a discussion of
the use of odd-lots by both individual and institutional investors.
---------------------------------------------------------------------------
(d) Improvements to Accessibility
The Commission believes that execution quality would also increase
as a result of the proposed amendment requiring reporting entities to
prepare human-readable summary reports,\917\ as market participants
would be better able to use information from Rule 605 reports to
compare execution quality across reporting entities and competition
between reporting entities on the basis of execution quality would
increase as a result.\918\ Specifically, individual investors, who may
be less likely to have access to the resources to retrieve and process
the raw data in Rule 605 reports, would be better able to access
information from Rule 605 reports to compare execution quality across
larger broker-dealers, which would increase the extent to which these
broker-dealers would need to compete on the basis of execution quality
to attract and retain these customers.
---------------------------------------------------------------------------
\917\ See proposed Rule 605(a)(2). See also supra note 462 and
accompanying text.
\918\ See supra section VII.D.1.(a)(3) for a discussion of how
the proposed amendment requiring reporting entities to prepare
human-readable summary reports would result in increased
transparency about execution quality.
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(2) Improvements to Components of Execution Quality
The Commission believes that the proposed amendments would have the
effect of improving the quality of executions along specific dimensions
of execution quality, including execution prices, size improvement,
execution speeds, and execution probabilities (i.e., fill rates), as
investors (and their broker-dealers) would be better able to identify
and route orders to those reporting entities that offer better quality
executions in terms of a particular dimension of execution
quality,\919\ and as reporting entities would further compete with one
another on the basis of these dimensions of execution quality.\920\ The
Commission believes that the proposed amendments would lead to
improvements in execution quality relative to a baseline in which the
MDI Rules are implemented, i.e., over and above any improvements in
execution quality that may result from the implementation of the MDI
Rules.\921\
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\919\ See supra section VII.D.1.(a) for a discussion of the
benefits to the proposed amendments for increased transparency.
\920\ See supra section VII.D.1.(b)(1) for a discussion of the
impact of the proposed amendments on competition between reporting
entities on the basis of execution quality.
\921\ See supra section VII.C.1.(d)(2) for further discussion.
---------------------------------------------------------------------------
(a) Execution Prices
The Commission believes that the proposed amendments would improve
execution quality in terms of execution prices by increasing the extent
to which reporting entities seek out executions at prices better than
the NBBO; i.e., increasing the extent to which market centers execute
order with price improvement, and/or increasing the extent to which
broker-dealers route to market centers offering price improvement.
First, the proposed amendment to require information on the average
percentage effective spread in addition to the average effective spread
in dollar terms would facilitate more apples-to-apples comparisons of
execution prices across reporting entities, permitting greater
competition and resulting in lower effective spreads; i.e., better
execution prices.\922\ Second, the proposed amendment to require
information about effective spreads for NMLOs, in addition to market
and marketable limit orders, would allow providers of limit orders (and
their broker-dealers) to make comparisons across market centers based
on the profitability of their limit order strategies, permitting
greater competition and resulting in lower (i.e., more negative)
effective spreads for NMLOs.\923\ Third, the proposed amendment to
require price improvement statistics using the best available displayed
price as the benchmark for market, marketable limit,
[[Page 3875]]
marketable IOC, and beyond-the-midpoint limit orders, would promote
incentives for reporting entities to seek out or offer price
improvement relative to the best displayed price, taking into account
all available displayed liquidity (including odd-lots).\924\ Continuing
the example from section VII.C.2.(c)(6), in which a market center
internalizing an order could post a positive price improvement metric
even though a better-priced odd-lot was available at another market
center, this would not be the case for price improvement metrics
measured relative to the best displayed price. Instead, the market
center may be incentivized to increase its offering of price
improvement from $0.05 above the NBBO to $0.15 above the NBBO (i.e.,
$0.05 above the best displayed price), in order to maintain the same
level of price improvement in its Rule 605 report. Lastly, the proposed
amendment to require reporting entities to report effective over quoted
spreads would make more readily available a measure that is already
often used and well understood by industry participants, and would
result in improved execution prices as a result of the effects on
competition.\925\
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\922\ See supra section VII.D.1.(a)(2)(b)(iv) for a discussion
of the effect of the proposed amendment to include the average
percentage effective spread on transparency.
\923\ See id. for a discussion of the effect of the proposed
amendment to include the average effective spread for NMLOs on
transparency.
\924\ See supra section VII.D.1.(a)(2)(b)(v) for a discussion of
the effect of the proposed amendments related to include information
about price improvement relative to the best displayed price on
transparency.
\925\ See supra section VII.D.1.(a)(2)(b)(iv) for a discussion
of the benefits to transparency of the proposed amendments related
to include information about E/Q into Rule 605 reporting
requirements.
---------------------------------------------------------------------------
(b) Size Improvement
The proposed amendments would improve execution quality in terms of
size improvement by increasing the extent to which market centers
execute orders beyond the liquidity available at the NBBO; i.e.,
execute order with size improvement, and by increasing the extent to
which broker-dealers route to market centers offering size improvement.
The proposed amendment would require reporting entities to report a
benchmark metric calculated as the consolidated reference quote size,
capped at the size of the order.\926\ In order to attract broker-dealer
order flow,\927\ market centers would be incentivized to compete on the
basis of size improvement, for example by executing orders against
their own inventory at or better than the NBBO, or offering additional
incentives to attract hidden liquidity priced at or better than the
NBBO. Investors that particularly value the ability of reporting
entities to offer size improvement, such as investors trading in larger
order sizes, would be able to use this metric to discern which
reporting entity might offer better size improvement to their orders,
which would allow them to make better routing decisions and obtain
increased size improvement as a result.\928\ Competition on the basis
of size improvement among reporting entities would also increase in
order to attract these customers and their orders.
---------------------------------------------------------------------------
\926\ See supra note 720 for an example.
\927\ See supra section VII.D.1.(b)(1)(a) for a discussion of
how the proposed amendments would increase competition between
broker-dealers on the basis of execution quality.
\928\ For example, compare the example of Market Center B
offering size improvement to a 200-share order in note 718, supra,
to the example of Market Center B offering price improvement to a
100-share order in note 719, supra. A trader that tends to submit
200-share orders would want to know a market center's ability to
offer the first scenario, while a trader that tends to submit 100-
share orders would want to know the market center's ability to offer
the second scenario. However, in both examples the Rule 605 report
would show an effective spread statistic of $0.05 for orders in the
order size category of 100-499 shares, which means that these
traders would not be able to use this statistic to discern a market
center's execution quality according to the dimension of execution
quality that they find most valuable.
---------------------------------------------------------------------------
(c) Execution Speeds
The proposed amendments would also improve execution quality by
increasing execution speeds for those investors that value fast
executions.\929\ The proposed amendments increasing the granularity of
the timestamp conventions required by Rule 605 from seconds to
milliseconds, replacing the time-to-execution categories currently
defined in Rule 605 with time-to-execution statistics, and measuring
time-to-execution for NMLOs from the time that the order becomes
executable, rather than from the time of order receipt, would lead to
improved execution times for investors, as the increased transparency
around reporting entities' execution times would increase their ability
to identify and route orders to reporting entities offering faster
execution speeds.\930\
---------------------------------------------------------------------------
\929\ See supra section VII.C.2.(c)(4) for a discussion of
current executions speeds. The Commission expects these benefits to
mainly accrue to investors that value faster executions, as these
investors (and their broker-dealers) would benefit from an improved
ability to compare execution speeds across trading venues and route
their orders accordingly. However, to the extent that changes in
order flow would result in an increase in market centers' incentives
to offer faster executions, e.g., by investing in faster trader
technology, this could result in a market-wide increase in trading
speeds for all investors.
\930\ See supra section VII.D.1.(a)(2)(b)(iii) for a discussion
of how these amendments to timestamp conventions would promote
transparency on the basis of execution quality.
---------------------------------------------------------------------------
Investors that may prioritize fast execution times would be able to
better identify the reporting entities offering better execution
quality in terms of time-to-execution. Different investors benefit from
faster execution times for different reasons. Individual investors
often benefit from faster executions to the extent that faster
executions result in better prices. For example, market orders benefit
from fast execution as any delay in execution could result in worse
price if prices are increasing (for buy orders) or decreasing (for sell
orders). This is particularly true for market orders submitted with
stop prices, which tend to be triggered during rapidly declining
markets, and which an analysis finds constitute 6.44% of market orders
submitted by individual investors.\931\ For IOCs, a faster execution
implies a faster routing time, which would reduce the chance of another
order stepping in and removing liquidity before the order gets a chance
to execute, thus increasing the order's probability of execution.
---------------------------------------------------------------------------
\931\ See Table 4 in supra section VII.C.2.(b)(2).
---------------------------------------------------------------------------
For institutional investors, the benefits of fast execution may be
different.\932\ Institutional investors, who often need to trade large
positions, may care more about reducing the price impact of their order
rather than executing the order quickly.\933\ However, the academic
literature suggests that institutional investors with short-lived
private information may benefit from faster time-to-executions, as they
are able to profit from trading against other, slower
institutions.\934\ On the same note, faster time-to-executions benefit
slower institutional investors by reducing their exposure to adverse
selection as much as possible.\935\ Institutional investors may also
care about the execution speed of their child orders.
---------------------------------------------------------------------------
\932\ While institutional investors are likely to have access to
alternative sources of more granular information about execution
speeds, such as reports obtained through TCA, the information on
execution quality that is individually collected by institutional
investors is typically non-public and highly individualized, and
therefore limited to the execution quality obtained from broker-
dealers with which the institutional investors currently does
business. Since Rule 605 reports are public, institutional investors
could use these reports to assess the execution quality of the
broker-dealers and market centers with which they do not currently
do business. See supra section VII.C.1.(c)(2) for further
discussion.
\933\ See supra section VII.C.3.(a)(1)(b) for a discussion of
the handling of institutional orders by broker-dealers as not held
orders.
\934\ See, e.g., Ohad Kadan, Roni Michaely & Pamela C. Moulton,
Trading in the Presence of Short-Lived Private Information: Evidence
from Analyst Recommendation Changes, 53 J. Fin. Quantitative
Analysis 1509 (2018).
\935\ See, e.g., Jonathan Brogaard, Bjorn Hagstr[ouml]mer, Lars
Nord[eacute]n & Ryan Riordan, Trading Fast and Slow: Colocation and
Liquidity, 28 Rev. Fin. Stud. 3407 (2015).
---------------------------------------------------------------------------
[[Page 3876]]
(d) Fill Rates
The Commission believes that the proposed amendments would improve
execution quality in terms of increased fill rates.\936\ Specifically,
the proposed amendment for reporting entities to report the number of
shares that executed while an executable NMLO was in force would
increase the ability of investors and their broker-dealers to route
orders to those reporting entities with higher fill rates of executable
NMLOs, as market participants would have access to information about
the extent to which a NMLO did not execute or executed after a large
number of shares executed elsewhere in the market, despite the fact
that the NMLO was executable.\937\ In order to attract this order flow,
reporting entities would need to improve their ability to achieve
executions for executable NMLOs. Market centers could achieve higher
fill rates for NMLOs, for example, by reducing access fees to encourage
more marketable orders to execute against resting NMLOs, or by
discouraging excessive submissions and cancellations of NMLOs, for
example by instituting or raising excessive messaging fees.\938\
Broker-dealers could achieve higher fill rates for NMLOs by improving
their order routing methods and by routing orders to market centers
that achieve higher fill rates for NMLOs.
---------------------------------------------------------------------------
\936\ See supra note 519 for a definition of the fill rate.
\937\ See supra section VII.D.1.(a)(2)(b)(vi) for a discussion
of how the proposed amendment requiring reporting entities to report
the number of shares that executed while an executable NMLO was in
force increase transparency.
\938\ See, e.g., Price List--Trading Connectivity, NASDAQ,
available at https://www.nasdaqtrader.com/trader.aspx?id=pricelisttrading2, which describes how one market
center charges its members a penalty for exceed a certain ``Weighted
Order-to-Trade Ratio.''
---------------------------------------------------------------------------
(c) Other Benefits
To the extent that the proposed amendments to Rule 605 increase
incentives for reporting entities to compete in areas other than
improved execution quality, customers may benefit from improvements
that are not directly related to execution quality, such as lower fees,
higher rebates, new products or functionalities, or better customer
service. Note that improvements in other quality areas as a result of
the increase in competition among reporting entities may be either
complementary to or a substitute for improvements in execution quality.
Investors are more likely to see an overall benefit from the proposed
amendments to the extent that these improvements are complementary.
Furthermore, to the extent that the proposed amendments increase
competition in related markets, market participants could benefit from
lower costs and/or improved quality in these markets. For example, the
quality of TCA reports may improve if their publishers need to offer
better products in order to complete with the publicly available data
under Rule 605.
(d) Potential Limitations to Benefits
There are certain factors, however, that could limit the effects of
the proposed amendments on transparency and competition, which would
limit the effectiveness of the proposed amendments in improving
execution quality.
(1) Effect on Smaller Broker-Dealers
The expanded scope of Rule 605 only includes larger broker-dealers.
Hence, investors, as they gain transparency into the execution at these
larger broker-dealers, may route more transactions to these broker-
dealers at the expense of smaller broker-dealers who are not included
in the scope of Rule 605. That said, smaller broker-dealers may gain a
competitive advantage in the form of lower costs as a result of not
having to prepare Rule 605 reports. Also, increased levels of
competition between larger broker-dealers may spill over to affect
smaller broker-dealers, as their customers may expect more
transparency, and smaller broker-dealers would continue to be able to
publish ad hoc execution quality reports that focus on execution
quality metrics in which they perform well.\939\ Altogether, the
Commission preliminarily believes that the cumulative effects on
smaller broker-dealers, who handle only a small fraction of all
orders,\940\ are likely to be minimal, and limiting the scope of Rule
605 to large broker-dealers should suffice for the purposes of
achieving the competitive effects discussed in prior sections.\941\
---------------------------------------------------------------------------
\939\ These information asymmetries are described in more detail
in supra section VII.C.1.(a).
\940\ See infra section VII.E.1.(a) for a discussion of an
analysis showing that broker-dealers with 100,000 customers or
greater handled 66.6% of customer orders and 1.5% of customer
accounts identified in the data sample. Note that, if these smaller
broker-dealers would attract enough customers such that they
represent a more significant fraction of orders, it is likely they
would also subsequently fall above the customer account threshold
and be required to begin publishing Rule 605 reports.
\941\ See supra section VII.D.1.(b)(1) for a discussion of the
effects of the proposed amendments on competition between reporting
entities on the basis of execution quality.
---------------------------------------------------------------------------
It is also possible that, as a result of the proposed amendments,
smaller broker-dealers that are unable,\942\ or choose not, to offer
the same levels of transparency as larger broker-dealers may lose
customers to larger broker-dealers for which better execution quality
information is available, which could cause some smaller broker-dealers
to exit the market. The Commission is unable to quantify the likelihood
that a brokerage firm would cease operating as a result of the proposed
amendments. Even if some smaller broker-dealers were to exit, the
Commission does not believe this would significantly impact competition
in the market for brokerage services because the market is served by a
large number of broker-dealers.\943\ The Commission recognizes that
smaller broker-dealers may have unique business models that are not
currently offered by competitors, but the Commission believes other
broker-dealers, including new entrants, could create similar business
models if demand was adequate.
---------------------------------------------------------------------------
\942\ For example, if investors make use of third-party
summaries of Rule 605 reports, these summaries may not incorporate
execution quality information outside of ``official'' Rule 605
reports. In that way, smaller broker-dealers would be unable to
offer the same level of transparency even if they were to prepare an
execution quality report containing all of the information and
according to the exact specifications of Rule 605.
\943\ See supra section VII.C.3.(a)(1) for a discussion of the
current structure of the market for brokerage services.
---------------------------------------------------------------------------
(2) Switching Costs
The effects of the proposed amendments on competition among
reporting entities \944\ may be limited if investors incur high costs
to switch between broker-dealers, and/or if broker-dealers incur costs
to switch between market centers in response to information about
execution quality. To the extent that competition between reporting
entities on the basis of execution quality is limited, this would limit
the extent to which execution quality would improve as a result of the
proposed amendments.\945\
---------------------------------------------------------------------------
\944\ See supra section VII.D.1.(b)(1) for a discussion of the
effects of the proposed amendments on competition between reporting
entities on the basis of execution quality.
\945\ The effect of switching costs on competition may also
depend on the variability of reporting entities' execution quality
over time. For example, if the execution quality of any given
reporting entity varies significantly over time, customers of those
reporting entities may find it optimal to switch between reporting
entities with some frequency, which would increase their overall
switching costs. On the other hand, if the execution quality of
reporting entities is relatively constant over time, the number of
times that a customer would optimally want to switch between
reporting entities would likely be more limited, and in this case
switching costs may be a relatively small and/or short-term
friction.
---------------------------------------------------------------------------
[[Page 3877]]
First, if the costs for customers to switch broker-dealers are
significant,\946\ this would limit the extent to which Rule 605
promotes competition among broker-dealers on the basis of execution
quality. However, switching costs for both individual and institutional
investors may be limited. For example, institutional investors are
likely to have multiple broker-dealers, which would facilitate the
transfer of business to better-performing broker-dealers, and, for
individual investors, transferring between retail brokers may be less
costly, for example, because some retail brokers will compensate new
customers for transfer fees that their outgoing broker-dealer may
charge them.\947\
---------------------------------------------------------------------------
\946\ See supra section VII.C.3.(a)(1) for a discussion of
switching costs related to switching broker-dealers.
\947\ See supra note 745 for an example.
---------------------------------------------------------------------------
Second, the presence of switching costs that broker-dealers incur
from changing the primary trading venues to which they route orders
\948\ may limit the effects of the proposed amendments on competition
among market centers. However, the Commission expects this to be less
of an issue for the larger broker-dealers that would be required to
produce Rule 605 reports,\949\ as these broker-dealers would likely
face lower switching costs. For example, larger broker-dealers are
likely already connected to multiple national securities exchanges.
They are experienced with routing order flow across a larger variety of
market centers and/or have sufficient bargaining power to renegotiate
any agreements that they might have with individual market centers.
---------------------------------------------------------------------------
\948\ See supra section VII.C.3.(b)(1) for discussions of
switching costs broker-dealers may face when switching trading
venues.
\949\ The Commission believes that the competitive effects of
the proposed amendments would principally accrue to larger broker-
dealers, who would be required to prepare Rule 605 reports, and thus
these would be the broker-dealers most likely to be incentivized to
switch market-centers as a result of additional information about
market center execution quality. However, these effects may spill
over to smaller broker-dealers as well per the discussion in supra
section VII.D.1.(d)(1). For these smaller broker-dealers, switching
costs may be more binding.
---------------------------------------------------------------------------
(3) Limited Usage and Search Costs
The benefits of the proposed amendments for transparency,
competition, and execution quality may be limited if market
participants are not likely to make use of the additional information
available under the proposed amendments, e.g., because this information
is difficult to access or is not useful to market participants due to
the availability of other sources of information about execution
quality.
For example, investors currently have access to information about
the execution quality achieved by their broker-dealers for their not
held orders,\950\ which in certain circumstances may be more relevant
for institutional investors than aggregate information about the
execution quality of broker-dealers' held orders \951\ and may lead to
a low usage rate by institutional investors of larger broker-dealers'
Rule 605 reports as proposed to be required. This would limit the
benefits of the proposed amendments for competition in the market for
institutional brokerage services. However, to the extent that
institutional investors' alternative sources of execution quality
information do not contain information about all of their relevant
orders, and/or cannot be easily used to compare across broker-dealers
that an investors does not do business with,\952\ the proposed
amendments would likely impact competition for institutional brokerage
services as well.
---------------------------------------------------------------------------
\950\ See supra note 60 and accompanying text discussing broker-
dealers' requirements under Rule 606(b)(3) to provide individualized
reports of execution quality upon request for not held orders.
\951\ See supra section VII.C.3.(a)(1)(b) for a discussion of
institutional investors' usage of not held orders.
\952\ See discussion in supra section VII.C.1.(c)(2).
---------------------------------------------------------------------------
Furthermore, the volume and complexity of data produced by Rule 605
reports (i.e., both the number of rows and columns of Rule 605 reports)
would increase as a result of the proposed amendments to modify the
coverage of orders and expand the information required by Rule 605.
Both of these factors could make the evaluation of the raw data in Rule
605 reports costlier. If, in order to avoid this additional complexity,
market participants would not incorporate the data elements or orders
types that are proposed to be added to Rule 605 reports under the
proposed amendments into their analyses of consumption of Rule 605
data, this would limit the potential benefits of the proposed
amendments. However, market participants that currently have the
resources to process and analyze the raw data contained in Rule 605
reports are likely to have the resources to process and analyze the
additional data elements. To the extent that some investors may not
have access to the resources to directly analyze the raw Rule 605 as a
result of its increase in complexity,\953\ the Commission expects that
independent analysts, consultants, broker-dealers, the financial press,
and market centers would continue to respond to the needs of investors
by analyzing the disclosures and producing more digestible information
using the data.\954\
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\953\ See supra section VII.C.1.(c)(1) for a discussion of the
difficulties that individual investors may face when accessing Rule
605 reports.
\954\ See supra note 545-546 for examples of how third parties
currently use Rule 605 data to produce information meant for public
consumption.
---------------------------------------------------------------------------
The benefits of the proposed amendments for transparency,
competition, and execution quality may also be limited by the presence
of search costs. The proposed amendments are expected to increase the
number of Rule 605 reporting entities from 236 to 359.\955\ For those
market participants that would seek to collect a complete or mostly
complete set of Rule 605 reports, these market participants would need
to search through and download reports from a greater number of
websites, which would increase their search costs.\956\ If, in order to
avoid this increase in search costs, market participants would not
incorporate execution quality information from the proposed additional
reporting entities into their search or analysis of Rule 605 reports,
this would limit the benefits of the proposed expansion of Rule 605
reporting entities.
---------------------------------------------------------------------------
\955\ See supra section VI.C for a description of these
estimates.
\956\ See supra section VII.C.2.(d) for a discussion of the
search costs associated with collecting information from Rule 605
reports.
