New Trade Execution Transparency Tests Data Exchange

By Jen Fagenson

March 18, 2020

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Complying with a new US regulatory requirement for brokers to give investors more information on trade routing decisions under the amended Rule 606 could come down in the short-term to technologists creating the right packaging as much as operations managers finding the right data.

With less than a month left to prepare for the April 1 deadline for collecting data on discretionary “look-through” trades under the Securities and Exchange Commission’s new Rule 606, introducing and executing brokers are deciding which data format and how much information they will use. Fund managers won’t be seeing any new reports until May 26 at the earliest. For now, IT directors are the ones doing the heavy lifting to figure out how firms can create and accept the agreed-upon data exchange. They have two options: a format designed by trade execution reporting vendor S3 and the New York-based regulatory technology and compliance consultancy Financial Information Forum (FIF), or proprietary formats agreed upon between introducing brokers and executing brokers.

Data format doesn’t refer strictly to the message protocol which in the case of the FIF format is XML. It also includes the level of granularity of granularity of data and how it is presented to the introducing broker by the executing broker. There are two levels of granularity: aggregated data and raw data. The aggregated data can theoretically be compiled by customer, month and venue or by order number venue and trade date, but the industry has opted for the latter approach. Raw data refers to data that has not been rolled up, summed up or aggregated in any way. “Aggregated data allows the executing broker to divulge the least amount of information about its trading strategy, but requires more work for executing brokers and trade execution venues,” says John Jannes, executive director of analytics for trade analytics firm IHS Markit in New York. “By contrast, raw data requires the least amount of work for executing brokers and more work for introducing brokers to turn it into Rule 606b(3) reports.”

The first easier iteration of the amended Rule 606 took effect in January for “held” orders typically executed immediately for retail investors and for some “not-held” orders for institutional investors. The second to occur on April 1 covers “not-held” orders for institutional investors in which the introducing broker has discretion over time and price. The SEC has cast a broad net of what the term discretionary means to include almost every order where the introducing broker is using the services of an executing broker, its algorithms or smart order routers.

The new Rule 606(b)3 report will show institutional investors where the executing broker routed its order, how it sliced its order, any the fees and rebates involved. The ultimate goal is to provide investors with an understanding of potential conflicts of interest on how their orders are routed depending on fees paid and rebates received by either introducing or executing brokers from trading venues. That level of transparency hasn’t been available under the current reporting format which is primarily designed to provide the basics of where trades were routed and at what price they were executed.

The so-called second hop of the trade order routing process is considered the most suspect, according to Jim Toes, president of the trade group Security Traders Association (STA) representing trading desks at broker-dealers and asset managers. That second hop, he explains, can refer to orders sent by introducing brokers to executing brokers in which introducing brokers tell executing brokers how to handle the order. Alternatively, the second-hop can also be an order which one executing broker sends to another executing broker with a “better-tier” meaning the second executing broker will receive a higher rebate from the trading venue than the first executing broker would have trading on the same venue. That rebate will be split between the two executing brokers.

Introducing brokers must depend on their executing brokers for much of the information needed to produce the new 606(b)3 report, but executing brokers are under no legal obligation to provide it. The obstacle executing brokers now face is how to work out the information exchange without giving away proprietary trade secrets. That is where the data format designed by S3 and FIF kicks in. “The new data format is designed to mitigate the need for executing brokers to spill their secret sauce to introducing brokers,” explains Mark Davies, chief executive of the Austin, Texas-based S3. “Likewise, introducing brokers won’t be divulging any information on individual fund manager clients.”

Davies calls the middle-ground format “the new industry” standard designed to ensure compliance with amended Rule 606. Relying on proprietary formats can be error-prone, he suggests. However, that characterization may end up being a bit of a stretch based on a telephone survey of operations managers at twenty introducing brokers, executing brokers and trade execution reporting vendors, FinOps Report found an even split between those which agreed to use the format, those who will rely entirely on proprietary formats — likely a tweak of the FIF format or raw data. The FIF format is based on the order ID the introducing broker sent to the executing broker.

Although the format designed by S3 and FIF was reportedly devised with