---------------------------------------------------------------------------
(4) Liquidity Externalities
The effects of the proposed amendments on competition between
market centers \957\ may be limited by the development of liquidity
externalities, or the consolidation of liquidity on a few dominant
market centers.\958\ Under such circumstances, while the consolidation
of liquidity on market centers offering superior execution quality may
benefit market participants in the short run, it may also lead to
barriers to entry in the market for trading services, as new entrants
may have a harder time attracting sufficient liquidity away from
established liquidity centers. This could also lead to consolidation or
exit by smaller market centers. This could have the effect of reducing
competition in the market for trading services. The Commission is
unable to quantify the likelihood that
[[Page 3878]]
some smaller market centers would cease operating.
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\957\ See supra section VII.D.1.(b)(1) for a discussion of the
effects of the proposed amendments on competition between reporting
entities on the basis of execution quality.
\958\ For theoretical discussions of liquidity externalities see
Marco Pagano, Trading Volume and Asset Liquidity, 104 Q. J. Econ.
255 (1989): Ananth Madhavan, Consolidation, Fragmentation, and the
Disclosure of Trading Information, 8 Rev. Fin. Stud. 579 (1995).
---------------------------------------------------------------------------
(5) Dimensions of Execution Quality Not Captured by Rule 605 Reports
The expected benefits from the proposed amendments to Rule 605 may
be lessened to the extent that there are dimensions of execution
quality not captured by Rule 605 reports which drive order handling
decisions. For example, the ability of customers and/or traders to
remain anonymous or limit information leakage may not be a dimension
that is easily discernible from looking at Rule 605 data, though it is
a feature of execution quality that may be valued by some
investors.\959\ Similarly, the extent to which the reported statistics
are perceived to fail to serve as an acceptable or timely proxy for a
reporting entities' ability to secure favorable executions may dampen
the benefits of proposed amendments for execution quality. This may
happen if, for example, future market developments render the monthly
reporting requirement to be too infrequent to be useful.
---------------------------------------------------------------------------
\959\ See, e.g., Carole Comerton-Forde & Kar Mei Tang,
Anonymity, Liquidity and Fragmentation, 12 J. Fin. Mkt. 337 (2009),
who found evidence of evidence of a migration in order flow from the
non-anonymous New Zealand Exchange (NZX) to the Australian Stock
Exchange after the latter increased anonymity by removing broker
identifiers from the central limit order book.
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2. Costs
As discussed in detail below, the Commission recognizes that the
proposed amendments to Rule 605 would result in initial and ongoing
compliance costs to reporting entities. The Commission quantifies the
costs where possible and provides qualitative discussion when
quantifying costs is not feasible. Most of the compliance costs related
to the proposed amendments to Rule 605 involve a collection of
information, and these costs are discussed above in relation to the
expected burdens under the Paperwork Reduction Act, with those
estimates being used in the economic analysis below.\960\
---------------------------------------------------------------------------
\960\ See supra section VI.D for a discussion of how the
proposed amendments would create burdens under the PRA.
---------------------------------------------------------------------------
(a) Compliance Costs
The Commission believes that the majority of costs related to the
proposed amendments would be in the form of compliance costs, including
both initial and ongoing. Table 9 provides a summary of the estimated
change in compliances costs \961\ resulting from the proposed
amendments. The majority of both initial and ongoing compliance costs
would be related to the proposed expansion of the scope of reporting
entities. However, a significant portion of initial compliance costs
would also result from the proposed amendments modifying the coverage
of orders and information required by Rule 605, as current reporters
would need to update their systems and additionally some new market
centers trading in fractional shares would be required to report.
Lastly, compliance costs resulting from the proposed amendment
requiring reporting entities to prepare summary execution quality
reports would mostly be ongoing.
---------------------------------------------------------------------------
\961\ Note that the discussion in section VI.D considers the
total expected ongoing compliance costs for all reporting entities,
both new respondents and current respondents. To focus on the costs
that would directly follow from the proposed amendments, this
section focuses on the expected change in ongoing costs, which
excludes the portions of ongoing costs that current respondents
currently incur.
Table 9--Estimated Compliance Costs, by Cost Category
------------------------------------------------------------------------
Initial Ongoing
compliance compliance
Cost category costs costs
(million) (million)
------------------------------------------------------------------------
Expanding the Scope of Reporting $3.8 $3.9
Entities...............................
Modifications to Information Required... 3.4 1.9
Proposed Summary Execution Quality 1.7 1.1
Reports................................
-------------------------------
Total............................... 8.9 6.8
------------------------------------------------------------------------
Table 9: Estimated Compliance Costs, by Cost Category. This table
presents estimates of the compliance costs related the to three broad
categories of the proposed amendments to Rule 605 (expanding the scope
of reporting entities, modifications to the coverage of orders and
information required, and the proposed amendment requiring the
preparation of summary reports). Numbers are based on the estimated
number of respondents and PRA costs in sections VI.C and VI.D supra
and have been rounded to the nearest tenth of million to avoid false
precision. Further breakdowns of these estimates are presented in
Tables 10, 11, and 12.
Table 9 further breaks compliance costs down into three separate
categories--costs related to the expansion of reporting entities, costs
related to modifications to information required, and costs related to
the preparation of summary execution quality reports.
Estimates for the costs in each of these categories depend on a
number of factors, including wages, inflation, and firm size, and the
Commission acknowledges that the costs presented could be
underestimated to the extent that wages and/or inflation are higher
than those used in the estimation. Meanwhile, costs in each of these
categories may also be overestimated if, instead of preparing reports
in-house, reporting entities contracted with third-party vendors to
prepare their reports.\962\ The costs in Table 9 are based on the
assumption that reporting entities would prepare their Rule 605 reports
in-house. Due to their ability to leverage their technical expertise
and potential economies of scale, third-party vendors may be able to
prepare Rule 605 reports for a lower cost than if each individual
reporting entity prepares its own report, and could pass these lower
costs on to their customers, resulting in lower compliance costs.
However, the Commission is unable to know the percentage of entities
that currently make use of third-party vendors to prepare their Rule
605 reports, nor the percentage of entities that would make use of
third-party vendors following the proposed amendments. Therefore,
Commission is basing its compliance cost estimates on the potentially
higher costs of in-house preparations of Rule
[[Page 3879]]
605 reports in order to be as conservative as possible.
---------------------------------------------------------------------------
\962\ Specifically, the Commission estimates that, while
preparing in-house reports would result on an annualized ongoing
cost of $37,248 per respondent, contracting with a third party to
prepare Rule 605 of their behalf would result in an annualized
ongoing cost of $36,000 per respondent. See supra section VI.D. The
Commission uses the higher of these costs in the present analysis to
obtain a more conservative estimate of potential costs.
---------------------------------------------------------------------------
(1) Compliance Costs Related To Expanding the Scope of Rule 605
Reporting Entities
As a result of the proposed amendments expanding the scope of Rule
605 reporting entities, market centers and broker-dealers that were
previously not required to publish Rule 605 reports would incur initial
costs to develop the policies and procedures to prepare Rule 605
reports for the first time, and ongoing costs to continue to prepare
them each month. Larger broker-dealers would incur initial and ongoing
compliance costs as a result of the proposed amendment expanding the
scope of Rule 605 reporting entities to include large broker-dealers.
Similarly, the proposed amendments requiring reporting entities to
prepare separate reports for their SDPs and qualified auctions would
similarly result in market centers that were previously not required to
prepare Rule 605 reports facing initial and ongoing compliance costs.
The Commission estimates that 85 broker dealers, along with 10 SDPs and
8 qualified auctions,\963\ would be required to start publishing Rule
605 reports as a result of the proposed amendments expanding the scope
of Rule 605 reporting entities. Table 10 breaks down the initial and
ongoing compliance costs associated these three types of reporting
entities.
---------------------------------------------------------------------------
\963\ See supra note 483 and accompanying text for a discussion
of these estimates. See also infra section VII.E.1.(a) for a
discussion of estimating the number of larger broker-dealers (i.e.,
broker-dealers that introduce or carry customers above a threshold
number of customer accounts), that would be required to prepare
execution quality reports pursuant to Rule 605, defining the
customer account threshold as 100,000 customer accounts.
Table 10--Estimated Compliance Costs Related to Proposed Expansion of Rule 605 Reporting Entities
----------------------------------------------------------------------------------------------------------------
Initial Ongoing
Number of compliance compliance
respondents costs costs
(million) (million)
----------------------------------------------------------------------------------------------------------------
Broker-Dealers.................................................. \a\ 85 \b\ $3.1 \c\ $3.2
SDPs............................................................ \d\ 10 \b\ 0.4 \c\ 0.4
Qualified Auctions.............................................. \e\ 8 \b\ 0.3 \c\ 0.3
-----------------------------------------------
Total....................................................... 103 3.8 3.9
----------------------------------------------------------------------------------------------------------------
Table 10: Estimated Compliance Costs Related to Proposed Expansion of Rule 605 Reporting Entities. This table
presents estimates of the compliance costs related to the proposed amendments to Rule 605 expanding the scope
of reporting entities. Numbers are based on the estimated number of respondents and PRA costs in sections VI.C
and VI.D supra and have been rounded to the nearest tenth of million to avoid false precision.
\a\ The number of new broker-dealer respondents is estimated using data from 2021 FOCUS Report Form X-17A-5
Schedule I filings and CAT, according to the procedure described in detail in infra note 1008.
\b\ The estimate of initial compliance costs to new respondents is based on the monetized initial burden in
supra note 491 for new respondents, assuming that these respondents would incur 100 initial burden hours at an
average hourly cost of ($37,020/100 hours) = $370.20 per respondent per hour.
\c\ The estimate of ongoing compliance costs to new respondents is based on the monetized annual burden in supra
note 492 for new respondents, assuming that these respondents would incur 8 ongoing burden hours per month (12
per year) at an average hourly cost of ($37,488/(8 hours * 12 months)) = $391.00 per respondent per hour.
\d\ The Commission does not have knowledge of the number of SDPs in operation and there has chosen a
conservative estimate of 10 SDPs.
\e\ The Commission is not able to know the number of qualified auctions that would begin operation if the Order
Competition Rule Proposal were to be adopted, and has therefore chosen a conservative estimate of 8 qualified
auctions.
New reporters would face one-time, initial compliance costs to
develop and implement the policies and procedures to prepare Rule 605
reports for the first time. The Commission believes that the majority
of these costs would relate to the development of systems to obtain,
store and process the data required for Rule 605 reports.
Larger broker-dealers that generally or exclusively route orders
away would need to obtain information, such as the time of order
execution and execution price, from trade confirmations provided by the
execution venue. In addition, both broker-dealers and market centers
would need to match their order information to historical price and
depth information available via the exclusive SIPs or, following the
implementation of the MDI Rules, competing consolidators,\964\ to
determine the NBBO (and/or best displayed) quote and size at the time
of order receipt (or executability) and at the time of order execution,
and use this data to calculate the required statistics.\965\ These new
reporters likely already retain most, if not all, of the underlying raw
data necessary to generate these reports in electronic format or may
obtain this information from publicly available data sources, and
currently calculate similar measures to those that would be required
under Rule 605 as proposed for their own internal purposes.\966\
However, as a result of the proposed amendments, new reporters may have
to acquire or develop data specialists and/or programmers to the extent
that the information required by Rule 605 as proposed is different or
more complex than the information that the new reporters typically
processes, and/or acquire legal specialists to ensure compliance with
the Rule.
---------------------------------------------------------------------------
\964\ See supra section VII.C.1.(d)(2).
\965\ See supra note 196 and accompanying text.
\966\ For example, broker-dealers may calculate similar measures
as part of their Best Execution Committees' periodic review. See
supra note 567 and accompanying text.
---------------------------------------------------------------------------
[[Page 3880]]
These compliance costs related to expanding the scope of Rule 605
reporting requirements may be under- or overestimated to the extent
that larger broker-dealers, which are assumed to have the same
compliance costs as SDPs and qualified auctions in Table 10, could
experience higher or lower initial and/or ongoing costs than other
types of reporting entities. For example, larger broker-dealers may
incur higher initial costs to the extent that they do not currently
obtain transaction information, such as the time of order execution and
execution price, from trade confirmations provided by execution venues,
and therefore would need to develop the procedures for doing so.
Broker-dealers may also face higher ongoing costs as compared to market
centers that mostly execute the shares that they receive, if collecting
information for trades executed at away market centers is costlier than
analyzing in-house trade information; e.g., because it results in
delays in processing the trade information. On the other hand, larger
broker-dealers may incur lower initial costs if they are more likely
than market centers to already calculate similar measures to those
proposed as part of their Best Execution Committees' periodic
review.\967\ In addition, the Commission does not believe that there
would be significant additional costs to collecting information for
trades executed at away market centers, as given the monthly reporting
frequency of Rule 605 reports, broker-dealers should have sufficient
time to collect and process the information. Since it is not possible
to determine whether larger broker-dealers would face higher or lower
compliance costs than other types of market centers, the Commission is
conservatively estimating that broker-dealers will incur the same
compliance costs as other types of reporting entities.
---------------------------------------------------------------------------
\967\ See supra note 567 and accompanying text.
---------------------------------------------------------------------------
Furthermore, many of the larger broker-dealers that would be newly
included in the scope of reporting requirements already have experience
with filing Rule 605 reports; e.g., because they operate an ATS, engage
in market making, or are otherwise affiliated with market centers that
currently files Rule 605 reports.\968\ Likewise, SDPs and qualified
auctions could also have lower initial costs to the extent that they
are operated by market centers that are currently required to publish
Rule 605 reports. In both cases, these reporting entities could
leverage this experience to prepare the reports for these additional
lines of businesses more cost effectively.
---------------------------------------------------------------------------
\968\ For example, based on larger broker-dealers' answers in
their Q4 2021 FOCUS Report Form X-17A-5 Schedules I and II, staff
estimates that 29 out of the 85 broker-dealers identified as
introducing or carrying at least 100,000 customers also engage in
OTC or specialist market making activities. Specifically, 20 of
these larger broker-dealers answered ``Yes'' to item 8075 of
Schedule I, asking whether a respondent is registered as a
specialist on a national securities exchange in equity securities,
16 of them reported non-missing gains or losses from OTC market
making in exchange listed equity securities in item 3943 of Schedule
II, while 7 of them reported both OTC and specialist equity market
maker activities.
---------------------------------------------------------------------------
(2) Compliance Costs Related to Modifications to the Coverage of Orders
and Information Required by Rule 605 Reports
As a result of the proposed amendments modernizing and expanding
the coverage of orders and information required by Rule 605 reports,
reporting entities would incur initial compliance costs and additional
ongoing compliance costs.\969\ First, the estimated 236 current
reporters \970\ would incur initial costs to update their systems to
collect and store new information and to calculate modernized and
additional metrics, as well as a potential increase in ongoing costs as
a result of additional data that would need to be collected and stored.
Second, the proposed amendment expanding the coverage of order sizes
included in Rule 605 to include orders for less than one share would
result in an additional estimated 20 market centers that trade
exclusively in fractional shares would be required to begin filing Rule
605 reports.\971\ Third, the 16 national securities exchanges and 1
national securities association would be required to amend the NMS Plan
to account for the new data fields required to be reported. Table 11
breaks down the associated initial and ongoing compliance costs.
---------------------------------------------------------------------------
\969\ This analysis considers the baseline against which to
compare the costs that would accrue to larger broker-dealers, SDPs,
and qualified auctions to be a world in which do not have to publish
Rule 605 reports, and not a world in which these reporting entities
are required to publish Rule 605 under current reporting
requirements. As such, this section does not consider the cost of
the proposed amendments modifying the coverage and information
required by Rule 605 to those reporting entities that would begin
publishing Rule 605 reports as a result of the proposed amendments
expanding the scope of Rule 605 reporting entities.
\970\ See supra note 483 and accompanying text for a discussion
of these estimates.
\971\ These market centers are identified using the CAT data
described in supra note 644, as firm MPIDs that executed fractional
shares during the sample time period that did not have a
corresponding Rule 605 report. These firms are relatively large,
with an average net capital of $1.66 billion, which is similar to
the average net capital of all larger broker-dealers that meet the
customer account threshold of at least 100,000 customer accounts
($1.59 billion). In fact, the Commission estimates that 16 of the
markets centers that exclusively execute fractional shares are also
larger broker-dealers that meet the customer account threshold.
Under proposed Rule 605(a)(7), to the extent that a market center
that exclusively executes fractional shares is also a broker-dealer
that meets or exceed the customer account threshold, then this
reporting entity would be required to file separate Rule 605 reports
pertaining to each function. See supra note 166.
Table 11--Estimated Compliance Costs Related to Proposed Amendments Modifying the Information Required by Rule
605
----------------------------------------------------------------------------------------------------------------
Initial Ongoing
Number of compliance compliance
respondents costs costs
(million) (million)
----------------------------------------------------------------------------------------------------------------
Costs to Current Reporters...................................... \a\ 236 \b\ $2.6 \c\ $1.1
Costs to Market Centers Trading Fractional Shares............... \d\ 20 \e\ 0.7 \f\ 0.7
Cost to NMS Plan Participants to Update Data Fields............. \g\ 17 \h\ 0.06 \i\ 0
-----------------------------------------------
Total....................................................... 272 3.4 1.9
----------------------------------------------------------------------------------------------------------------
Table 11: Estimated Compliance Costs Related to Proposed Amendments Modifying the Information Required by Rule
605. This table presents estimates of the compliance costs related to the proposed amendments to Rule 605
modifying the coverage of orders and information required by Rule 605 reports. Numbers are based on the
estimated number of respondents and PRA costs in sections VI.C and VI.D supra and have been rounded to the
nearest tenth of million to avoid false precision.
[[Page 3881]]
\a\ The number of current respondents includes 16 national securities exchanges, 1 securities association, 32
ATSs (based on the number of effective Form ATS-N filings), and an estimated 93 OTC market makers and 94
exchange market makers (based on firms' responses on their 2021 FOCUS Report Form X-17A-5 Schedules I and II).
\b\ The estimate of initial compliance costs to current respondents is based on the monetized initial burden in
supra note 488 for current respondents, assuming that these respondents would incur 30 initial burden hours as
a result of the amendments at an average hourly cost of ($18,510/50 hours) = $370.20 per respondent per hour.
\c\ The estimate of ongoing compliance costs to current respondents is based on the monetized annual burden in
supra note 489 for current respondents, assuming that these respondents would incur 1 additional ongoing
burden hours per month (12 per year) as a result of the amendments at an average hourly cost of ($37,488/(8
hours * 12 months)) = $391.00 per respondent per hour.
\d\ The Commission does not have knowledge of the number of market centers currently trading in fractional
shares that would newly be required to prepare Rule 605 reports, and has therefore chosen a conservative
estimate of 20 firms.
\e\ The estimate of initial compliance costs to new respondents (in this case, market centers that would newly
be required to prepare Rule 605 reports as a result of trading fractional shares) is based on the monetized
initial burden in supra note 491 for new respondents, assuming that these respondents would incur 100 initial
burden hours at an average hourly cost of ($37,020/100 hours) = $370.20 per respondent per hour.
\f\ The estimate of ongoing compliance costs to market centers that would newly be required to prepare Rule 605
reports as a result of trading fractional shares is based on the monetized annual burden in supra note 492 for
new respondents, assuming that these respondents would incur 8 ongoing burden hours per month (12 per year) at
an average hourly cost of ($37,488/(8 hours * 12 months)) = $391.00 per respondent per hour.
\g\ The number of NMS plan participants includes 16 national securities exchanges and 1 securities association.
\h\ The estimate that the monetized initial burden for preparing and filing an amendment to the NMS Plan would
include approximately $40,222 in aggregate internal costs per participants as well as an aggregate external
cost of $16,864 resulting from outsourced legal work. See supra section VI.D.
\i\ The Commission estimates that the costs related to updating data fields would be a one-time cost, and thus
would not incur any additional ongoing compliance costs.
As a result of the proposed amendments, current Rule 605 reporters
would incur initial compliance costs to update their systems to collect
and store new information.\972\ For example, current Rule 605 reporters
would need to expand their data collection systems to include
additional order types, such as stop orders, short sale orders, and
orders submitted outside of regular trading hours, and would need to
update their systems to reclassify certain orders, such as IOCs,
riskless principal orders, and beyond-the-midpoint NMLOs, into new or
different order type categories. Similarly, current reporters would
need to expand their data collection systems to incorporate additional
order sizes, including odd-lots, fractional orders, and larger-sized
orders.
---------------------------------------------------------------------------
\972\ The Commission assumes that the majority of reporting
entities' initial burden hours under the PRA would be spent updating
current systems as a result of the many changes to Rule 605, and
thus estimate that 30 of the 50 initial burden hours estimated for
current respondents and described in supra note 488 would be
allocated to compliance with the proposed amendments modifying the
information contained in Rule 605.
---------------------------------------------------------------------------
Current Rule 605 reporters would also incur initial compliance
costs to update their data processing software to generate modernized
and additional metrics. For example, current Rule 605 reporters would
need to update their methodologies for calculating realized spread,
first, to include two measures, and, second, to calculate the realized
spread using 15 second and 1 minute horizons, instead of 5 minutes, and
would need to develop programs (i.e., code) to calculate newly required
metrics, such as E/Q. Some of the metrics would involve matching trade
information to data elements that are not currently required by Rule
605 but that can be obtained from public data sources, such as the best
displayed price for calculating the proposed new price improvement
metrics,\973\ and the number of shares displayed at the NBBO for
calculating the benchmark measure related to size improvement.\974\ To
the extent that they do not already do so, current Rule 605 reporters
would also need to update their systems to record timestamps in terms
of milliseconds rather than seconds as a result of the proposed
amendment increasing the granularity of time-to-execution metrics.
---------------------------------------------------------------------------
\973\ See supra section IV.B.5 for a discussion of the data
required to calculate this measure.
\974\ See supra section IV.B.4.(e) for a discussion of the data
required to calculate this measure.
---------------------------------------------------------------------------
The Commission believes that, after current Rule 605 reporters
update their systems to reflect the amendments, changes to their
ongoing costs would be limited, as the process for generating and
publishing Rule 605 reports would largely be unchanged.\975\ This is
because most reporting entities currently retain most, if not all, of
the underlying raw data necessary to generate the additional data
elements, or are easily able to obtain this information from publicly
available data sources. Furthermore, once reporting entities have
developed the necessary programs to calculate the required metrics,
there is limited additional effort that needs to be made beyond what
current reporters are already doing, such as monitoring and debugging
these statistical programs. However, the Commission recognizes that
there may be some additional ongoing costs to the extent that some
metrics introduced under the proposed amendments may require more data
storage or more complex calculations, such that the cost of preparing
monthly Rule 605 reports may increase. Therefore, the Commission has
allocated addition ongoing costs to account for this possibility.\976\
---------------------------------------------------------------------------
\975\ One exception is the proposed amendment requiring
reporting entities to prepare summary reports summarizing key
information from their Rule 605 reports. The Commission assumes that
current reporters would face additional ongoing costs as a result of
this amendment, and discuss these costs in infra section
VII.D.2.(a)(3).
\976\ Specifically, one additional ongoing monthly burden hour
per respondent has been added to account for this possibility. See
footnote to Table 11.
---------------------------------------------------------------------------
As a result of the proposed amendment expanding the scope of Rule
605 to include information about orders for less than one share, the
Commission estimates that some broker-dealers that exclusively execute
fractional shares, and therefore do not currently file Rule 605 reports
in their capacity as a market center due to fractional shares falling
below the smallest order size category in current Rule 605, would be
required to begin publishing Rule 605 reports. These broker-dealers
would incur similar initial and ongoing costs as those discussed above
for larger broker-dealers, SDPs, and qualified auctions that would be
included as a result of the expanded scope of reporting entities. These
compliance costs may be over- or underestimated if broker-dealers that
exclusively execute fractional shares have different characteristics
(e.g., fewer customers) than the larger broker-dealers that would be
included as a result of the expanded scope of reporting entities.
Lastly, the Commission estimates that the 16 national securities
exchanges and 1 national securities association would incur a one-time
initial cost to amend the NMS Plan to account for the new data fields
required to be reported. The Commission estimates that this would
mostly consist of legal time to develop
[[Page 3882]]
and draft the amendments to the NMS Plan.
(3) Compliance Costs Related to the Proposed Summary Execution Reports
The estimated 236 current Rule 605 reporters \977\ would face
additional initial and ongoing compliance cost as a result of the
proposed amendment requiring reporting entities to prepare summary
reports summarizing key information from their Rule 605 reports.\978\
Table 12 breaks down the initial and ongoing compliance costs
associated with this amendment.
---------------------------------------------------------------------------
\977\ This section does not consider the cost of the proposed
amendments to those reporting entities that would begin publishing
Rule 605 reports as a result of the proposed amendments expanding
the scope of Rule 605 reporting entities. See explanation in supra
note 969.
\978\ The Commission believes that a significant portion of
reporting entities' initial burden hours under the PRA would be
allocated to updating current systems to prepare summary reports,
which would entail both a new format and a new level of information
aggregation as compared to current Rule 605, and thus estimate that
20 of the 50 initial burden hours estimated for current respondents
and described in supra note 488 would be allocated to compliance
with the proposed amendments modifying the information contained in
Rule 605.
Table 12--Estimated Compliance Costs Related to Proposed Amendment Requiring Summary Execution Quality Reports
----------------------------------------------------------------------------------------------------------------
Initial Ongoing
Number of compliance compliance
respondents costs costs
(million) (million)
----------------------------------------------------------------------------------------------------------------
Costs to Prepare Summary Execution Quality Reports.............. \a\ 236 \b\ $1.7 \c\ $1.1
----------------------------------------------------------------------------------------------------------------
Table 12: Estimated Compliance Costs Related to Proposed Amendment Requiring Summary Execution Quality Reports.
This table presents estimates of the compliance costs related to the proposed amendments to Rule 605 requiring
Rule 605 reporting entities to prepare summary execution quality reports. Numbers are based on the estimated
number of respondents and PRA costs in sections VI.C and VI.D supra and have been rounded to the nearest tenth
of million to avoid false precision.
\a\ The number of current respondents is estimated as including 16 national securities exchanges, 1 securities
association, 32 ATSs (based on the number of effective Form ATS-N filings), 93 OTC market makers, and 94
exchange market makers (based on firms' responses on their 2021 FOCUS Report Form X-17A-5 Schedules I and II).
\b\ The estimate of initial compliance costs to current respondents is based on the monetized initial burden in
supra note 488 for current respondents, assuming that these respondents would incur 20 initial burden hours as
a result of the amendments at an average hourly cost of ($18,510/50 hours) = $370.20 per respondent per hour.
\c\ The estimate of ongoing compliance costs to current respondents is based on the monetized annual burden in
supra note 489 for current respondents, assuming that these respondents would incur 1 additional ongoing
burden hours per month (12 per year) as a result of the amendments at an average hourly cost of ($37,488/(8
hours * 12 months)) = $391.00 per respondent per hour.
The Commission estimates that these costs would be only a fraction
of the overall costs to comply with Rule 605 reporting requirements, as
they would contain only a small subset of the information published in
the fuller Rule 605 reports. However, this may underestimate costs to
the extent that these summary reports, which are intended to be human-
readable and therefore have a different format (PDF file), are costlier
to prepare and/or store than machine-readable data.\979\
---------------------------------------------------------------------------
\979\ For example, a single letter ``a'' results in a PDF file
of 7,706 bytes vs. a TXT file of 1 byte. See, e.g., File Size, U.S.
Pat. & Trademark Office, available at https://www.uspto.gov/ebc/portal/infofilesize.htm. However, the lower information content of
the summary file PDFs likely results in lower file sizes despite the
larger per-pixel storage requirements.
---------------------------------------------------------------------------
(4) Implications of Compliance Costs for Competition
While the Commission believes that the primary competitive effect
of the proposed amendments would be to increase competition between
reporting entities on the basis of execution quality,\980\ it is
possible that the proposed amendments would have a negative impact on
competition if the associated compliance costs described above prevent
the entry of new reporting entities or cause some entities to leave the
market.
---------------------------------------------------------------------------
\980\ See supra section VII.D.1.(b)(1) for a discussion of the
effects of the proposed amendments on competition between reporting
entities on the basis of execution quality.
---------------------------------------------------------------------------
The Commission is unable to quantify the likelihood that a either a
trading venue or a brokerage firm would cease operating as a result of
the compliance costs associated with the proposed amendments. While the
Commission does not believe that these compliance costs are large
enough such that this would be likely,\981\ the Commission recognizes
this possibility depends in part on whether the compliance costs
associated with Rule 605 are likely to be fixed or variable. If Rule
605 compliance costs represent a fixed cost, these costs could
represent a significant portion of a smaller reporting entity's
revenue, such that the reporting entity could become unprofitable if
subjected to these costs.\982\ This could impact competition between
reporting entities, for example, by causing some reporting entities to
leave the market, or preventing the entry of new ones. It could also
result in broker-dealers avoiding taking on more than 100,000
customers, to avoid crossing the customer account threshold such that
they would need to being complying with Rule 605 reporting
requirements.
---------------------------------------------------------------------------
\981\ For example, data on broker-dealers' median monthly
revenues from FOCUS Report Form X-17A-5 Schedule II show that the
estimated monthly compliance cost would represent 0.09% of the
monthly revenues of broker-dealers with 100,000 customers or less,
and 0.003% of the monthly revenues of broker-dealers with 100,000
customers or more.
\982\ The Commission does not believe that this compliance costs
are large enough such that this would be likely. See id.
---------------------------------------------------------------------------
On the other hand, if Rule 605 compliance costs are variable, then
the scalability of compliance costs would mean that smaller reporting
entities would incur lower compliance costs related to execution
quality reports, which would mitigate some of these concerns. Rule 605
compliance costs could be variable, e.g., because smaller reporting
entities handle lower order volumes and therefore would require less
data storage and less complexity when calculating the metrics required
by Rule 605 as proposed.
Furthermore, even if compliance costs of preparing Rule 605 reports
are fixed from the perspective of reporting entities (this would be the
case, e.g., if variable costs such as data storage are dominated by
fixed costs such as costs for compliance and data personnel), they may
be lower if reporting entities make use of third-party vendors, who can
leverage economies of scale to spread fixed costs across the
potentially many reporting entities that they
[[Page 3883]]
service, to prepare Rule 605 reports on their behalf. Therefore, to the
extent that reporting entities make use of third-party vendors to
prepare their Rule 605 reports, and these vendors charge reporting
entities variable report preparation fees (e.g., based on the amount of
data), this could lead to data vendors charging lower prices to prepare
the Rule 605 reports of smaller reporting entities. This would also
reduce the burdens of compliance costs for smaller reporting entities.
However, even if some smaller reporting entities were to exit, the
Commission does not believe this would significantly impact competition
in either the market for brokerage services or the market for trading
services, because both markets are served by a large number of
competitors.\983\ The Commission recognizes that smaller reporting
entities may have unique business models that are not currently offered
by competitors, but the Commission believes a competitor could create
similar business models if demand were adequate.
---------------------------------------------------------------------------
\983\ See supra section VII.C.3.(a)(1) for a discussion of the
structure of the market for brokerage services, and supra section
VII.C.3.(a)(2) for a discussion of the structure of the market for
trading services.
---------------------------------------------------------------------------
(b) Other Potential Costs
The Commission has preliminarily identified costs in addition to
compliance costs that some market participants may incur as a result
from the proposed amendments. Many of these costs are difficult to
quantify, especially as the practices of market participants are
expected to evolve and may change due to the information on execution
quality that is required to be reported under the proposed amendments
to Rules 605. Therefore, much of the following discussion is
qualitative in nature.
(1) Costs to Reporting Entities of Improvements to Execution Quality
In addition to compliance costs, the proposed amendments could
result in costs to some reporting entities based on how market
participants adjust their behavior in response to increased
transparency and competition on the basis of execution quality.\984\
---------------------------------------------------------------------------
\984\ See supra Section VII.D.1.(b)(1) for a discussion on how
the proposed amendments would increase competition on the basis of
execution quality. The costs to reporting entities associated with
increased transparency and competition on the basis of execution
quality would likely represent a transfer from these reporting
entities to other market participants.
---------------------------------------------------------------------------
First, increased transparency and competition on the basis of
execution quality, and subsequent scrutiny by customers and other
market participants, might make broker-dealers less likely to route
orders based on payment relationships and/or fees and rebates. While
this would likely benefit customers in the form of better execution
quality, if broker-dealers were to reduce the order flow sent to
wholesalers who pay for it, the broker-dealers would receive less
payment for such order flow and might pass the lost payments on to
their customers, for example, by raising brokerage commissions or other
fees. Similarly, if broker-dealers were to route orders to trading
centers with lower rebates and higher fees, they might pass the
reduction in rebate revenue and increase in fee costs on to their
customers, for example, by raising brokerage commissions or other fees.
Broker-dealers may pass lost payments or revenues along to customers in
other ways as well, for example by reducing the quality of some bundled
services or paying a lower interest rate on deposit accounts.
Second, increased competition on the basis of execution quality may
result in costs to reporting entities to the extent that they need to
update or improve their routing or execution systems in order to remain
competitive. However, should these improvements result in improved
execution quality for investors, any costs to a reporting entity of
improvements to their routing or execution systems would be offset by
benefits to other market participants, i.e., investors.
It is possible that the capital expenditure associated with such an
upgrade may be such that some reporting entities would no longer remain
profitable. The Commission is unable to estimate the number of
reporting entities that may leave the market as a result of no longer
being able to compete with other reporting entities on the basis of
execution quality. However, the Commission does not believe this would
significantly impact competition in either the market for brokerage
services or the market for trading services, because both markets are
served by a large number of competitors and that, if a reporting entity
were to exit for this reason, these markets would be served by more
efficient firms that are better able to offer execution quality to
customers in line with its industry peers.
(2) Costs for Smaller Broker-Dealers
There may be additional costs to the proposed amendments if smaller
broker-dealers, who would not be subject to Rule 605 reporting
requirements under the proposed amendments but may face competitive
pressure to provide customers with more information and execution
quality, would also face initial and ongoing costs to provide customers
with execution quality reports.\985\ The costs for smaller broker-
dealers to prepare execution quality reports may not be the same as the
costs for larger broker-dealers. Smaller-broker dealers may lack the
technical expertise and compliance experience of larger broker-dealers,
which would tend to lead to higher costs; however, smaller broker-
dealers may also have lower costs if their lower order volume and
customer account numbers lead to less complexity when calculating the
metrics required in the reports.
---------------------------------------------------------------------------
\985\ See infra section VII.D.1.(d)(1) for a discussion of the
impact of the proposed amendments on smaller broker-dealers.
---------------------------------------------------------------------------
(3) Potential for Less Transparency
The proposed amendments expanding the set of Rule 605 reporting
entities to include larger broker-dealers could impose a cost on
broker-dealer customers if those broker-dealers that currently
voluntarily provide their customers with execution quality reports stop
providing these reports, which potentially contain more or different
information than what the proposed amendments require.\986\ Some
broker-dealer customers, especially institutional investors, currently
request reports about the handling of their orders from their broker-
dealers.\987\ These reports may be less or more detailed and provide
different and potentially less or potentially more information than
those required by Rule 605 as proposed to be amended. To the extent
that these reports are more detailed or provide more information than
Rule 605 as proposed to be amended, and to the extent that broker-
dealers would be less incentivized to provide these reports to their
customers as a result of the proposed amendments,\988\ broker-dealer
customers may have access to less information as a result of the
proposed amendments. The Commission preliminarily believes that this
scenario is not very likely because customers could still request
additional information or customized reports from
[[Page 3884]]
their broker-dealers and broker-dealers may be incentivized to satisfy
such requests, to the extent they currently do, to retain their
customers.\989\
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\986\ These reports could include, for example, public reports
prepared according to the FIF Template (see supra note 450), or
private ad hoc reports the broker-dealers prepare for their
customers (see discussion in section VII.C.1.(c)(2) supra).
\987\ See supra section VII.C.1.(c)(2) for a discussion of the
practice of institutional investors requesting execution quality
reports from their broker-dealers.
\988\ Note that this does not apply to broker-dealer's
requirements to provide customers with execution quality information
about their not held orders.
\989\ See, e.g., 2018 Rule 606 Amendments Release, 83 FR 58338
(Nov. 19, 2018) at 58403, which discusses a similar potential cost
and further notes that the willingness of broker-dealers to provide
such customized reports to customers and the level of detail in such
a report might depend on the business relationship between the
broker-dealer and the customer, such as whether the customer does a
large amount of business with the broker-dealer.
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(4) Potential for Lower Execution Quality
The Commission acknowledges that, to the extent that the proposed
amendments to Rule 605 fail to capture relevant dimensions of execution
quality or cause market participants to focus on some dimensions of
execution quality to the detriment of others, the proposed amendments
may reduce execution quality along certain dimensions that may be
relevant to some investors. The nature of execution quality as a multi-
faceted concept has been a focus of academic papers, which have pointed
out that execution quality is composed of multiple aspects or
dimensions, including price and speed, among others.\990\ As stated by
the Commission in the Adopting Release, different investors may have
different concerns and priorities related to execution of their
orders.\991\ If the proposed amendments tend to favor certain
dimensions of execution quality while excluding or neglecting others,
there is a possibility that certain investor groups may be advantaged
by the proposed amendments to the disadvantage of other investor
groups.
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\990\ See, e.g., Robert Battalio, Brian Hatch & Robert Jennings,
All Else Equal?: A Multidimensional Analysis of Retail, Market Order
Execution Quality, 6 J. Fin. Mkt. 143 (2003); Ekkehart Boehmer,
Dimensions of execution quality: Recent evidence for US equity
markets, 78 J. Fin. Econ. 553 (2005); Emiliano S. Pagnotta & Thomas
Philippon, Competing on Speed, 86 Econometrica 1067 (2018).
\991\ See Adopting Release, 65 FR 75414 (Dec. 1, 2000) at 75432.
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For example, average effective spreads calculated for NMLOs capture
the portion of the spread that is earned by liquidity providers and
paid by liquidity demanders.\992\ If reporting entities compete for
NMLOs by offering a wider effective spread, NMLO execution prices would
improve at the expense of the execution prices of the marketable
orders. There is a similar trade-off between, e.g., time-to-execution
and execution prices for NMLOs, as a broker-dealer seeking to improve
the time-to-execution of NMLOs may favor routing those orders to an
inverted venue where, as marketable orders earn a rebate, it may be
more likely to attract a counterparty; this could incentivize trading
venues to compete on rebates rather than on execution quality. Another
example would be, if size improvement becomes a major driver of order
flow, national securities exchanges may try to incentivize hidden
liquidity and broker-dealers may route orders to venues with higher
expected hidden orders, as size improvement measures mechanically
benefit from a greater degree of hidden volume.\993\ It is possible
that incentivizing hidden liquidity at the cost of displayed orders may
negatively impact market quality by obfuscating trading interest
information and discouraging trade by making order books look thinner
than they actually are.
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\992\ See supra note 709 and accompanying text for a discussion
of the interpretation of average effective spreads for NMLO.
\993\ For example, if two exchanges have 200 shares available at
the NBO price but one exchange is hiding a portion of this interest,
a market order to purchase 200 shares would record size improvement
on the venue with hidden liquidity but wouldn't on the other venue.
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(5) Costs To Update Best Execution Methodologies
As a result of the proposed amendments, financial service providers
that are subject to best execution obligations \994\ would likely
reevaluate their best execution methodologies to take into account the
availability of new statistics and other information that may be
relevant to their decision making. This may impose a cost only to the
extent that broker-dealers and/or investment advisers choose to build
the required statistics into their best execution methodologies. The
proposed amendments do not, however, address and therefore do not
change the existing legal standards that govern financial service
providers' best execution obligations.\995\
---------------------------------------------------------------------------
\994\ See supra notes 565-566 and accompanying text.
\995\ See supra note 69.
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3. Economic Effects on Efficiency, Competition, and Capital Formation
(a) Efficiency
The Commission preliminarily believes the proposed amendments to
Rule 605 would improve the efficiency of analyzing 605 reports, which
would result in improved price efficiency. Price efficiency would
improve as a result of improvements in order execution quality that
would result from increased transparency and thus competition. As
investors would benefit from improved execution quality as a result of
the proposed amendments, these investors would also likely benefit from
lower transaction costs. Transaction costs reflect the level of
efficiency in the trading process, with higher transaction costs
reflecting less efficiency and more friction, which limits the ability
for prices to fully reflect a stock's underlying value.\996\ Academic
literature defines friction in financial markets to measure ``the
difficulty with which an asset is traded,'' \997\ and as ``the price
paid for immediacy.'' \998\ Friction makes it more costly to trade and
makes investing less efficient, and it limits the ability of
arbitrageurs or informed customers to push prices to their underlying
values. Thus, friction makes prices less efficient. The proposed
amendments to Rule 605 would improve order execution quality and reduce
transaction costs. This, in turn, would reduce financial frictions and
improve price efficiency.
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\996\ See Hans R. Stoll, Friction, 55 J. Fin. 1479 (2000).
\997\ See id.
\998\ See Harold Demsetz, The Cost of Transacting, 82 Q. J.
Econ. 33 (1968).
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(b) Competition
As previously discussed in the benefits section of this economic
analysis, the Commission believes that the proposed amendments to Rule
605 would facilitate competition on the basis of execution quality in
the markets for brokerage services and trading services.\999\ The
proposed amendments may also have additional effects on competition,
such as increasing the extent to which Rule 605 reporting entities
compete within other quality areas (such as rebates and transaction
fees), and increasing competition in related markets (such as the
market for TCA).
---------------------------------------------------------------------------
\999\ See supra section VII.D.1.(b)(1) for a detailed discussion
of the effects of the proposed amendments on competition in these
markets on the basis of execution quality.
---------------------------------------------------------------------------
(1) Competition in Other Areas
An increase in the extent to which Rule 605 reporting entities
compete on the basis of execution quality as a result of the proposed
amendments may also spill over to increase incentives to compete along
other lines, i.e., reduce fees or increase rebates (including PFOF), or
offer new products or functionalities to attract customers.
First, national securities exchanges may be incentivized to
increase rebates or lower fees as a result of the proposed amendments.
Exchanges compete on the basis of fees and rebates to incentivize
broker-dealers to route more order flow to them.\1000\ If an exchange
offers the
[[Page 3885]]
same execution quality as another reporting entity, an exchange may be
incentivized to lower its transaction fees or raise its rebates in
order to increase its competitive position in attracting more customers
or order flow.\1001\ To the extent that this occurs and to the extent
that the resulting lower fees or higher rebates would be passed on to
investors, this could be beneficial for investors.
---------------------------------------------------------------------------
\1000\ See supra section VII.C.3.(b)(2) for a discussion of
competition between national securities exchanges on the basis of
fees and rebates.
\1001\ Another possibility is that a reporting entity that
offers inferior execution quality may try to compete on the basis of
lower fees or higher rebates instead of increasing its execution
quality. To the extent that this occurs, this may limit the extent
to which competition would lead to improved execution quality for
the customers of these reporting entities. However, these customers
would still benefit from the lower fees or higher rebates.
---------------------------------------------------------------------------
Reporting entities may also be incentivized to innovate to offer
new products in order to compete. For example, some broker-dealers may
be incentivized to differentiate themselves by offer new
functionalities that appeal to customers, such as the ability to trade
on margin, in additional asset classes, such as options, or trade
fractional shares.\1002\
---------------------------------------------------------------------------
\1002\ See, e.g., supra note 642, describing how trading volume
increased substantially for brokers after they introduced the use of
fractional shares.
---------------------------------------------------------------------------
(2) Competition in Related Markets
Second, the proposed amendments to Rule 605 could also have an
impact on markets other than brokerage and trading services, such as
the market for TCA. For example, suppose that a customer chooses to no
longer purchase TCA once Rule 605 reports as proposed to be amended
become available, because the customer decides that the information
contained in the reports is sufficient. If fewer customers purchase
TCA, this would have a negative impact on the market for third-party
providers of TCA as well as third-party data vendors, because of a
reduction in the demand for their services. Further, the quality of TCA
provided by third parties may decrease because third-party providers of
TCA might have fewer resources for the development and maintenance of
their product offerings and because with fewer customers, third-party
providers may have less data to use to build their models. At the same
time, the quality of TCA reports may also improve if their publishers
need to offer better products in order to compete with the publicly
available data, and/or use the expanded information available under the
proposed amendments to Rule 605 to offer new or better products.
(c) Capital Formation
The Commission preliminary believes the proposed amendments to Rule
605 may promote capital formation by improving price efficiency. As
discussed above, the proposed amendments would improve order execution
quality and reduce transaction costs, which would improve price
efficiency. Improved price efficiency would cause firms' prices to more
accurately reflect their underlying values, which may improve capital
allocation and promote capital formation.
Financial frictions may have an adverse impact on capital
formation. In particular, higher transaction costs may hinder
customers' trading activity that would support efficient adjustment of
prices and, as a result, may limit prices' ability to reflect
fundamental values. Less efficient prices may result in some issuers
experiencing a cost of capital that is higher than if their prices
fully reflected underlying values, and in other issuers experiencing a
cost of capital that is lower than if their prices accurately reflected
their underlying value, as a result of the market's incomplete
information about the value of the issuer. This, in turn, may limit
efficient allocation of capital and capital formation.
By improving order execution quality and reducing transaction
costs, the proposed amendments would reduce financial frictions and
promote investor's ability to trade. This would have the effect of
promoting capital formation through improved price efficiency.
E. Reasonable Alternatives
1. Reasonable Alternative Modifications to Reporting Entities
(a) Different Customer Account Thresholds for Differentiating Larger
Broker-Dealers
The Commission also considered alternatives to the proposed
amendment to require larger broker-dealers \1003\ to prepare execution
quality reports pursuant to Rule 605 and exclude broker-dealers that
introduce or carry less than a threshold number of customer accounts,
defining the customer account threshold as 100,000 customer
accounts.\1004\ Lowering this threshold would increase the total costs
of the proposed amendments, as more broker-dealers would be subject to
the costs of preparing Rule 605 reports; however, lowering the
threshold may also be beneficial if more broker-dealer customers are
able to benefit from the proposed modifications to reporting
entities.\1005\ On the other hand, raising the customer account
threshold would lower the total costs of the proposal, but may result
in fewer broker-dealer customers benefiting from the proposed
modifications to reporting entities.
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\1003\ See supra note 1 defining the term ``larger broker-
dealers.''
\1004\ See supra note 166 and accompanying text discussing the
proposed customer account threshold.
\1005\ See supra section VII.D.1.(d)(1) for a discussion of the
extent to which excluding smaller-brokers dealers (i.e., those
broker-dealers with customer accounts numbers below the customer
account threshold) limits the benefits of the enhanced reporting
requirements on competition for customer order flow.
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In order to examine the number of broker-dealers that would be
subject to the collection of information obligations of Rule 605 as a
result of the proposed modifications to reporting entities for
different levels of the customer account threshold, it is necessary to
estimate the number of customers for both carrying and introducing
broker-dealers.\1006\ In order to estimate the number of carrying
broker-dealers' customers, the Commission used data from broker-
dealers' 2021 FOCUS Report Form X-17A-5 Schedule I, which asks
respondents whether they carry their own public customer accounts,
along with the number of carrying broker-dealers' public customer
accounts.\1007\ In order to estimate the number of introducing broker-
dealers' customers, the Commission used data from CAT during the
calendar year 2021 on the number of unique customer accounts whose
trades are associated with broker-dealers that do not identify as
carrying their own public customer accounts in FOCUS Report Form X-17A-
5 Schedule I.\1008\ The resulting customer numbers
[[Page 3886]]
are then used to estimate the number of both carrying and introducing
broker-dealers that would be subject to the reporting requirements of
Rule 605 as proposed, using various different definitions of the
customer account threshold. The estimated costs of the proposed
amendments from the various definitions of the customer account
thresholds are then calculated using the estimated initial and ongoing
costs for new Rule 605 filers.\1009\
---------------------------------------------------------------------------
\1006\ See supra note 736 and accompanying text for a definition
of carrying and introducing broker-dealers.
\1007\ Specifically, item 8080 asks for information on
``respondent's total number of public customer accounts,'' but only
broker-dealers that are carrying firms are requiring to answer this
question, so information on introducing broker-dealers' customers is
not included.
\1008\ Customer accounts are identified in CAT as accounts
belonging to either the ``Institutional Customer'' account type,
defined as accounts that meet the definition in FINRA Rule 4512(c),
or the ``Individual Customer'' account holder type, defined as
accounts that do not meet the definition of FINRA Rule 4512(c) and
are also not a proprietary account. See supra note 609 for more
information about account types in CAT. Broker-dealers are
identified according to their FDID as defined in section 1.1 of the
CAT NMS Plan. Introducing broker-dealers are identified as those
broker-dealers that report trades by customer accounts in the CAT
dataset and do not identify as carrying their own public customer
accounts in FOCUS Report Form X-17A-5 Schedule I. However, a
customer account is only observed in this dataset if it actually
traded during the sample period from January to December 2021.
Therefore, to the extent that there are customer accounts that did
not trade during this period, these accounts would be missing from
our sample. In order to adjust for these missing accounts, an
adjustment factor was constructed based on the assumption that, for
carrying broker-dealers identified in both FOCUS and CAT, the number
of customer accounts associated with the broker-dealer in CAT
represents some percentage of that broker-dealer's total customer
base available from FOCUS (i.e., those customer accounts that
actually traded during 2021). Dividing the number of accounts from
CAT by the number of customer accounts from FOCUS reveals that, on
average, around 29% of these broker-dealers' customer accounts
traded during 2021. Observed customer numbers from CAT are then
scaled up using the adjustment factor of 1/0.29 to estimate of the
total number of customers for each broker-dealer (both carrying and
introducing). In order to ensure that our estimate of customer
account numbers is as conservative as possible, if a broker-dealer
is observed in both datasets, the number of customers for that
broker-dealer is taken as the higher of their customer account
number reported in FOCUS and the adjusted number of customers
estimated from CAT. Note that this method may underestimate the
total number of customers to the extent that carrying broker-dealers
identified in FOCUS introduce customers that they do not carry (see
supra note 736 discussing hybrid carrying/introducing broker-
dealers), and/or that introducing broker-dealers would have a higher
or lower adjustment factor than carrying broker-dealers. This method
may also underestimate or overestimate any particular broker-
dealer's total number of customers to the extent that a larger or
smaller portion of the broker-dealer's customer base traded during
the sample period than the number implied by the adjustment factor.
Lastly, this method may underestimate the number of customer
accounts to the extent that some broker-dealers introduce customer
accounts on an omnibus basis, which pool together the accounts of
potentially multiple underlying customers but would only be recorded
as a single account in CAT.
\1009\ See supra section VI.D for a description of these costs.
See supra notes 488 and 489 for initial and ongoing costs for
existing respondents; and supra notes 491 and 492 for initial and
ongoing costs for new respondents. This analysis assumes the same
costs for both larger and smaller broker-dealers.
---------------------------------------------------------------------------
Lowering the customer account threshold may be beneficial if more
broker-dealer customer accountholders are able to benefit from the
enhanced reporting requirements. In order to estimate the benefits of
different customer account thresholds, the Commission calculated the
cumulative number of customer accounts (expressed as a percentage of
all identified carrying and introducing broker-dealer customer
accounts) associated with broker-dealers that would be subject to the
reporting requirements of Rule 605 as proposed according to various
definitions of the customer account threshold. Similarly, using
estimates of the number of transactions associated with the broker-
dealers' customer accounts, the Commission calculated the cumulative
number of customer orders (expressed as a percentage of all customer
orders belonging to carrying and introducing broker-dealer customer
accounts) associated with broker-dealers that would be included under
the various thresholds.\1010\
---------------------------------------------------------------------------
\1010\ Specifically, the Commission used the total number of
transactions associated with the broker-dealer customer accounts
identified in CAT during calendar year 2021, along with the sum of
broker-dealers' responses to items 8107 and 8108 from their 2021
FOCUS Report Form X-17A-5 Schedule I (``Number of respondent's
public customer transactions: equity securities transactions
effected on a national securities exchange'' and ``equity securities
transactions effected other than on a national securities
exchange''). See Focus Report Form X-17A-5 Schedule I, SEC,
available at https://www.sec.gov/files/formx-17a-5_schedi.pdf. Note
that some of these orders are likely to be excluded from Rule 605
reporting requirements to the extent that they belong to an order
type or size group that is not subject to Rule 605. In order to
ensure that our estimate of customer transactions is as conservative
as possible, if a broker-dealer is observed in both datasets, the
number of customer transactions for that broker-dealer is taken as
the higher of the number of transactions as reported in FOCUS and
the number of transactions observed in CAT.
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Table 13 presents the estimated number of broker-dealers (both
carrying and introducing) that would be subject to Rule 605 reporting
requirements according to different customer account thresholds, the
resulting estimated costs of the proposed amendments, and the resulting
estimated benefits in terms of the cumulative percentage of included
customer accounts and orders. The table shows that increasing the
customer account threshold from 100,000 to 500,000 would reduce the
costs of the proposed amendments by around 47%, but would also result
in lower coverage of customer transactions and accounts. In particular,
only 6.2% of the customer transactions observed in 2021 would be
included. Meanwhile, reducing the customer account threshold from
100,000 to 10,000 would almost triple both initial and ongoing costs.
The amount of included transactions would increase by an additional
14.8 percentage points, which would be beneficial. However, the
percentage of included customer accounts increases only marginally, by
1.2 percentage points, implying that the additional customer coverage
resulting from the lower threshold is associated with only a small
number of accounts that trade in large volumes. Such accounts are
likely to belong to institutional traders, who are likely to have
access to alternative information about the execution quality achieved
by their broker-dealers and/or are likely to make use of not held
orders that are excluded from Rule 605 reporting requirements, and
would therefore be less likely to depend on Rule 605 reports for
information about their broker-dealers' execution quality.\1011\
Therefore, lowering the customer account threshold to include these
customers may not be particularly beneficial, especially when compared
to the substantial increase in cost.
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\1011\ See supra section VII.C.1.(c)(2) for a discussion of
institutional investors' access to alternative sources of execution
quality other than Rule 605 reports.
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Table 13--Cost-Benefit Analysis of Different Customer Account
Thresholds Defining ``Larger Broker-Dealers''
[[Page 3887]]
[GRAPHIC] [TIFF OMITTED] TP20JA23.016
An indirect cost of requiring these smaller broker-dealers to
publish Rule 605 reports is an increased risk of information leakage.
To the extent that a broker-dealer serves multiple institutional
investors and/or these institutional investors exclusively use not held
orders, it would be difficult to identify the orders of a particular
customer in the proposed reports. However, a smaller broker-dealer may
have only a few institutional investor customers that represents the
majority of its business and this may be known to other market
participants. In this case, it may be possible to learn from Rule 605
reports some information about the customer's order flow that is
handled by the specific broker-dealer. This information would only
pertain to historical order flow and would only include a possibly
limited subset of the customer's orders that are held orders, but could
nevertheless provide information about the general characteristics of
the customer's order flow, which may be useful to other market
participants. Such a potential outcome could put smaller broker-dealers
(that is, those with a small set of customers or handling a relatively
small number of institutional orders) at a competitive disadvantage
relative to larger broker-dealers, as institutional investors might
avoid using smaller broker-dealers to avoid possible disclosure that
could be traced back to the customer.
(b) Require All Broker-Dealers To Prepare Rule 605 Reports
Another alternative to the proposed amendment to require larger
broker-dealers to prepare execution quality reports pursuant to Rule
605 is to require all broker-dealers to prepare such reports, excluding
broker-dealers with de minimis order flow.\1012\
---------------------------------------------------------------------------
\1012\ This alternative was suggested by EMSAC; see supra notes
104-106; 171 and accompanying text.
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Expanding reporting requirements to all broker-dealers, subject to
a de minimis threshold, would greatly increase the scope of the
proposed amendments, as there were 3,498 registered broker-dealers as
of Q2 2022.\1013\ However, only around a third (specifically, 1,267) of
these broker-dealers introduced or carried at least one individual and/
or institutional investor in the market for NMS stocks within the
sample time period.\1014\ The Commission is mindful of the additional
costs that broad expansion of the rule to all broker-dealers would
entail, relative to the likely limited benefits of expanding reporting
requirements to a substantial number of broker-dealers that do not
directly handle, and thus have less discretion over the execution
quality of, individual and institutional investors' orders. Therefore,
the Commission believes that the increase in cost that would accompany
a requirement for all broker-dealers to prepare Rule 605 reports,
subject to a de minimis threshold, would not be justified by the
corresponding benefit, and that limiting reporting obligations to
broker-dealers that handle customer orders would focus the associated
implementation costs on those broker-dealers for which the availability
of more specific execution quality statistics would provide a greater
benefit.
---------------------------------------------------------------------------
\1013\ See supra note 735 and corresponding discussion.
\1014\ See analysis in supra Table 13 for estimated number of
broker-dealers that introduce or carry at least one customer
account.
---------------------------------------------------------------------------
(c) Defining the Threshold for Differentiating Larger Broker-Dealers
Using Number of Customer Transactions Rather Than Number of Customer
Accounts
The Commission also considered defining the threshold for
differentiating larger broker-dealers using number of customer
transactions rather than number of customer accounts. An approach
requiring that broker-dealers handling above a threshold level of
customer transactions publish Rule 605 reports would likely capture an
overall larger number of customer orders. However, it would also be
subject to a
[[Page 3888]]
number of issues that would limit the benefits of this approach.
First, this approach would likely exclude from reporting
requirements broker-dealers that have a large number of relatively
inactive customer accounts, and include broker-dealers that have a
small number of accounts associated with large amounts of trading
volume. While the former are likely to be accounts belonging to
individual investors, the latter are very likely to be institutional
accounts. Institutional investors are likely to have access to
alternative information about the execution quality achieved by their
broker-dealers and/or are likely to make use of not held orders that
are excluded from Rule 605 reporting requirements, and would therefore
be less likely to depend on Rule 605 reports for information about
their broker-dealers' execution quality.\1015\ Meanwhile, individual
investors have few alternatives other than Rule 605 for information
about the execution quality achieved by their broker-dealers.\1016\
Therefore, while expanding overall coverage, defining the threshold
using the number of customer transactions would be less likely to
target the types of orders that may be most useful for consumers of
Rule 605 reports.
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\1015\ See section VII.C.1.(c)(2) for a discussion of
institutional investors' access to alternative sources of execution
quality other than Rule 605 reports.
\1016\ See section VII.C.1.(c)(1) for a discussion of individual
investors' usage of Rule 605 reports.
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Secondly, defining the threshold using the number of customer
transactions may result in a less stable classification of broker-
dealers into those that are and are not subject to Rule 605
requirements, as there is likely to be more month-to-month variation in
transaction numbers resulting from changes in market conditions, as
compared to number of customer accounts.\1017\ This could potentially
be disruptive to broker-dealers to have to coordinate compliance with
the Rule during some periods but not others and interfere with
customers' or market participants' ability to look at a broker-dealer's
execution quality over time by analyzing historical data. Furthermore,
the dependence of transaction volumes on market conditions may result
in broker-dealers being newly defined as ``larger broker-dealers''
subject to reporting requirements, even though their size relative to
other broker-dealers did not change. For example, a period of sustained
market volatility resulting in overall increases in market activity
levels may trigger the need for many or even most broker-dealers to
file Rule 605 reports, even if the broker-dealer's relative portion of
order flow (as a percentage of total broker-dealer customer order flow)
did not change.\1018\ This would increase the total compliance costs
associated with the proposed amendments.
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\1017\ Note that this possibility is somewhat limited by the
proposal that a broker or dealer that equals or exceeds the customer
account threshold would be required to provide reports for at least
three calendar months. See supra note 183 and corresponding
discussion.
\1018\ Note that this possibility would be somewhat limited by
the proposal to only require broker-dealers to publish Rule 605
reports after a three-month initial grace period. See supra note 186
and corresponding discussion.
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Lastly, the number of customer accounts is likely less costly for
broker-dealers to calculate and track compared to the number of
transactions associated with customer accounts. Given that only 41.1%
of customer-carrying broker-dealers report the actual number of their
customer transactions (rather than an estimated number) on their FOCUS
Report Form X-17A-5 Schedule I,\1019\ the extent to which broker-
dealers currently are able or choose to track the number of
transactions associated with their customer accounts is unclear.
---------------------------------------------------------------------------
\1019\ See supra note 168 for a description of FOCUS Report Form
X-17A-5 Schedule I.
---------------------------------------------------------------------------
2. Reasonable Alternative Modifications to Scope of Covered Orders
(a) Explicitly Include ISO Orders With Limit Prices Inferior to the
NBBO
Currently, marketable Intermarket Sweep Orders (``ISOs'') with a
limit price inferior to the NBBO, i.e., an ISO with a limit price less
than the national best bid for sell orders or higher than the national
best offer for buy orders, may be viewed as being subject to special
handling, which would exclude them from Rule 605 reports.\1020\ One
alternative could be to explicitly include these orders within the
scope of covered orders, either aggregated with other orders types or
as a separate order type category.
---------------------------------------------------------------------------
\1020\ See supra notes 36-37, discussing the exclusion of orders
for which the customer requests special handling from the definition
of ``covered orders''. See also 2013 FAQs, answer to Question 1.
---------------------------------------------------------------------------
ISOs make up a large percentage of on-exchange trade volume; one
academic working paper found that, between January 2019 and April 2021,
ISOs accounted for 48% of on-exchange trade volume.\1021\ In order to
estimate the volume of ISOs that are excluded from Rule 605 reporting
requirements as a result of the exclusion of ISOs with inferior limit
prices, an analysis was performed using data on ISO marketable limit
orders from the Tick Size Pilot B.II Market and Marketable Limit Order
dataset.\1022\ Table 14 shows that ISO orders with limit prices
inferior to the NBBO make up 4.9% of ISO buy orders (6.3% of buy share
volume), and 4.7% of ISO sell orders (9.0% of ISO sell volume).
Therefore, it could be the case that these orders make up a small but
non-negligible percent of order flow.\1023\
---------------------------------------------------------------------------
\1021\ See Ariel Lohr, Sweep Orders and the Costs of Market
Fragmentation (Sept. 18, 2021), available at https://ssrn.com/abstract=3926296 (retrieved from SSRN Elsevier database).
\1022\ See supra note 723 for dataset description. For the
analysis of ISO orders, the Commission limited this analysis to a
randomly selected sample of 100 stocks and for the time-period of
March 2019.
\1023\ As the Tick Size Pilot covered only small-cap stocks
(i.e., NMS common stocks that have a market capitalization of $3
billion or less, a closing price of at least $2.00, and a
consolidated average daily volume of one million shares or less),
ISO volumes and properties may be different for mid- or large-cap
stocks. Furthermore, as the Tick Size Pilot data is based on self-
reported data by trading centers, there is the possibility that the
data may be subject to certain errors or omissions.
Table 14--Marketable Intermarket Sweep Orders by Price Relative to NBBO,
March 2019
------------------------------------------------------------------------
ISO sell
ISO buy orders orders
(percent) (percent)
------------------------------------------------------------------------
Percent of Orders:
Price Equal to the NBBO............. 95.1 95.2
Price Worse Than NBBO............... 4.9 4.7
Price Better Than NBBO.............. 0.05 0.06
Percent of Share Volume:
Price Equal to the NBBO............. 93.5 90.1
Price Worse Than NBBO............... 6.3 9.0
[[Page 3889]]
Price Better Than NBBO.............. 0.2 0.9
------------------------------------------------------------------------
Table 14: Marketable Intermarket Sweep Orders by Price Relative to NBBO,
March 2019. This table shows the percentage of ISO marketable limit
orders with limit prices inferior to the NBBO, equal to the NBBO, and
better than the NBBO, using a randomly selected sample of 100 stocks
from the Tick Size Pilot B.II Market and Marketable Limit Order
dataset and for the time period of March 2019. See supra note 723 for
dataset description. The numbers reported here, in particular those
related to the NBBO, may change once the amendments in the MDI
Adopting Release are implemented. See supra note 613 and section
VII.C.1.(d)(2).
However, there are questions as to whether ISOs with inferior limit
prices would be comparable to other marketable limit orders. When the
limit price of an ISO is inferior to the NBBO at time of order receipt,
the customer is effectively instructing the trading center that it can
execute the order at a price inferior to the NBBO. If the order
executes, any adverse effects that this inferior limit price has on the
order's execution quality metrics (e.g., a negative price improvement,
or a higher effective spread) would be a result of the customer's
instructions, rather than the market center or broker-dealer's
discretion. As a result, these orders are likely to skew execution
quality metrics downwards if included with other order types, which
would harm market participants' ability to use these metrics to
accurately compare reporting entities.
One alternative could be to explicitly include ISOs with inferior
limit prices as a separate order type category in Rule 605 reports.
However, the instruction that a market center should execute an ISO
order at a price inferior to the NBBO, even when other market centers
are displaying liquidity at better prices, limits broker-dealers'
discretion over the execution price of these orders. Thus, market
participants may only benefit from this information to the extent that
market centers or broker-dealers still have some discretion over some
dimension of the order's execution quality such that this information
would be useful in comparing metrics across reporting entities. For
example, the willingness of traders to accept prices worse than the
NBBO could help illuminate the premium paid by traders to quickly trade
in a fragmented trading environment, which could differ across market
centers.
(b) Exclude Orders That Are Cancelled Quickly After Submission
Limit orders that are canceled within a very short amount of time
after submission are likely driven by trading strategies (for example,
high frequency trading \1024\ and ``pinging'') that are not intended to
provide liquidity, and therefore may have limited information about the
execution quality of a particular market center. Excluding quickly
cancelled orders from the definition of covered orders may allow fill
rates (i.e., number of shares executed at or away from the market
center, divided by number of covered shares) to better capture the
execution probability of resting orders that are given a minimum
opportunity to be executed, leading to a more meaningful ranking of
Rule 605 reporting entities. At the same time, excluding cancelled
orders also may entail losing important information if these
cancellations capture information about orders that did not or could
not receive a fill, rather than trading strategies.
---------------------------------------------------------------------------
\1024\ The Concept Release on Equity Market Structure states
that ``the submission of numerous orders that are cancelled shortly
after submission'' is a primary characteristic of high-frequency
traders. See 75 FR 3594 (Jan. 21, 2010) at 3606.
---------------------------------------------------------------------------
In order to examine how the presence of quickly cancelled orders
may impact fill rates and subsequently impact the ranking of market
centers, the Commission first examined data on cancellation and
execution times of executable NMLOs from MIDAS during the month of
March 2022.\1025\ Figure 16 plots the conditional distribution of
cancellation and execution times,\1026\ and shows that cancellation
times tend to be shorter than execution times: while the largest
percentage (29.8%) of cancelled executable NMLOs are cancelled between
1 and 100 milliseconds after submission, the largest percentage (44.8%)
of executable NMLOs that received execution are not executed until
between 1 and 30 seconds after submission. In fact, while 75% of
cancelled orders are cancelled in less than 1 second, only 41.1% of
executions happen within the same time frame. This imbalance implies
that many orders may be cancelled before they are given a reasonable
opportunity to execute.
---------------------------------------------------------------------------
\1025\ See supra note 634 for data description. Note that this
analysis doesn't include IOC NMLOs, which are not captured in MIDAS
metrics. As discussed in supra section VII.C.2.(c)(7), these orders
may also contribute to low fill rates in Rule 605 reports.
\1026\ Note that the conditional distribution examines the
percentage of cancelled (executed) orders that are cancelled
(executed) within the defined time thresholds, and not the
percentage of all orders that are cancelled or executed within the
defined thresholds. Therefore, the cancellation (execution)
percentages plotted in the Figure should sum up to 100%.
---------------------------------------------------------------------------
BILLING CODE 8011-01-P
Figure 16: Distribution of Execution and Cancellation Times for
Executable NMLOs, March 2022
[[Page 3890]]
[GRAPHIC] [TIFF OMITTED] TP20JA23.017
Therefore, it may be the case that excluding orders cancelled below
some minimum threshold may lead to more informative fill rates.
However, one question might be how to determine this threshold. For
example, if the intent is to exclude cancellations that are part of
high-frequency trading strategies such as pinging, it may be useful to
keep in mind that estimates of human reaction time range from between
one second and several hundred milliseconds, setting an upper bound for
what might be considered high-frequency trading.\1027\ Meanwhile, one
recent academic paper found that high frequency trading strategies
operate in approximately 5 to 10 microseconds.\1028\ This would imply
that a useful range for determining an appropriate threshold might be
between approximately a few microseconds and one second. Figure 17
plots the fill rates of executable NMLOs that result from excluding
orders that are cancelled below a variety of minimum time thresholds,
showing that fill rates increase and approach 100% as more and more
cancelled orders are excluded from the calculation of the fill rate.
Importantly, fill rates do not change much when orders cancelled in
less than 100 microseconds, only increasing by 0.2%. Fill rates
increase substantially when orders cancelled in less than 1 second are
excluded, but still remain on the lower side at 11.5%. This implies
that the impact of excluding quickly cancelled orders on fill rates may
be limited.\1029\
---------------------------------------------------------------------------
\1027\ See, e.g., Neil Johnson, Guannan Zhao, Eric Hunsader,
Hong Qi, Nicholas Johnson, Jing Meng & Brian Tivnan, Abrupt Rise of
New Machine Ecology Beyond Human Response Time, 3 Sci. Reps. 1
(2013); Albert Menkveld & Marius A. Zoican, Need for Speed? Exchange
Latency and Liquidity, Rev. Fin. Stud. 1188 (2017).
\1028\ See Matteo Aquilina, Eric Budis & Peter O'Neill,
Quantifying the High-Frequency Trading ``Arms Race, 137 Q. J. Econ.
493 (2022).
\1029\ Note that this sample contains a mixture of stocks in
terms of share price and market capitalization, and these numbers
are likely to look different for individual stocks according to
their market capitalization and liquidity characteristics.
---------------------------------------------------------------------------
Figure 17: Effect of Excluding Quickly Cancelled Orders on Fill Rates
for Executable NMLOs, March 2022
[[Page 3891]]
[GRAPHIC] [TIFF OMITTED] TP20JA23.018
BILLING CODE 8011-01-C
The benefit of excluding quickly cancelled orders is also likely to
be limited if excluding these orders systemically increases fill rates
across all reporting entities and does not necessarily lead to a change
in ranking between reporting entities. To explore this possibility, the
Commission limited the sample to the five largest market centers in
terms of execution volume, to examine how the rankings between these
market centers changes in terms of their fill rates for executable
NMLOs resulting from changes to the threshold below which to exclude
cancelled orders. Then it examined changes to their fill rate rankings
for executable NMLOs as the threshold below which to exclude cancelled
orders increased. The Commission found that market centers' rankings
did not change until cancellations below one second were excluded, when
the market centers ranked first and third switched places. As for
reasons described above one second represents a maximum bound on a
reasonable threshold for excluding cancellations, this again implies
that the benefits of excluding quickly cancelled orders on fill rates
may be limited.
(c) Include NMLOs Submitted Outside of Regular Trading Hours as a
Separate Order Category
The Commission is proposing to include NMLOs submitted outside of
regular trading hours if they become executable during regular trading
hours into the scope of covered orders. If NMLO orders submitted
outside of regular trading hours have characteristics that are
fundamentally different from other types of orders and have sufficient
volume such that their inclusion along with other orders may skew
execution quality statistics, it may be useful to include these orders
are a separate order type category in Rule 605 reports. Pre-open orders
likely have characteristics that differ from orders submitted during
regular hours.\1030\ However, these pre-open orders make up only a very
small percentage of order volume, representing only around 4.8% of the
volume of orders submitted during a single ten-minute period of the
trading day. Therefore, it is unlikely that the inclusion of these
orders along with other order types would significantly skew execution
quality statistics, and including them as a separate order type
category would likely only increase the complexity and size of Rule 605
report files.
---------------------------------------------------------------------------
\1030\ See supra section VII.D.1.(a)(2)(a) for an analysis
showing that orders submitted pre-open tend to be larger and further
away from the midpoint as compared to orders submitted during
regular opening hours.
---------------------------------------------------------------------------
3. Reasonable Alternative Modifications to Required Information
(a) Reasonable Alternative Order Size Categories
(1) Defining Order Sizes Based on Dollar Volume Categories Rather
Than Number of Round Lots
Instead of redefining order size categories according to number of
round lots, one alternative would be to redefine categories based on
the dollar value of the order. This approach has several advantages.
First, similarly to defining categories based on numbers of round lots
as in the current proposed amendments, notional size buckets based on
orders' dollar values may make it easier to compare execution quality
metrics across market centers that may trade in differently priced
stocks. Pre-controlling for the stock price would thus eliminate the
need for users of Rule 605 to go through the extra step of collecting
and controlling for stock price information before being able to
meaningful compare market centers using Rule 605 data. Secondly, unlike
categories based on numbers of round lots, which according to the MDI
Rules are based on the previous month's trading price,\1031\ categories
based on dollar volumes incorporate information about changing stock
prices in real time, thereby better grouping together similarly sized
orders, e.g., stocks that experience a large price increase or drop
within a single month.
---------------------------------------------------------------------------
\1031\ See supra note 265 and accompanying text.
---------------------------------------------------------------------------
On the other hand, while remaining in the spirit of distinguishing
between ``small'' and ``large'' orders, defining order size buckets
according to dollar values would no longer produce a meaningful
distinction between round lot and odd-lot orders according to the
[[Page 3892]]
new definitions under the MDI Rules, so it would not be possible to
distinguish orders that may not be at quotes protected under Rule 611.
Therefore, it is not clear that defining order size categories in terms
of dollar values is superior to defining them by number of round lots
as is currently proposed.
(b) Reasonable Alternative Time-to-Execution Statistics
(1) Increase the Granularity of Time-to-Execution Buckets
One alternative to eliminating time-to-execution buckets would be
to redefine the time-to-executions to have a granularity that better
suits the speed of modern markets. Time-to-executions for both
marketable and non-marketable order types calculated using the Tick
Size Pilot B.II dataset was analyzed,\1032\ and Figure 12 shows
execution speeds of market and marketable limit orders, along with the
three categories of non-marketable limit orders currently required in
Rule 605 (inside-the-quote, at-the-quote, and near-the-quote).
---------------------------------------------------------------------------
\1032\ See supra note 723 for dataset description.
---------------------------------------------------------------------------
The figure shows that, for market and marketable limit orders,
time-to-execution speeds are mostly bunched up at the fastest end of
their time buckets, and the longer time-to-execution buckets are left
virtually empty. However, the figure shows a very different picture for
NMLOs, in particular for at-the-quote and near-the-quote limit orders.
In contrast to market and marketable limit orders, a vast majority of
these orders are executed in over one second.
While the proposed amendment to include only NMLOs that eventually
touch the NBBO could cause average execution speeds to differ between
Rule 605 and that of the Tick Size Pilot, e.g., by excluding some NMLOs
with very long execution times, virtually all of the orders in the at-
the-quote category would by definition be included within the proposed
new scope of executable NMLOs. These orders also have a very different
distribution of time-to-executions compared to that of market and
marketable limit orders. Therefore, the granularity of time-to-
execution that would be granular enough to usefully capture the
execution speeds of market and marketable limit orders would likely be
too granular to capture the execution speeds of non-marketable limit
orders. One solution might be to define two different sets of time-to-
execution buckets: one for market/marketable orders, and one for non-
marketable limit orders. However, this would likely increase the
complexity of reporting requirements.
(c) Reasonable Alternative Spread Measures
(1) Use Different Clock Time Horizons To Calculate Realized Spread
The Commission is proposing to require the realized spread to be
calculated at both 15 seconds and one minute time horizons. The
Commission also considered alternative time horizons. An ideal
measurement horizon would be one that aligns with the amount of time an
average liquidity provider holds onto the inventory positions
established from providing liquidity.\1033\ Selecting an appropriate
time horizon to calculate the realized spread is important, as realized
spreads vary significantly as the time horizon is changed, as well as
according to stock characteristics, such as size.\1034\
---------------------------------------------------------------------------
\1033\ See supra section IV.B.4.
\1034\ See supra Figure 1.
---------------------------------------------------------------------------
An analysis of variations in realized spreads calculated over time
horizons ranging from 1 second to 5 minutes, as well as how they differ
based on stock size, generally showed that, by the 1-minute horizon,
realized spreads captured the majority of the information contained in
realized spreads for all stocks, and a substantial majority for the two
groups of larger stocks.\1035\ However, while increasing the time
horizon from 1 minute to 5 minutes has only a minimal impact on
realized spreads for larger stocks, for the two smaller-stock groups, a
sizeable proportion of the overall decline (37%) does not occur until
the 5-minute horizon. Therefore, it may be that retaining a 5-minute
horizon, in addition to the proposed 1-minute and 15-second horizon,
would capture additional information about realized spreads, particular
for the smallest stocks. However, requiring an additional specification
of realized spreads would entail adding another data item, which would
also increase the complexity of Rule 605 reports and thereby add to the
costs that market participants face when collecting, interpreting, and
evaluating Rule 605 reports.\1036\ Given that more than 50% of the
variation in realized spreads is already captured by the 1-minute
horizon, the Commission does not believe that this additional cost
would be justified by the benefit of requiring an additional
specification for realized spreads.
---------------------------------------------------------------------------
\1035\ See supra Table 1.
\1036\ See supra section VII.C.2.(d) discussing search costs
related to Rule 605 reports.
---------------------------------------------------------------------------
(2) Use Trade Time Horizons To Calculate Realized Spread
The Commission also considered whether the time horizon used to
calculate realized spreads should be measured in terms of ``trade
time,'' rather than ``clock time.'' An ideal measurement horizon for
realized spreads would be one that aligns with the amount of time an
average liquidity provider holds onto the inventory positions
established from providing liquidity. As discussed above, one would
expect that this horizon varies according to characteristics that
impact liquidity providers' ability to turn over their positions,
including stock characteristics such as size as described above;
however, this time horizon also varies over time, as overall market
conditions change. The use of a fixed time horizon could therefore make
it so that the ability of realized spread measures to capture
information about adverse selection varies over time.
Instead of setting a fixed ``clock time'' horizon, volume or
``trade time'' measures changes between the ``the initial trade to the
ith trade thereafter,'' \1037\ and therefore allows for a time horizon
that is flexible to different levels across stocks, and also over
different time periods. In other words, while prices may update under
liquid conditions in a few seconds or less, during very illiquid
conditions several minutes may go by without a trade. Measuring time in
terms of number of trades allow for the horizon to match these
different speed ``regimes'' and may result in realized spread
calculations that are more consistently relevant.\1038\
---------------------------------------------------------------------------
\1037\ See Conrad and Wahal at 241.
\1038\ For this reason, some academic studies use of trade time
instead of clock time when calculating metrics; see, e.g., David
Easley, Marcos M. Lopez De Prado & Maureen O'Hara, Flow Toxicity and
Liquidity in a High-Frequency World, 25 Rev. Fin. Stud. 1457 (2012).
---------------------------------------------------------------------------
However, the Commission is mindful of the additional computational
resources that would be required if trade time were required to
calculate realized spreads, as it would require reporting entities to
match their execution information both to information on the NBBO, as
would be necessary under the proposed clock time horizons, but
additionally historical trade information from the exclusive
SIPs.\1039\ More computationally intensive metrics would likely
increase reporting entities' compliance costs. Therefore, the
Commission believes that the proposed amendment to include multiple
fixed time horizons (15 seconds and 1 minute) would allow for
sufficient
[[Page 3893]]
flexibility in capturing realized spread information for stocks and/or
time periods with different liquidity characteristics without
increasing the computational resources required to calculate this
measure.
---------------------------------------------------------------------------
\1039\ See supra note 195.
---------------------------------------------------------------------------
(3) Use Weighted Midpoint To Calculate Effective and Realized Spread
Rule 600(b)(9) currently defines effective spreads as, for buy
orders, double the amount of difference between the execution price and
the midpoint of the national best bid and national best offer at the
time of order receipt and, for sell orders, as double the amount of
difference between the midpoint of the national best bid and national
best offer at the time of order receipt and the execution price.\1040\
The Commission is further proposing to add a definition of the average
percentage effective spread, which would be equal to the share-weighted
average of effective spreads, divided by the midpoint.\1041\ However,
an academic study \1042\ found that measuring the effective spread
relative to the midpoint overestimates effective spreads by an average
of 13%-18%, and that the bias can vary across stocks, trading venues,
and investor groups. The paper instead suggests measuring effective
spreads relative to a weighted midpoint, which factors in the depth
available at the best bid and ask price, in order to reduce this
bias.\1043\
---------------------------------------------------------------------------
\1040\ See 17 CFR 242.600(b)(8).
\1041\ See proposed Rule 600(b)(11).
\1042\ See Bj[ouml]rn Hagstr[ouml]me, Bias in the Effective Bid-
Ask Spread, 142 J. Fin. Econ. 314 (2021).
\1043\ See supra note 419 for a precise definition of the
weighted midpoint.
---------------------------------------------------------------------------
The presence of bias in effective spreads in Rule 605 reports would
impact market participants' ability to use this metric to make
comparisons across reporting entities, particularly if the bias leads
to a systematic over- or under-estimation of spreads for a particular
entity or group of entities. However, there are benefits and costs to
the use of the midpoint compared to the weighted midpoint for
calculating effective spreads. On the one hand, the midpoint requires
only data on the best available bid and ask price. Calculating the
weighted midpoint on the other hand would require that reporting
entities additionally collect data on the depth available at the
NBBO.\1044\ Furthermore, the midpoint may be easier to compute and
interpret, as it is more familiar to market participants than the
weighted midpoint.
---------------------------------------------------------------------------
\1044\ Note that this may not be a significant cost, as
reporting entities are required to collect information on NBBO depth
for computing the size improvement benchmark measure under the
proposed amendments. See supra section IV.B.4.(e).
---------------------------------------------------------------------------
(d) Reasonable Alternative Size Improvement Measures
(1) Allow Market Centers To Voluntarily Report ``Real Price
Improvement'' Measures
The Commission considered alternative measures of size improvement,
including a measure of ``real price improvement'' (``RPI''), which the
petitioner suggested would take into account the depth available at
market quotes.\1045\ RPI is calculated as the signed difference between
the transaction price and a reference price calculated as the value-
weighted average price that the trader would have gotten from walking a
consolidated limit order book consisting of displayed liquidity from
all national securities exchanges, taking into account both odd-lots
and depth available at prices outside of the NBBO. In other words, it
calculates how much money a trader saved by the market center executing
their trade at a particular price, rather than having their order walk
the consolidated limit order book.
---------------------------------------------------------------------------
\1045\ See supra note 411 and accompanying text.
---------------------------------------------------------------------------
As the calculation of RPI takes into account the complete set of
information related to the consolidated depth of book, RPI may be a
more informative measure of size improvement than a measure that can be
calculated using the benchmark metric \1046\ proposed to be required by
Rule 605, such as the size enhancement rate,\1047\ which only includes
information about depth at the best displayed prices. However, as the
complete set of consolidated depth of book information is not available
from public data sources, the RPI would require reporting entities to
subscribe to all national securities exchanges' proprietary depth-of-
book data feeds, which would entail a significant cost for those
reporting entities that do not already subscribe to these feeds.\1048\
This could make it so the benefits to market participants from having
access to a potentially more accurate measure of size improvement are
not justified by these additional costs to reporting entities of
needing to subscribe to national securities exchanges' proprietary data
feeds.
---------------------------------------------------------------------------
\1046\ See supra section IV.B.4.(e) for more information about
this benchmark.
\1047\ See supra note 884 for information about how the size
enhancement rate is constructed.
\1048\ In a white paper, one market center estimated its costs
related to subscribing to depth of book data feeds for 11 national
securities exchanges to be between $51,480 and $226,320 per exchange
per year. See The Cost of Exchange Services: Disclosing the Cost of
Offering Market Data and Connectivity as a National Securities
Exchange, IEX (Jan. 2019), available at https://iextrading.com/docs/TThe%20Cost%20Tof%20Exchange%20Services.Tpdf.
---------------------------------------------------------------------------
In order to compare the extent to which RPI and the size
enhancement rate contain similar information about size improvement,
staff used data from the Tick Size Pilot B.II Market and Marketable
Limit Order dataset \1049\ to calculate the average correlation \1050\
between these two measures. Similar to the analysis in Table 8
examining whether price improvement and size improvement measures
contain different information, staff also calculated the average
correlation between RPI, price improvement and effective spreads, to
confirm that this measure of size improvement contains different
information than the metrics that are already included in Rule 605
reporting requirements. As in Table 8, the analysis is performed
separately for national securities exchanges and off-exchange market
centers.
---------------------------------------------------------------------------
\1049\ See supra note 882 for dataset description. This analysis
uses data from prior to the implementation of the MDI Rules and the
specific numbers may be different following the implementation of
the MDI Rules. However, it is unclear whether or how these effects
would impact the correlations between these measures documents in
this analysis. See supra note 882 and section VII.C.1.(d)(2).
\1050\ See supra note 883 for a description of how average
correlations are calculated.
---------------------------------------------------------------------------
Results are presented in Table 15 and show that RPI and price
improvement are relatively strongly correlated for both national
securities exchanges and off-exchange market centers, implying that
these measures contain some (but not all) of the same information about
execution quality. Similarly, there is moderate correlation between RPI
and effective spreads, implying that these measures are somewhat
overlapping in terms of their information about execution quality for
both types of market centers. This confirms the results from Table 8
that measures of size improvement contain information that is currently
missing from Rule 605 reports. In terms of the extent to which RPI and
the size enhancement rate contain the same information about size
improvement, the Commission found that there is a moderate level of
correlation between RPI and the size enhancement rate (18.4% for
exchanges and 22.7% for off-exchange market centers).
[[Page 3894]]
Table 15--Average Correlation Between Measures of Price and Size
Improvement
------------------------------------------------------------------------
National
securities Off-exchange
Correlations exchanges market centers
(percent) (percent)
------------------------------------------------------------------------
RPI and Price Improvement............... 42.1 37.2
RPI and Effective Spreads............... 17.1 25.8
RPI and Size Enhancement Rate........... 18.4 22.7
------------------------------------------------------------------------
Table 15: Average Correlation between Measures of Price and Size
Improvement. This table presents correlations between three measures
of price improvement and size improvement: price improvement,
calculated as the signed difference between the execution price and
the NBBO, the effective spread, calculated as twice the signed
difference between the execution price and the NBBO midpoint, and the
size enhancement rate, calculated as the size improvement share count
divided by the benchmark share count (see supra note 884 for a
detailed description of this measure). See supra note 882 for dataset
description and supra note 883 for methodology. This analysis uses
data from prior to the implementation of the MDI Rules and specific
numbers may be different following the implementation of the MDI
Rules. See supra note 882 and section VII.C.1.(d)(2).
Given that correlation levels between these two measures are only
moderate, the implication is that RPI does contain information that is
not contained by the proposed benchmark metric. However, even though
RPI may be a more informative measure of size improvement, it is not
clear that the cost of requiring reporting entities to have access to
full set of consolidated depth information would justify the benefit to
market participants of having access to this additional information
about size improvement. If not, the proposed amendment to include the
benchmark consolidated reference quote size, capped at the size of the
order, in Rule 605 reporting requirements would still be a reasonable
proxy for size improvement.
One alternative might be to add a field to Rule 605 reports for
real PI, but allow reporting entities to voluntarily report this
measure if they subscribe to the full set of proprietary data feeds and
thus have access to the complete set of consolidated depth information.
Note that the requirements would need to specify that only firms that
subscribe to the full set of proprietary data feeds could report this
measure, as an incomplete set of information about availability
liquidity at market prices would systematically overstate any size
improvement measure.
4. Reasonable Alternative Modifications to Accessibility
(a) Require a System for the Centralized Posting of Rule 605 Reports
Instead of or in addition to having market centers and larger
broker-dealers post Rule 605 reports to their websites, the Commission
could require Rule 605 reports be submitted to a centralized electronic
system, which would then make these reports available to market
participants. Compared to the proposed amendments, requiring the
creation of a centralized electronic system for Rule 605 reports would
promote even greater transparency by better enabling market
participants to access and evaluate the reports of multiple (or even
the complete set of) reporting entities for the purposes of comparison.
Market participants may currently face search costs when collecting
existing Rule 605 reports in order to compare execution quality across
reporting entities, in particular when collecting Rule 605 reports for
multiple entities and across longer time periods.\1051\ A centralized
electronic system for Rule 605 reports would make it easier for market
participants to collect and aggregate data in order to compare
reporting entities as the reports would be available at a single
central location. Compared to the proposed amendments, which maintain
the existing requirement to disseminate Rule 605 reports on a website,
the creation of a centralized electronic system would lower these
search costs. Such search costs would likely increase under the
proposed amendments, which would increase the number of reporting
entities from 236 to 359, including 85 broker-dealers that introduce or
carry 100,000 or more customer accounts.\1052\ The creation of a
centralized electronic system would reduce these search costs by making
it easier for market participants to locate Rule 605 reports, as well
as to collect subsets or even the complete set of Rule 605 reports for
the purpose of comparisons.
---------------------------------------------------------------------------
\1051\ See supra section VII.C.2.(d) for a discussion of the
current search costs associated with collecting a complete or mostly
complete set of Rule 605 reports to, for example, select the
reporting entity offering the best execution quality in a given
stock. See also supra section VII.D.1.(d)(3) for a discussion of how
these search costs may increase as a result of an increase in the
number of Rule 605 reporting entities under the proposed amendments.
\1052\ See supra note 486 and accompanying text for a discussion
of the estimated number of reporting entities under the proposed
amendments. See also supra section VII.D.1.(d)(3) for a discussion
of how the increase in reporting entities under the proposed
amendments may increase search costs for some market participants.
---------------------------------------------------------------------------
The creation of a centralized electronic system would also promote
greater transparency as compared to the proposed amendments by reducing
these search costs and increasing the accessibility of Rule 605 reports
by ensuring that all reports are able to be obtained from a single
location. As a result of this increase in transparency, investors would
be better able to use Rule 605 reports to compare execution quality
across larger broker-dealers, which would increase the extent to which
broker-dealers would need to compete on the basis of execution quality.
Likewise, compared to the proposed amendments, broker-dealers would be
better able to use Rule 605 reports to compare execution quality across
market centers, increasing the extent to which market centers compete
on the basis of execution quality in order to attract order flow.
Requiring a centralized electronic system would also enable
programmatic checks that the Rule 605 reports are appropriately
standardized, formatted, and complete before posting, potentially
reducing processing costs for users. The Commission recognizes that the
entity responsible for administering the Rule 605 centralized
electronic system would incur compliance costs as a result of the
creation and maintenance of such a system (including any programmatic
formatting, completeness, and/or consistency checks on the reports
before posting), which could be passed on to reporting entities in the
form of filing fees and/or to consumers of Rule 605 reports in the form
of access fees. However, to ensure that Rule 605 reports continue to be
freely available, the current requirement for reporting entities to
post a free version of the report on their websites (incorporating any
corrections made pursuant to any aforementioned programmatic
formatting, completeness, and/or consistency checks on the reports)
could be retained along with the additional
[[Page 3895]]
requirement for reports to be made available through a centralized
electronic system.\1053\
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\1053\ To the extent that potential consumers of Rule 605
reports would not access the reports as a result of a centralized
electronic system's access fees, this would represent a limitation
to the benefits from increased accessibility. If the number of
current consumers of Rule 605 would actually decrease as a result of
these potential access fees, this would represent a cost in the form
of reduced accessibility of Rule 605 reports. However, maintaining
the current requirement for reporting entities to post a free
version of the report on their websites would obviate this cost.
---------------------------------------------------------------------------
Furthermore, to the extent that the centralized electronic system
would include programmatic formatting, completeness, and/or consistency
checks on Rule 605 reports before accepting them, reporting entities
would also incur costs to resolve any issues detected by such checks.
Reporting entities would be most efficiently situated to remedy any
identified issues in their own reports before they are posted.
The Commission has specifically considered two options for how to
implement the centralized electronic system: using the existing Rule
605 NMS Plan and the Commission's Electronic Data Gathering, Analysis,
and Retrieval (``EDGAR'') system. Table 16 summarizes the costs and
benefits of each of these alternatives, which are also discussed in
more detail in the sections below. The Commission acknowledges there
may be other options for a centralized system and requests comment on
these other options.
Table 16--Summary of Costs and Benefits of Alternative Centralized
Electronic Systems
------------------------------------------------------------------------
Mechanism for centralized
posting of reports EDGAR NMS plan
------------------------------------------------------------------------
Benefits Relative to Proposed Amendments
------------------------------------------------------------------------
Accessibility............... Reports would be in Reports would be in
one place, reducing one place, reducing
search costs and search costs and
increasing the increasing the
benefits of Rule benefits of Rule
605 reporting. 605 reporting. The
EDGAR could include NMS Plan could
programmatic checks include
to ensure the programmatic checks
reports are to ensure the
appropriately reports are
standardized, appropriately
formatted, and standardized,
complete before formatted, and
posting, complete before
potentially posting,
reducing processing potentially
costs for users. reducing processing
EDGAR functionality costs for users.
would allow However, the
consumers to search specific
for specific functionality and
reports or all ease of access is
reports for a given uncertain. Any
month. However, access fees could
consumers wishing limit benefits.
to combine reports
for analysis would
need to pull each
report separately.
EDGAR does not
charge access fees.
------------------------------------------------------------------------
Costs Relative to Proposed Amendments
------------------------------------------------------------------------
Costs to Build.............. n/a................. Plan participants
would incur costs
to build a system
to collect and
validate or to
contract with
someone who already
has a system that
could work.
Costs to Maintain........... n/a................. Plan participants
would incur the
cost of maintaining
a reporting system.
Reporting Costs............. Reporting entities Reporting entities
that do not already could pay a
submit documents to reporting fee to
the Commission via cover the costs of
EDGAR would incur a the Plan
one-time burden to participants.
obtain EDGAR access Reporting entities
codes. Reporting would incur costs
entities would if their reports
incur costs if contain formatting,
their reports completeness, or
contain formatting, consistency issues
completeness, or that would require
consistency issues resolution before
that would require acceptance.
resolution before
acceptance. EDGAR
does not charge
filing fees.
Coordination Costs.......... n/a................. Plan participants
would incur costs
to coordinate on
amending the NMS
Plan.
------------------------------------------------------------------------
Table 16: Summary of Costs and Benefits of Alternative Centralized
Electronic Systems. This table presents a qualitative summary of the
benefits and costs that the Commission estimates would result from
various alternatives requiring the centralized posting of Rule 605
reports, relative to the proposed amendments. These benefits and costs
are discussed in more detail in infra sections VII.E.4.(a)(1)-(2).
(1) Require Rule 605 Reports To Be Provided Through the NMS Plan
One alternative would be to require that procedures established
pursuant to the NMS Plan provide for the creation and maintenance of a
centralized electronic system to serve as a repository for Rule 605
reports. In this alternative, the proposed rule text could specify that
the NMS plan procedures shall provide for the creation and maintenance
of a centralized electronic system for such reports and make such
reports available for viewing and downloading in a manner that is free
and readily accessible to the public. However, the rule text could
retain existing language such that, in the event there is no plan or
system currently establishing such procedures, reports shall be
prepared in a consistent, usable, and machine-readable electronic
format and be made available for downloading from an internet website
that is free and readily accessible to the public.\1054\ In other
words, in the absence of procedures providing for the creation and
maintenance of a centralized electronic system, Rule 605 reports are
required to be made available for download from an internet website
that is free and readily accessible to the public (or as specified by
the then-current NMS plan). This backstop requirement will help to
assure the continued availability of execution quality information
while a centralized electronic system is developed.
---------------------------------------------------------------------------
\1054\ See 17 CFR 242.605(a)(2).
---------------------------------------------------------------------------
As discussed above, the creation of a centralized electronic system
would generally result in additional economic benefits as compared to
the proposed amendments by further promoting transparency and
competition, and by reducing market participants' search costs by
ensuring that all Rule 605 reports could be obtained from a single
[[Page 3896]]
location. However, as the NMS Plan would be tasked with designing and
implementing the centralized electronic system, the Commission would ex
ante be uncertain as to the specific functionality and ease of access
that such a centralized electronic system would provide. Any
differences between this alternative and any other alternative in terms
of the accessibility and timeliness of centralized Rule 605 information
would depend on how the NMS Plan would develop the functionality for
distributing or making the Rule 605 reports public.
The Commission estimates that the NMS Plan participants, consisting
of 16 national securities exchanges and 1 national securities
association, would incur initial and ongoing compliance costs
associated with this alternative. First, the NMS Plan participants
would incur initial compliance costs associated with preparing and
filing amendments to the NMS Plan to account for the creation of a
centralized electronic system to make reports available for viewing and
downloading, along with the implementation and enforcement of that
system. The Commission estimates that there would be a one-time (or
initial) burden of 65 hours per NMS Plan participant to account for the
creation of a centralized electronic system.\1055\ Furthermore, the
Commission estimates that the NMS Plan participants would incur an
ongoing, annual burden of 15 hours per NMS Plan participant \1056\
associated with the maintenance of the centralized electronic system.
NMS Plan participants would likely also incur coordination costs to
reach an agreement on the design and implementation of a centralized
electronic system. However, the Commission is unable to quantify these
potential coordination costs as it would depend on the extent to which
there would be disagreements among the NMS plan participants.
---------------------------------------------------------------------------
\1055\ The Commission believes the monetized initial burden for
this requirement to be $294,950. The Commission derived this
estimate based on per hour figure from SIFMA's Management &
Professional Earnings in the Securities Industry 2013, modified by
Commission staff to account for an 1,800-hour work-year and
inflation, and multiplied by 5.35 to account for bonuses, firm size,
employee benefits and overhead: [(Programmer Analyst at $267 for 40
hours) + (Business Analyst at $255 for 5 hour) + (Attorney at $462
for 15 hours) + (Assistant General Counsel at $518 for 5 hours)] =
$17,350 per respondent for a total initial monetized burden of
$365,075 ($21,475 x 17 respondents).
\1056\ The Commission believes the monetized annual burden for
this requirement to be $80,444. The Commission derived this estimate
based on per hour figure from SIFMA's Management & Professional
Earnings in the Securities Industry 2013, modified by Commission
staff to account for an 1,800-hour work-year and inflation, and
multiplied by 5.35 to account for bonuses, firm size, employee
benefits and overhead: [(Attorney at $462 for 10 hours) + (Assistant
General Counsel at $518 for 5 hours)] = $4,732 per respondent for a
total initial monetized burden of $122,570 ($7,210 x 17
respondents).
---------------------------------------------------------------------------
The Commission estimates that the above initial and ongoing burdens
would result in an estimated total initial compliance cost of
approximately $294,950 and a total annual compliance cost of $80,444
for all NMS Plan participants. These costs would likely be passed on to
reporting entities in the form of reporting fees, or to consumers of
Rule 605 reports in the form of access fees. Thus, these costs could
result in an increase in the initial and ongoing compliance costs
incurred by reporting entities, and/or an increase in costs or a
limitation to benefits for Rule 605 consumers. As discussed above, to
the extent that the centralized electronic system would include pre-
acceptance checks that Rule 605 reports are appropriately standardized,
formatted, and complete, reporting entities would also incur costs to
resolve any issues flagged by such checks, though the specific process
for resolving such issues would determine the precise costs involved.
(2) Require Rule 605 Reports To Be Provided to the Commission Through
EDGAR
As another alternative, the Commission could propose to have
reporting entities disclose Rule 605 information directly to the
Commission through the Commission's Electronic Data Gathering,
Analysis, and Retrieval (``EDGAR'') system, with the Commission
subsequently making the information publicly available on EDGAR. Such
an alternative would increase certain reporting entities' compliance
costs relative to the proposed amendments, as any reporting entities
that do not already submit documents to the Commission via EDGAR would
incur a one-time burden of submitting a notarized Form ID application
to obtain EDGAR access codes, a burden that would not apply under the
proposed amendments.\1057\ However, an EDGAR requirement would not
involve any costs to NMS Plan participants of creating and maintaining
an electronic system for Rule 605 reports, and, as EDGAR would not
charge any reporting or access fees, would not involve the cost to
reporting entities of paying reporting fees or the cost to consumers of
Rule 605 reports of paying access fees.
---------------------------------------------------------------------------
\1057\ See 17 CFR 232.10; section 3 of the EDGAR Filer Manual
(Volume I) version 40 (June 2022). Any market centers, brokers, and
dealers that already submit documents on EDGAR would not incur this
burden. For example, some broker-dealers choose to file the annual
audit reports required by Form X-17A-5 Part III on EDGAR rather than
via paper, and would thus already have the required access and
procedures in place to submit Rule 605 Reports to EDGAR. See section
8.2.19 of the EDGAR Filer Manual (Volume II) version 62 (June 2022).
---------------------------------------------------------------------------
EDGAR functionality would allow consumers of Rule 605 to search for
specific reports or all reports for a given month. However, consumers
wishing to combine reports for analysis would need to pull each report
separately. EDGAR functionality would also allow for programmatic
checks to ensure Rule 605 reports are appropriately standardized,
formatted, and complete before posting; Commission staff could design
and periodically assess such checks to ensure they are effective. To
the extent that these checks detect any issues in Rule 605 reports
before posting, reporting entities may incur costs in resolving these
issues and re-submitting their reports.
Under this alternative, entities would submit Rule 605 information
to the Commission, but would not file Rule 605 information with the
Commission. Under the Exchange Act, documents filed with the Commission
are subject to heightened liability for misstatements contained therein
than documents otherwise provided to the Commission (e.g., documents
furnished to the Commission).\1058\ Because this alternative is
intended to alter the manner by which Rule 605 reports are made
available, and not the liability attached to Rule 605 reports, the
alternative does not contemplate filing Rule 605 information with the
Commission.
---------------------------------------------------------------------------
\1058\ See section 32 of the Exchange Act.
---------------------------------------------------------------------------
(b) Require Rule 605 Reports To Be Filed Using an Expanded Version of
the Rule 606 XML Schema
Rule 605 currently requires that reports be provided in a machine-
readable electronic format,\1059\ and the governing NMS Plan specifies
that Rule 605 reports must be provided in pipe-delimited ASCII, which
is a machine-readable electronic format.\1060\ This would not be
changed under the proposed amendments. As an alternative, the
Commission could revise Rule 605 to specify that Rule 605 reports must
be provided using an
[[Page 3897]]
expanded version of the existing XML schema for Rule 606 reports.\1061\
This alternative would allow the data on Rule 605 reports to be used
interchangeably with the data in Rule 606 reports, thus facilitating
the usage of Rule 605 data together with Rule 606 data, in line with
the Commission's original intent for the rules.\1062\ In addition, the
use of XML rather than pipe-delimited ASCII would facilitate the use of
more complex data error checks (such as checks on elements in nested
structures).
---------------------------------------------------------------------------
\1059\ See CFR 242.605(a)(2) requiring that ``. . . market
centers shall prepare their reports in a consistent, usable, and
machine-readable electronic format . . .''
\1060\ See Plan at 2 (``Section V . . . provides that market
center files must be in standard, pipe-delimited ASCII format'').
See also supra note 49 and accompanying text.
\1061\ See 17 CFR 242.606(a)(2) and (b)(3), requiring reports to
be made available ``using the most recent versions of the XML schema
and the associated PDF renderer as published on the Commission's
website.'' See also Order Routing and Handling Data Technical
Specification, SEC (Feb. 25, 2022), available at https://www.sec.gov/files/order_handling_data_technical_specification-2022-02-25.pdf.
\1062\ See supra note 141.
---------------------------------------------------------------------------
On the other hand, this alternative would require reporting
entities to establish technical systems to format the reports using the
expanded XML schema and render them using the PDF renderer, thus
imposing additional compliance costs relative to the baseline and the
proposed amendments. Furthermore, because Rule 605 reports consist
solely of a series of discrete numeric values, and do not contain
elements in nested structures, the Commission does not believe the more
sophisticated validations enabled by the use of XML would provide
significant benefits for Rule 605 reports. In addition, because the
nature of the Rule 606 data (which includes narrative discussions)
differs from the nature of the Rule 605 data (which is limited to a
discrete set of numerical statistics), and because the population of
entities that report Rule 606 data (broker-dealers) does not coincide
with the population of entities that report Rule 605 data (market
centers, and, under the proposed amendments, certain broker-dealers),
the Commission does not believe the benefits to be realized from
interchangeable usage of Rule 605 and Rule 606 data would justify the
compliance costs that would arise under this alternative.
5. Other Reasonable Alternatives
(a) Releasing Aggregated CAT Data
As an alternative to the proposed amendments, the Commission could
use CAT data to have either the Commission or the CAT Plan Processor
\1063\ provide execution quality information to the public at monthly
intervals--or more frequently. This alternative would effectively
eliminate the need for Rule 605 reports.
---------------------------------------------------------------------------
\1063\ As set forth in the CAT NMS Plan, the Plan Processor is
required to develop and, with the prior approval of the Operating
Committee, implement policies, procedures, and control structures
related to the CAT System that are consistent with 17 CFR
242.613(e)(4), and Appendix C and Appendix D of the CAT NMS Plan.
See Joint Industry Plan; Order Approving the National Market System
Plan Governing the Consolidated Audit Trail, SEC, n.136 (Nov. 15,
2016), available at https://www.sec.gov/rules/sro/nms/2016/34-79318.pdf.
---------------------------------------------------------------------------
This approach would have lower compliance costs for reporting
entities than the current proposal, as it would not require reporting
entities to prepare Rule 605 reports. Another benefit of this
alternative with regard to the current proposal is that the data in
this alternative could be more comprehensive in terms of the breadth of
broker-dealers whose execution quality information could be aggregated
and published, because the Commission could publish aggregated data on
execution quality from all broker-dealers instead of just those that
meet the customer account threshold. As a result, the data would be
more comprehensive, resulting in even greater benefits from
transparency.\1064\
---------------------------------------------------------------------------
\1064\ See supra section VII.D.1.(a)(1)(a) for a discussion of
the benefits of increased transparency from expanding reporting
requirements to include larger broker-dealers.
---------------------------------------------------------------------------
However, it would be a major undertaking for the Plan Processor to
build out and adapt systems to collect, process, and publish this
information, which would increase costs associated with the Plan
Processor. Costs associated with the Plan Processor would also increase
as a result of increased requirements for processing power for the
aggregation of CAT data if such computations could not be performed
with existing resources (without reducing other functionality). Any
costs incurred by the Plan Processor would be passed along to Plan
Participants and Industry Members, which could result in larger costs
to some reporting entities.\1065\ Another drawback to this alternative
is that releasing CAT data to the public could increase security risks.
CAT contains highly sensitive information and creating a process that
would release portions of the data, even if aggregated, could present
risks.
---------------------------------------------------------------------------
\1065\ Some reporting entities, on the other hand, may incur
lower costs if they pay a smaller proportion of CAT costs.
---------------------------------------------------------------------------
F. Request for Comment
The Commission requests comment on all aspects of this initial
economic analysis, including whether the analysis has: (1) identified
all benefits and costs, including all effects on efficiency,
competition, and capital formation; (2) given due consideration to each
benefit and cost, including each effect on efficiency, competition, and
capital formation; and (3) identified and considered reasonable
alternatives to the proposed new rules and rule amendments. The
Commission requests and encourages any interested person to submit
comments regarding the proposed rules, our analysis of the potential
effects of the proposed rules and proposed amendments, and other
matters that may have an effect on the proposed rules. The Commission
requests that commenters identify sources of data and information as
well as provide data and information to assist us in analyzing the
economic consequences of the proposed rules and proposed amendments.
The Commission also is interested in comments on the qualitative
benefits and costs identified here and any benefits and costs that may
have been overlooked. In addition to the general request for comments
on the economic analysis associated with the proposed rules and
proposed amendments, the Commission requests specific comment on
certain aspects of the proposed amendments to Rule 605:
56. Do commenters believe that rulemaking is necessary to provide
investors with a more modernized source of standardized execution
quality information than what is currently contained in Rule 605
reports? What are commenters' views on why alternative market-based
sources of standardized execution quality information, such as the FIF
Template, have not been more widely adopted?
57. Has the Commission accurately assessed the current usage of
Rule 605 reports? Do commenters agree that broker-dealers currently use
Rule 605 reports in assessing best execution? Do commenters believe
that Rule 605 reports currently have low usage among individual
investors? If so, why? Do commenters believe that Rule 605 reports
currently have low usage among institutional investors? If so, why?
What are commenters' understandings of the current availability and
cost of data products and/or summary reports sourced from Rule 605
data? Does the availability and costs of such products vary depending
on the type of investor that the product is targeting (i.e., individual
or institutional)?
58. Do market participants currently lack information about the
execution quality of broker-dealers? If so, does this limit the extent
to which broker-dealers must compete on the basis of execution quality?
Why or why not? Do commenters believe that the ability to use
information on broker-dealer routing in Rule 606 reports and
[[Page 3898]]
information on market center execution quality in Rule 605 reports in
order to discern the execution quality of broker-dealers currently
limited? Why or why not?
59. Are commenters aware of any inconsistencies in how reporting
entities separate or combine information across several market centers
or business lines that they operate for the purposes of Rule 605
reporting? To the best of commenters' knowledge, is it common practice
for market centers that operate SDPs to combine information about
orders submitted to their SDPs with information about other orders
handled by the market center for the purposes of Rule 605 reporting?
Are commenters aware of any other situations in which reporting
entities typically co-mingle execution quality statistics across
several market centers or business lines that they operate?
60. Do commenters agree that orders submitted to qualified auctions
would likely differ from other types of orders? If so, in what ways
might these differences impact execution quality metrics?
61. Do commenters agree that the number of order types has
increased since the early 2000s? If so, do commenters believe that a
proliferation of order types has contributed to any changes in the
extent to which Rule 605 reports contain information about relevant
order sizes and order types? Are there any additional order types that
are currently excluded from Rule 605 reporting requirements that the
Commission should include?
62. Do commenters believe that a significant portion of ISO order
volume may be made up of ISO orders trading at prices inferior to the
NBBO? Are commenters aware of whether a significant portion of ISO
orders are excluded from Rule 605 reporting requirements? Do commenters
believe that it would be useful for market participants to have access
to information about the execution quality of ISO orders submitted with
limit prices inferior to the NBBO? Why or why not?
63. Do commenters believe that there are any other market or
regulatory changes that have significantly contributed to changes in
the extent to which Rule 605 reports contain information about relevant
order sizes and order types?
64. Do commenters agree that, by excluding odd-lots, fractional
shares, and block orders (i.e., orders that are larger than 10,000
shares), Rule 605 reports are missing information about an important
segments of order flow? Why or why not? Do commenters agree that
individual investors would benefit from the inclusion of information
about odd-lots and fractional share orders? Why or why not? Do
commenters agree that the use of block trades has decreased since the
initial adoption of Rule 605 but still represents an important segment
of order flow in terms of total share volume? Why or why not? Are
commenters aware of whether the majority of block orders tend to be not
held to the market?
65. Do commenters agree that information about the execution
quality of stop orders would be useful for investors? Why or why not?
Do commenters agree that market centers and broker-dealers may differ
in how they handle stop orders? Why or why not? Do commenters believe
that the use of stop orders (e.g., as a percent of total order flow)
has increased or decreased in recent years? How might stop orders be
different from other types of orders in terms of their execution
quality metrics? Do commenters agree that grouping executable stop
orders together with other types of NMLOs would skew or add noise to
execution quality metrics? Why or why not? Do commenters believe that
there could be any negative consequences associated with increasing the
transparency of stop-loss order volume, such as the increasing the risk
of certain trading strategies, i.e., ``gunning for stops''? Why or why
not?
66. Do commenters agree that information about the execution
quality of non-exempt short sale orders would be useful for investors?
Why or why not? How might non-exempt short sale orders be different
from other types of orders in terms of their execution quality metrics?
Do commenters believe that grouping non-exempt short sale orders
together with other types of orders would skew or add noise to
execution quality metrics? Why or why not?
67. Do commenters agree that orders submitted outside of regular
market hours represent a small portion of overall order flow, but
contain a higher concentration of individual investor orders compared
to order flow during regular market hours? Why or why not? Are
commenters aware of any other ways in which orders submitted outside of
regular market hours differ from other types of orders and, if so,
whether these differences would impact execution quality metrics in
ways that may skew or add noise to these metrics?
68. Do commenters believe that, following the new definition of
``round lot'' under the MDI Rules, the order size categories currently
defined in Rule 605 reports would lead to the exclusion of a relevant
portion of order flow? Do commenters find the order size categories
currently defined in Rule 605 reports useful? Why or why not?
69. Do commenters believe that the current categorization of NMLOs
does not lead to meaningful information about execution quality? Why or
why not? Do commenters find these categories useful? If so, why? Do
commenters believe that the Commission should use a 10 cent threshold
to determine whether a NMLO should be included within the scope of Rule
605?
70. Do commenters believe that information about the execution
quality of beyond-the-midpoint limit orders is currently missing from
Rule 605 reports and would be useful for investors? Do commenters
believe that some market centers, such as wholesalers, may handle
beyond-the-midpoint limit orders more like marketable limit orders than
NMLOs? Are commenters aware of any other differences in the handling of
beyond-the-midpoint limit orders, as compared to other types of NMLOs?
If so, do commenters believe that these differences would impact
execution quality metrics in ways that may skew or add noise to these
metrics?
71. Do commenters believe that the current time-to-execution
information required by Rule 605 is inappropriate given the current
speed of trading in equity markets? Do commenters believe that the
current time-to-execution categories defined in Rule 605 are not
granular enough? What do commenters believe would be an appropriate
granularity, and does it depend on the type of order (marketable, NMLO,
etc.)?
72. Do commenters believe that the current requirements in Rule 605
related to measures of effective, realized and quotes spreads may lead
to inaccurate or incomplete information? Do commenters agree that the
use of a five-minute time horizon to calculate the realized spread is
inappropriate? If so, why? Do commenters believe that the use of a
five-minute time horizon leads to biased realized spreads, noisy
realized spreads, both, or potentially other issues? Do commenters find
effective and realized spreads expressed in dollar terms to be useful?
If so, why? Do commenters believe that there are any problems with
using effective and realized spreads expressed in dollar terms? If so,
what?
73. Do commenters believe that size improvement information is
currently missing from Rule 605 reports? If not, what specific
information in Rule 605 reports (e.g., effective spreads, price
improvement) do commenters make use
[[Page 3899]]
of in order to proxy for size improvement?
74. Do commenters believe that information about IOC orders is
currently missing from Rule 605 reports and would be useful for
investors? Do commenters believe that IOCs likely have different
execution quality characteristics than other types of orders? If so, in
what ways might these differences impact execution quality metrics? Do
commenters believe that these differences would impact execution
quality metrics in ways that may skew or add noise to these metrics?
75. Do commenters believe that the reporting of riskless principal
transactions as shares executed at the market center is inappropriate?
Why or why not? Would commenters find it useful to have access to more
information about the extent to which wholesalers internalize orders?
If so, in what ways would this information be beneficial?
76. Do commenters believe that the search costs to access,
aggregate, and compare execution quality metrics across Rule 605
reporting entities are currently high? Do commenters believe that the
search costs are high enough to limit the utility of Rule 605 reports?
Are commenters currently able to use Rule 605 reports to compare
execution quality measures across market centers? If not, why not? Do
commenters believe that the use of third parties to collect Rule 605
data alleviates some of these costs?
77. Do commenters believe the Commission has adequately described
the baseline for the market for brokerage services? Are there elements
of this market that are relevant to the proposed amendments that are
not discussed in the release? If so, please describe.
78. Do commenters believe the Commission has adequately described
the baseline for the market for trading services? Are there elements of
this market that are relevant to the proposed amendments that are not
discussed in the release? If so, please describe.
79. What do commenters believe would be the effect of expanding the
scope of Rule 605 reporting entities to include larger broker-dealers
on transparency and competition in the market for brokerage services?
Do commenters believe that the costs to switching broker dealers are
significant? Do commenters believe that there are other significant
limits to the effects on competition of expanding the scope of Rule 605
reporting entities and, if so, what are these limits? Do commenters
believe that any broker-dealer(s) would need to exit the market as a
result of the proposal? If so, what effect if any would this have on
competition? What do commenters believe are the effects on competition
of limiting the scope of broker-dealers subject to Rule 605 to only
include larger broker-dealers?
80. What are commenters' views regarding the effects of the
proposal on transparency and competition in the market for trading
services? Do commenters believe that there are significant limits to
these effects? Do commenters believe that the effects on competition
would be different (e.g., stronger or weaker) for competition for
individual investor order flow vs. institutional order flow? Do
commenters believe that any market center(s) would need to exit the
market as a result of the proposal? If so, what effect if any would
this have on competition?
81. Do commenters believe that Rule 605 reports as proposed to be
amended would contain sufficient information such that the reports
could be used to make apples-to-apples comparisons across reporting
entities? If not, is there any additional or alternative information
that could be required to ensure a more apples-to-apples comparison?
Please be specific.
82. Do commenters believe the proposed summary report reflecting
aggregated execution quality information would contain sufficient
information such that the summary reports could be used to make apples-
to-apples comparisons across reporting entities? If not, is there any
additional or alternative information that could be required to ensure
a more apples-to-apples comparison? Please be specific. Do commenters
believe that the availability of Rule 605 summary reports would have an
impact on competition between reporting entities? Why or why not? Do
commenters believe that the availability of Rule 605 summary reports
would increase the likelihood that investors would use execution
quality information to compare across reporting entities? Why or why
not?
83. Do commenters believe that the availability of alternative
sources of execution quality information would limit the effects of the
proposal on competition across reporting entities? Do commenters
believe that the availability of alternative sources of execution
quality information decreases the likelihood that investors would use
reports to compare execution quality across reporting entities? If so,
which sources?
84. Do commenters agree with the Commission's assessment that the
proposal would impact the market for TCA? Why or why not? Are
commenters aware of any other market whose competitive structure would
be effected by the proposal?
85. What are commenters' views of the benefits of the proposal? Do
commenters believe that the proposal would increase transparency
regarding the execution quality of reporting entities? Do commenters
believe that the proposal would increase competition between reporting
entities on the basis of execution quality? Do commenters believe that
the proposal would improve execution quality for investors? Would the
benefits of the proposal depend on the type of investor (i.e.,
individual or institutional)? Why or why not? Do commenters believe
that there would be any limitations to the benefits and, if so, what?
Do commenters believe that the lack of a centralized electronic system
for Rule 605 reports represents a limitation to the benefits of the
proposed amendments? Why or why not?
86. Do commenters agree that the benefits of the proposed
amendments would be limited if investors incur high costs to switch
between broker-dealers, and/or if broker-dealers incur costs to switch
between market centers in response to information about execution
quality? Do commenters believe that these switching costs are currently
high? Why or why not?
87. Are commenters aware of circumstances in which customers may
not be able to select the broker-dealers of their choice, for example
as a result of the customers' order flow characteristics, and whether
this has or would have an impact on the switching costs for these
customers? Do commenters believe that the proposal, if adopted, would
affect such circumstances and, if so, how?
88. What are commenters' views of the costs of the proposal? What
do commenters believe would be the main costs of the proposal? What do
commenters believe would be the other costs of the proposal, if any? Do
commenters believe that costs may vary across reporting entities? If
so, which characteristics of the reporting entities would be the main
drivers of cost differences between reporting entities? Do commenters
believe that the complexity of Rule 605 reports would increase as a
result of the proposed amendments and, if so, would this result in
additional costs to market participants? Why or why not? Do commenters
believe that search costs would increase as a result of the proposed
amendments? Why or why not?
89. What are commenters' views regarding the effects the proposed
[[Page 3900]]
amendments might have on efficiency and capital formation?
90. Do commenters believe the proposed amendments may have
unintended consequences that are not captured by the Commission's
assessment of the effects the proposed amendments may have on
efficiency, competition and capital formation? Why or why not?
91. Should the Commission adopt an alternative approach to any of
the proposed amendments? Why or why not? Which alternatives? What are
the benefits and costs of such an approach?
92. Do commenters believe that the Commission should adopt
alternatives to the proposal to include only larger broker-dealers with
100,000 or more customer accounts into the scope of Rule 605? Should
the Commission adopt alternative thresholds for determining which
broker-dealers to include or exclude? What would be the benefits and
costs of these alternative thresholds?
93. Do commenters believe that the Commission should adopt
alternative amendments to the scope of orders covered by Rule 605?
Should the Commission include ISO orders with limit prices inferior to
the NBBO into the scope of Rule 605, either as a separate order type
category or together with other orders, and what would be the costs and
benefits of this approach? Should the Commission exclude orders that
are quickly cancelled from Rule 605 reporting requirements? If so, what
would be an appropriate threshold cancellation time below which to
exclude orders? What would be the costs and benefits of excluding
quickly cancelled orders? Should the Commission separate NMLOs
submitted outside of regular trading hours as a separate order type
category? What would be the costs and benefits of separating NMLOs
submitted outside of regular trading hours as a separate order type
category?
94. Do commenters believe the Commission should add additional
price improvement statistics to Rule 605 reports for segmented orders
in qualified auctions measuring price improvement compared to the
initial price at which a segmented order was submitted to a qualified
auction? If so, what would be the benefits and costs of adding these
additional metrics? How would these additional metrics affect
competition between qualified auctions at different market centers?
95. Do commenters believe that pipe-delimited ASCII is the best
format for Rule 605 reports? Should the Commission instead expand the
existing XML Schema that it has created for Rule 606 reports? Should
the Commission create a new XML Schema for Rule 605 reports in a manner
similar to the XML Schema for Rule 606 reports? Would XML be an
improvement over the use of pipe-delimited ASCII and, if so, why? Is
there another format--other than pipe-delimited ASCII and XML--that the
Commission should require for Rule 605 reports? If so, which format
should the Commission use, and why?
96. Should the Commission require that Rule 605 reports be posted
in a centralized electronic system? Would a centralized electronic
system for Rule 605 reports make it easier for investors, analysts, and
others to access and gather information from Rule 605 reports? Would it
be beneficial for such a system to include programmatic checks to
ensure Rule 605 reports are appropriately standardized, formatted, and
complete before acceptance? Do commenters believe there would be any
additional benefits from establishing or requiring to be established a
centralized electronic system for Rule 605 reports? If so, what? Do
commenters have a view on how a centralized electronic system could be
implemented? What do commenters estimate would be the costs associated
with such a centralized electronic system (including any costs
associate with programmatic checks for completeness, consistency, and
proper formatting), and who do commenters believe would incur these
costs?
97. If the Commission were to adopt a centralized electronic system
for Rule 605 reports, do commenters believe EDGAR or a system created
and maintained by the NMS Plan is the optimal alternative? Are there
other alternatives that the Commission should consider? If so, what
would be the costs and benefits associated with posting Rule 605
reports through that system? Should separate centralized electronic
systems be established for different categories of reporting entities?
98. Do commenters agree with the Commission's analysis of the
accessibility, data quality, costs to build, costs to maintain,
reporting costs, and coordination costs associated with using EDGAR or
a system created and maintained by the NMS Plan for a centralized
electronic system for Rule 605 reports?
99. Are market participants likely to access and download Rule 605
reports from a centralized electronic system, rather than from a
reporting entity's website? For which customers will a centralized
electronic system be most beneficial, and why? How will these benefits
differ if the centralized electronic system uses EDGAR, a system
created maintained by the NMS Plan, or any other system proposed by
commenters?
VIII. Consideration of Impact on the Economy
For purposes of the Small Business Regulatory Enforcement Fairness
Act of 1996, (``SBREFA''),\1066\ the Commission requests comment on the
potential effect of the proposed amendments to Rule 605 on the United
States economy on an annual basis. The Commission also requests comment
on any potential increases in costs or prices for consumers or
individual industries, and any potential effect on competition,
investment, or innovation. Commenters are requested to provide
empirical data and other factual support for their views to the extent
possible.
---------------------------------------------------------------------------
\1066\ Public Law 104-121, Title II, 110 Stat. 857 (1996)
(codified in various sections of 5 U.S.C., 15 U.S.C., and as a note
to 5 U.S.C. 601).
---------------------------------------------------------------------------
IX. Initial Regulatory Flexibility Analysis
The Regulatory Flexibility Act (``RFA'') \1067\ requires Federal
agencies, in promulgating rules, to consider the impact of those rules
on small entities. Section 603(a) \1068\ of the Administrative
Procedure Act,\1069\ as amended by the RFA, generally requires the
Commission to undertake a regulatory flexibility analysis of all
proposed rules, or proposed rule amendments, to determine the impact of
such rulemaking on ``small entities.'' \1070\ Section 605(b) of the RFA
states that this requirement shall not apply to any proposed rule or
proposed rule amendment which, if adopted, would not have a significant
economic impact on a substantial number of small entities.\1071\
---------------------------------------------------------------------------
\1067\ 5 U.S.C. 601 et seq.
\1068\ 5 U.S.C. 603(a).
\1069\ 5 U.S.C. 551 et seq.
\1070\ Although section 601(b) of the RFA defines the term
``small entity,'' the statute permits agencies to formulate their
own definitions. The Commission adopted definitions for the term
``small entity'' for purposes of Commission rulemaking in accordance
with the RFA. Those definitions, as relevant to this proposed
rulemaking, are set forth in 17 CFR 240.0-10.
\1071\ See 5 U.S.C. 605(b).
---------------------------------------------------------------------------
The proposed rule would apply to market centers--which includes any
exchange market maker, OTC market maker, ATS, national securities
exchange registered with the Commission under section 6 of the Exchange
Act, or national securities association registered with the Commission
under section 15A of the Exchange Act--and certain brokers or dealers
that are not a market center.\1072\
---------------------------------------------------------------------------
\1072\ A broker or dealer that is not a market center would not
be subject to the requirements unless it reaches or exceeds the
customer account threshold.
---------------------------------------------------------------------------
[[Page 3901]]
None of the exchanges registered under section 6 that would be
subject to the proposed amendments are ``small entities'' for purposes
of the RFA.\1073\ There is only one national securities association,
and it is not a small entity as defined by 13 CFR 121.201.1220.\1074\
---------------------------------------------------------------------------
\1073\ See 17 CFR 240.0-10(e). 17 CFR 240.0-10(e) states that
the term ``small business,'' when referring to an exchange, means
any exchange that has been exempted from the reporting requirements
of Rule 601 of Regulation NMS, 17 CFR 242.601, and is not affiliated
with any person (other than a natural person) that is not a small
business or small organization as defined in Rule 0-10. The
exchanges subject to this proposed rulemaking do not satisfy this
standard. See also Securities Exchange Act Release Nos. 82873 (Mar.
14, 2018), 83 FR 13008, 13074 (Mar. 26, 2018) (File No. S7-05-18)
(Transaction Fee Pilot for NMS Stocks Proposed Rule); 55341 (May 8,
2001), 72 FR 9412, 9419 (May 16, 2007) (File No. S7-06-07) (Proposed
Rule Changes of Self-Regulatory Organizations Proposing Release).
\1074\ See, e.g., Securities Exchange Act Release No. 90610
(Dec. 9, 2020), 86 FR 18808 (Apr. 9, 2021), n.2549 and accompanying
text.
---------------------------------------------------------------------------
A broker-dealer is considered a small entity for purposes of
Regulatory Flexibility Act if: (1) it had total capital of less than
$500,000 on the date in the prior fiscal year as of which its audited
financial statements were prepared, or, if not required to prepare such
statements, it had total capital of less than $500,000 on the last
business day of the preceding fiscal year; and (2) it is not affiliated
with any person (other than a natural person) that is not a small
entity. Applying this standard, the Commission estimates that, of the
firms that would be impacted by the Rule, only two exchange market
makers, no OTC market makers, and no ATS are small entities.\1075\
Because the Commission estimates that not more than two small entities
would be required to comply with the proposed rule changes, the
Commission certifies that the proposed amendments to Rule 605 would
not, if adopted, have a significant economic impact on a substantial
number of small entities.
---------------------------------------------------------------------------
\1075\ These estimates are based on the FYE 2021 FOCUS Reports
received by the Commission from exchange market makers, OTC market
makers, and ATSs that would be subject to the changes proposed to 17
CFR 242.600 and 17 CFR 242.605.
---------------------------------------------------------------------------
For the above reasons, the Commission certifies that the proposed
amendments to Rules 600 and 605, if adopted, would not have a
significant economic impact on a substantial number of small entities
for purposes of the RFA.
The Commission invites commenters to address whether the proposed
rules would have a significant economic impact on a substantial number
of small entities, and, if so, what would be the nature of any impact
on small entities. The Commission requests that commenters provide
empirical data to support the extent of such impact.
Statutory Authority and Text of Proposed Rule
Pursuant to the Exchange Act and particularly sections 3(b), 5, 6,
11A, 15, 17, 19, 23(a), 24, and 36 thereof, 15 U.S.C. 78c, 78e, 78f,
78k-1, 78o, 78q, 78s, 78w(a), 78x, and 78mm, the Commission proposes to
amend 17 CFR 242.600 and 17 CFR 242.605 in the manner set forth below.
List of Subjects in 17 CFR Part 242
Brokers, Confidential business information, Fraud, Reporting and
recordkeeping requirements, Securities.
For the reasons stated in the preamble, the Commission is proposing
to amend title 17, chapter II of the Code of Federal Regulations:
PART 242--REGULATIONS M, SHO, ATS, AC, NMS, AND SBSR AND CUSTOMER
MARGIN REQUIREMENTS FOR SECURITY FUTURES
0
1. The authority for part 242 continues to read as follows:
Authority: 15 U.S.C. 77g, 77q(a), 77s(a), 78b, 78c, 78g(c)(2),
78i(a), 78j, 78k-1(c), 78l, 78m, 78n, 78o(b), 78o(c), 78o(g),
78q(a), 78q(b), 78q(h), 78w(a), 78dd-1, 78mm, 80a-23, 80a-29, and
80a-37.
0
2. Amend Sec. 242.600 by:
0
a. Removing paragraph (b)(40).
0
b. Redesignating paragraphs (b)(9) through (b)(110) as follows:
------------------------------------------------------------------------
Old paragraph New paragraph
------------------------------------------------------------------------
(b)(9).................................... (b)(10)
(b)(10)................................... (b)(13)
(b)(11)................................... (b)(15)
(b)(12)................................... (b)(17)
(b)(13)................................... (b)(18)
(b)(14)................................... (b)(19)
(b)(15)................................... (b)(20)
(b)(16)................................... (b)(21)
(b)(17)................................... (b)(22)
(b)(18)................................... (b)(23)
(b)(19)................................... (b)(24)
(b)(20)................................... (b)(25)
(b)(21)................................... (b)(26)
(b)(22)................................... (b)(27)
(b)(23)................................... (b)(28)
(b)(24)................................... (b)(29)
(b)(25)................................... (b)(30)
(b)(26)................................... (b)(31)
(b)(27)................................... (b)(32)
(b)(28)................................... (b)(33)
(b)(29)................................... (b)(34)
(b)(30)................................... (b)(35)
(b)(31)................................... (b)(36)
(b)(32)................................... (b)(37)
(b)(33)................................... (b)(38)
(b)(34)................................... (b)(39)
(b)(35)................................... (b)(40)
(b)(36)................................... (b)(41)
(b)(37)................................... (b)(43)
(b)(38)................................... (b)(45)
(b)(39)................................... (b)(46)
(b)(40)................................... deleted
(b)(41)................................... (b)(48)
(b)(42)................................... (b)(49)
(b)(43)................................... (b)(50)
(b)(44)................................... (b)(51)
(b)(45)................................... (b)(52)
(b)(46)................................... (b)(53)
(b)(47)................................... (b)(54)
(b)(48)................................... (b)(55)
(b)(49)................................... (b)(56)
(b)(50)................................... (b)(57)
(b)(51)................................... (b)(58)
(b)(52)................................... (b)(59)
(b)(53)................................... (b)(60)
(b)(54)................................... (b)(61)
(b)(55)................................... (b)(62)
(b)(56)................................... (b)(63)
(b)(57)................................... (b)(64)
(b)(58)................................... (b)(65)
(b)(59)................................... (b)(66)
(b)(60)................................... (b)(67)
(b)(61)................................... (b)(68)
(b)(62)................................... (b)(69)
(b)(63)................................... (b)(70)
(b)(64)................................... (b)(71)
(b)(65)................................... (b)(72)
(b)(66)................................... (b)(73)
(b)(67)................................... (b)(74)
(b)(68)................................... (b)(75)
(b)(69)................................... (b)(76)
(b)(70)................................... (b)(77)
(b)(71)................................... (b)(78)
(b)(72)................................... (b)(79)
(b)(73)................................... (b)(80)
(b)(74)................................... (b)(81)
(b)(75)................................... (b)(82)
(b)(76)................................... (b)(83)
(b)(77)................................... (b)(84)
(b)(78)................................... (b)(85)
(b)(79)................................... (b)(86)
(b)(80)................................... (b)(87)
(b)(81)................................... (b)(88)
(b)(82)................................... (b)(89)
(b)(83)................................... (b)(90)
(b)(84)................................... (b)(91)
(b)(85)................................... (b)(92)
(b)(86)................................... (b)(93)
(b)(87)................................... (b)(94)
(b)(88)................................... (b)(95)
(b)(89)................................... (b)(96)
(b)(90)................................... (b)(97)
(b)(91)................................... (b)(98)
(b)(92)................................... (b)(99)
(b)(93)................................... (b)(100)
(b)(94)................................... (b)(101)
(b)(95)................................... (b)(102)
(b)(96)................................... (b)(103)
(b)(97)................................... (b)(104)
(b)(98)................................... (b)(105)
(b)(99)................................... (b)(106)
(b)(100).................................. (b)(107)
(b)(101).................................. (b)(108)
(b)(102).................................. (b)(109)
(b)(103).................................. (b)(110)
(b)(104).................................. (b)(111)
(b)(105).................................. (b)(112)
(b)(106).................................. (b)(113)
(b)(107).................................. (b)(114)
(b)(108).................................. (b)(115)
(b)(109).................................. (b)(116)
(b)(110).................................. (b)(117)
------------------------------------------------------------------------
[[Page 3902]]
0
c. Adding new paragraphs (b)(9), (b)(11), (b)(12), (b)(14), (b)(16),
(b)(42), (b)(44), and (b)(47).
0
d. Revising newly redesignated paragraphs (b)(10), (b)(13), (b)(19),
(b)(20), (b)(30), (b)(57), (b)(108), and (b)(109).
The revisions and additions read as follows:
Sec. 242.600 NMS security designation and definitions.
* * * * *
(b) * * *
(9) Average effective over quoted spread means the share-weighted
average for order executions of effective spread divided by the
difference between the national best offer and the national best bid at
the time of order receipt or, for order executions of non-marketable
limit orders, beyond-the-midpoint limit orders, and orders submitted
with stop prices, the difference between the national best offer and
the national best bid at the time such orders first become executable.
The effective spread shall be calculated, for buy orders, as double the
amount of difference between the execution price and the midpoint of
the national best bid and national best offer at the time of order
receipt and, for sell orders, as double the amount of difference
between the midpoint of the national best bid and national best offer
at the time of order receipt and the execution price. For order
executions of non-marketable limit orders, beyond-the-midpoint limit
orders, and orders submitted with stop prices, average percentage
effective spread shall be calculated from the time such orders first
become executable rather than the time of order receipt.
(10) Average effective spread means the share-weighted average of
effective spreads for order executions calculated, for buy orders, as
double the amount of difference between the execution price and the
midpoint of the national best bid and national best offer at the time
of order receipt and, for sell orders, as double the amount of
difference between the midpoint of the national best bid and national
best offer at the time of order receipt and the execution price. For
order executions of non-marketable limit orders, beyond-the-midpoint
limit orders, and orders submitted with stop prices, average effective
spread shall be calculated from the time such orders first become
executable rather than the time of order receipt.
(11) Average percentage effective spread means the share-weighted
average for order executions of effective spread divided by the
midpoint of the national best bid and national best offer at the time
of order receipt or, for non-marketable limit orders, beyond-the-
midpoint limit orders, and orders submitted with stop prices, at the
time such orders first become executable. The effective spread shall be
calculated, for buy orders, as double the amount of difference between
the execution price and the midpoint of the national best bid and
national best offer at the time of order receipt and, for sell orders,
as double the amount of difference between the midpoint of the national
best bid and national best offer at the time of order receipt and the
execution price. For order executions of non-marketable limit orders,
beyond-the-midpoint limit orders, and orders submitted with stop
prices, average percentage effective spread shall be calculated from
the time such orders first become executable rather than the time of
order receipt.
(12) Average percentage realized spread means the share-weighted
average for order executions of realized spread divided by the midpoint
of the national best bid and national best offer at the time of order
receipt or, for non-marketable limit orders, beyond-the-midpoint limit
orders, and orders submitted with stop prices, at the time such orders
first become executable. The realized spread shall be calculated, for
buy orders, as double the amount of difference between the execution
price and the midpoint of the national best bid and national best offer
at a specified interval after the time of order execution and, for sell
orders, as double the amount of difference between the midpoint and the
national best bid and national best offer at a specified interval after
the time of order execution and the execution price; provided, however,
that the midpoint of the final national best bid and national best
offer disseminated for regular trading hours shall be used to calculate
a realized spread if it is disseminated less than that specified
interval after the time of order execution.
(13) Average realized spread means the share-weighted average of
realized spreads for order executions calculated, for buy orders, as
double the amount of difference between the execution price and the
midpoint of the national best bid and national best offer at a
specified interval after the time of order execution and, for sell
orders, as double the amount of difference between the midpoint and the
national best bid and national best offer at a specified interval after
the time of order execution and the execution price; provided, however,
that the midpoint of the final national best bid and national best
offer disseminated for regular trading hours shall be used to calculate
a realized spread if it is disseminated less than that specified
interval after the time of order execution.
(14) Best available displayed price means, with respect to an order
to buy, the lower of: the national best offer at the time of order
receipt or the price of the best odd-lot order to sell at the time of
order receipt as disseminated pursuant to an effective transaction
reporting plan or effective national market system plan; and, with
respect to an order to sell, the higher of: the national best bid at
the time of order receipt or the price of the best odd-lot order to buy
at the time of order receipt as disseminated pursuant to an effective
transaction reporting plan or effective national market system plan.
With respect to a beyond-the-midpoint limit order, the best available
displayed price shall be determined at the time such order becomes
executable rather than the time of order receipt.
* * * * *
(16) Beyond-the-midpoint limit order means, with respect to an
order received at a time when a national best bid and national best
offer is being disseminated, any non-marketable buy order with a limit
price that is higher than the midpoint of the national best bid and
national best offer at the time of order receipt and any non-marketable
sell order with a limit price that is lower than the midpoint of the
national best bid and national best offer at the time of order receipt,
and, with respect to an order received at a time when a national best
bid and national best offer is not being disseminated, any non-
marketable buy order with a limit price that is higher than the
midpoint of the national best bid and national best offer at the time
that the national best bid and national best offer is first
disseminated after the time of order receipt, or any non-marketable
sell order with a limit price that is lower than the midpoint of the
national best bid and national best offer at the time that the national
best bid and national best offer is first disseminated after the time
of order receipt.
* * * * *
(19) Categorized by order size means dividing orders into separate
categories for the following sizes:
(i) Less than a share;
(ii) Odd-lot;
(iii) 1 round lot to less than 5 round lots;
(iv) 5 round lots to less than 20 round lots;
(v) 20 round lots to less than 50 round lots;
[[Page 3903]]
(vi) 50 round lots to less than 100 round lots; and
(vii) 100 round lots or greater.
(20) Categorized by order type means dividing orders into separate
categories for market orders, marketable limit orders (excluding
immediate-or-cancel orders), marketable immediate-or-cancel orders,
beyond-the-midpoint limit orders, executable non-marketable limit
orders (excluding orders submitted with stop prices and beyond-the-
midpoint limit orders), and executable orders submitted with stop
prices.
* * * * *
(30) Covered order means any market order or any limit order
(including immediate-or-cancel orders) received by a market center,
broker, or dealer during regular trading hours at a time when a
national best bid and national best offer is being disseminated and
after the primary listing market has disseminated its first firm,
uncrossed quotations in the security, and, if executed, is executed
during regular trading hours; or any non-marketable limit order
(including an order submitted with a stop price) received by a market
center, broker, or dealer outside of regular trading hours or at a time
when a national best bid and national best offer is not being
disseminated and, if executed, is executed during regular trading
hours. Covered order shall exclude any order for which the customer
requests special handling for execution, including, but not limited to,
orders to be executed at a market opening price or a market closing
price, orders to be executed only at their full size, orders to be
executed on a particular type of tick or bid, orders submitted on a
``not held'' basis, orders for other than regular settlement, and
orders to be executed at prices unrelated to the market price of the
security at the time of execution.
* * * * *
(42) Executable means, for any non-marketable buy order (excluding
orders submitted with stop prices), that the limit price is equal to or
greater than the national best bid during regular trading hours, and,
for any non-marketable sell order (excluding orders submitted with stop
prices), that the limit price is equal to or less than the national
best offer during regular trading hours. Executable means, for any buy
order submitted with a stop price, that the stop price is equal to or
greater than the national best bid during regular trading hours, and,
for any sell orders submitted with a stop price, that the stop price is
equal to or less than the national best offer during regular trading
hours. The time an order becomes executable shall be measured in
increments of a millisecond or finer.
* * * * *
(44) Executed outside the best available displayed price means, for
buy orders, execution at a price higher than the best available
displayed price; and, for sell orders, execution at a price lower than
the best available displayed price.
* * * * *
(47) Executed with price improvement relative to the best available
displayed price means, for buy orders, execution at a price lower the
best available displayed price and, for sell orders, execution at a
price higher than the best available displayed price.
* * * * *
(57) Marketable limit order means, with respect to an order
received at a time when a national best bid and national best offer is
being disseminated, any buy order with a limit price equal to or
greater than the national best offer at the time of order receipt, or
any sell order with a limit price equal to or less than the national
best bid at the time of order receipt, and, with respect to an order
received at a time when a national best bid and national best offer is
not being disseminated, any buy order with a limit price equal to or
greater than the national best offer at the time that the national best
offer is first disseminated during regular trading hours after the time
of order receipt, or any sell order with a limit price equal to or less
than the national best bid time at the time that the national best bid
is first disseminated during regular trading hours after the time of
order receipt.
* * * * *
(108) Time of order execution means the time (at a minimum to the
millisecond) that an order was executed at any venue.
(109) Time of order receipt means the time (at a minimum to the
millisecond) that an order was received by a market center for
execution, or in the case of a broker or dealer that is not acting as a
market center, the time (at a minimum to the millisecond) that an order
was received by the broker or dealer for execution.
* * * * *
Sec. 242.605 [Amended]
0
2. Amend Sec. 242.605 by revising the introductory text and paragraph
(a) to read as follows:
Sec. 242.605 Disclosure of order execution information.
This section requires market centers, brokers, and dealers to make
available standardized, monthly reports of statistical information
concerning their order executions. This information is presented in
accordance with uniform standards that are based on broad assumptions
about order execution and routing practices. The information will
provide a starting point to promote visibility and competition on the
part of market centers and broker-dealers, particularly on the factors
of execution price and speed. The disclosures required by this section
do not encompass all of the factors that may be important to investors
in evaluating the order routing services of a broker-dealer. In
addition, any particular market center, broker, or dealer's statistics
will encompass varying types of orders routed by different broker-
dealers on behalf of customers with a wide range of objectives.
Accordingly, the statistical information required by this section alone
does not create a reliable basis to address whether any particular
broker-dealer failed to obtain the most favorable terms reasonably
available under the circumstances for customer orders.
(a) Monthly electronic reports by market centers, brokers, and
dealers. (1) Every market center, broker, or dealer shall make
available for each calendar month, in accordance with the procedures
established pursuant to paragraph (a)(3) of this section, a report on
the covered orders in NMS stocks that it received for execution from
any person or that it received for execution in a prior calendar month
but which remained open. Any market center that operates a qualified
auction shall produce a separate report pertaining only to covered
orders that the market center receives for execution in a qualified
auction. Any market center that provides a separate routing destination
that allows persons to enter orders for execution against the bids and
offers of a single dealer shall produce a separate report pertaining
only to covered orders submitted to such routing destination.
Alternative trading systems (as defined in Regulation ATS, Sec.
242.300(a)) shall prepare reports separately from their broker-dealer
operators to the extent such entities are required to prepare reports.
Each report shall be in electronic form; shall be categorized by
security, order type, and order size; and shall include the following
columns of information:
(i) For market orders, marketable limit orders, marketable
immediate-or-cancel orders, beyond-the-midpoint limit orders,
executable non-marketable limit orders, and executable orders with stop
prices:
(A) The number of covered orders;
[[Page 3904]]
(B) The cumulative number of shares of covered orders;
(C) The cumulative number of shares of covered orders cancelled
prior to execution;
(D) The cumulative number of shares of covered orders executed at
the receiving market center, broker, or dealer (excluding shares that
the market center, broker, or dealer executes on a riskless principal
basis);
(E) The cumulative number of shares of covered orders executed at
any other venue;
(F) For executions of covered orders, the cumulative number of
shares of the full displayed size of the protected bid at the time of
execution, in the case of a market or limit order to sell, or the full
displayed size of the protected offer at the time of execution, in the
case of a market or limit order to buy. For each order, the share count
shall be capped at the order size;
(G) For executions of covered orders, the average realized spread
as calculated fifteen seconds after the time of execution;
(H) For executions of covered orders, the average percentage
realized spread as calculated fifteen seconds after the time of
execution;
(I) For executions of covered orders, the average realized spread
as calculated one minute after the time of execution;
(J) For executions of covered orders, the average percentage
realized spread as calculated one minute after the time of execution;
(K) For executions of covered orders, the average effective spread;
(L) For executions of covered orders, the average percentage
effective spread; and
(M) For executions of covered orders, the average effective over
quoted spread, expressed as a percentage; and
(ii) For market orders, marketable limit orders, marketable
immediate-or-cancel orders, and beyond-the-midpoint limit orders:
(A) The cumulative number of shares of covered orders executed with
price improvement;
(B) For shares executed with price improvement, the share-weighted
average amount per share that prices were improved;
(C) For shares executed with price improvement, the share-weighted
average period from the time of order receipt to the time of order
execution, expressed in increments of a millisecond or finer, or, in
the case of beyond-the-midpoint limit orders, from the time such orders
first become executable to the time of order execution, expressed in
increments of a millisecond or finer;
(D) For shares executed with price improvement, the share-weighted
median period from the time of order receipt to the time of order
execution, expressed in increments of a millisecond or finer, or, in
the case of beyond-the-midpoint limit orders, from the time such orders
first become executable to the time of order execution, expressed in
increments of a millisecond or finer;
(E) For shares executed with price improvement, the share-weighted
99th percentile period from the time of order receipt to the time of
order execution, expressed in increments of a millisecond or finer, or,
in the case of beyond-the-midpoint limit orders, from the time such
orders first become executable to the time of order execution,
expressed in increments of a millisecond or finer;
(F) The cumulative number of shares of covered orders executed at
the quote;
(G) For shares executed at the quote, the share-weighted average
period from the time of order receipt to the time of order execution,
expressed in increments of a millisecond or finer, or, in the case of
beyond-the-midpoint limit orders, from the time such orders first
become executable to the time of order execution, expressed in
increments of a millisecond or finer;
(H) For shares executed at the quote, the share-weighted median
period from the time of order receipt to the time of order execution,
expressed in increments of a millisecond or finer, or, in the case of
beyond-the-midpoint limit orders, from the time such orders first
become executable to the time of order execution, expressed in
increments of a millisecond or finer;
(I) For shares executed at the quote, the share-weighted 99th
percentile period from the time of order receipt to the time of order
execution, expressed in increments of a millisecond or finer, or, in
the case of beyond-the-midpoint limit orders, from the time such orders
first become executable to the time of order execution, expressed in
increments of a millisecond or finer;
(J) The cumulative number of shares of covered orders executed
outside the quote;
(K) For shares executed outside the quote, the share-weighted
average amount per share that prices were outside the quote;
(L) For shares executed outside the quote, the share-weighted
average period from the time of order receipt, expressed in increments
of a millisecond or finer, or, in the case of beyond-the-midpoint limit
orders, from the time such orders first become executable to the time
of order execution, expressed in increments of a millisecond or finer;
(M) For shares executed outside the quote, the share-weighted
median period from the time of order receipt to the time of order
execution, expressed in increments of a millisecond or finer, or, in
the case of beyond-the-midpoint limit orders, from the time such orders
first become executable to the time of order execution, expressed in
increments of a millisecond or finer;
(N) For shares executed outside the quote, the share-weighted 99th
percentile period from the time of order receipt to the time of order
execution, expressed in increments of a millisecond or finer, or, in
the case of beyond-the-midpoint limit orders, from the time such orders
first become executable to the time of order execution, expressed in
increments of a millisecond or finer;
(O) The cumulative number of shares of covered orders executed with
price improvement relative to the best available displayed price;
(P) For shares executed with price improvement relative to the best
available displayed price, the share-weighted average amount per share
that prices were improved as compared to the best available displayed
price;
(Q) The cumulative number of shares of covered orders executed at
the best available displayed price;
(R) The cumulative number of shares of covered orders executed
outside the best available displayed price;
(S) For shares executed outside the best available displayed price,
the share-weighted average amount per share that prices were outside
the best available displayed price; and
(iii) For beyond-the-midpoint limit orders, executable non-
marketable limit orders, and executable orders with stop prices:
(A) The number of orders that received either a complete or partial
fill;
(B) The cumulative number of shares executed regular way at prices
that could have filled the order while the order was in force, as
reported pursuant to an effective transaction reporting plan or
effective national market system plan. For each order, the share count
shall be capped at the order size;
(C) For shares executed, the share-weighted average period from the
time the order becomes executable to the time of order execution
expressed in increments of a millisecond or finer, or, in the case of
beyond-the-midpoint limit orders, from the time such orders first
become executable to the time of order execution, expressed in
increments of a millisecond or finer;
[[Page 3905]]
(D) For shares executed, the share-weighted median period from the
time the order becomes executable to the time of order execution,
expressed in increments of a millisecond or finer, or, in the case of
beyond-the-midpoint limit orders, from the time such orders first
become executable to the time of order execution, expressed in
increments of a millisecond or finer; and
(E) For shares executed, the share-weighted 99th percentile period
from the time the order becomes executable to the time of order
execution, expressed in increments of a millisecond or finer, or, in
the case of beyond-the-midpoint limit orders, from the time such orders
first become executable to the time of order execution, expressed in
increments of a millisecond or finer.
(2) Every market center, broker, or dealer shall make publicly
available for each calendar month a report providing summary statistics
on all executions of covered orders that are market and marketable
limit orders that it received for execution from any person. Such
report shall be made available using the most recent version of the XML
schema and the associated PDF renderer as published on the Commission's
website for all reports required by this paragraph (a)(2). Such report
shall include a section for NMS stocks that are included in the S&P 500
Index as of the first day of that month and a section for other NMS
stocks. Each section shall include, for market orders and marketable
limit orders, the following summary statistics for executed orders,
equally weighted by symbol based on share volume:
(i) The average order size;
(ii) The percentage of shares executed at the quote or better;
(iii) The percentage of shares that received price improvement;
(iv) The average percentage price improvement per order;
(v) The average percentage effective spread;
(vi) The average effective over quoted spread, expressed as a
percentage; and
(vii) The average execution speed, in milliseconds.
(3) Every national securities exchange on which NMS stocks are
traded and each national securities association shall act jointly in
establishing procedures for market centers, brokers, and dealers to
follow in making available to the public the reports required by this
section in a uniform, readily accessible, and usable electronic form.
(4) In the event there is no effective national market system plan
establishing such procedures, market centers, brokers, and dealers
shall prepare their reports in a consistent, usable, and machine-
readable electronic format, in accordance with the requirements in
paragraph (a)(1) of this section, and make such reports available for
downloading from an internet website that is free and readily
accessible to the public.
(5) Every market center, broker, or dealer shall keep the reports
required by paragraphs (a)(1) and (a)(2) of this section posted on an
internet website that is free and readily accessible to the public for
a period of three years from the initial date of posting on the
internet website.
(6) A market center, broker, or dealer shall make available the
reports required by paragraphs (a)(1) and (a)(2) of this section within
one month after the end of the month addressed in the reports.
(7) A broker or dealer that is not a market center shall not be
subject to the requirements of this section unless that broker or
dealer introduces or carries 100,000 or more customer accounts through
which transactions are effected for the purchase or sale of NMS stocks
(the ``customer account threshold'' for purposes of this paragraph).
For purposes of this section, a broker or dealer that utilizes an
omnibus clearing arrangement with respect to any of its underlying
customer accounts shall be considered to carry such underlying customer
accounts when calculating the number of customer accounts that it
introduces or carries. Any broker or dealer that meets or exceeds this
customer account threshold and is also a market center shall produce
separate reports pertaining to each function. A broker or dealer that
meets or exceeds the customer account threshold shall be required to
produce reports pursuant to this section for at least three calendar
months (``Reporting Period''). The Reporting Period shall begin the
first calendar day of the next calendar month after the broker or
dealer met or exceeded the customer account threshold, unless it is the
first time the broker or dealer has met or exceeded the customer
account threshold, in which case the Reporting Period shall begin the
first calendar day four calendar months later. If, at any time after a
broker or dealer has been required to produce reports pursuant to this
section for at least a Reporting Period, a broker or dealer falls below
the customer account threshold, the broker or dealer shall not be
required to produce a report pursuant to this paragraph for the next
calendar month.
* * * * *
By the Commission.
Dated: December 14, 2022.
J. Matthew DeLesDernier,
Deputy Secretary.
[FR Doc. 2022-27614 Filed 1-19-23; 8:45 am]
BILLING CODE 8011-01-P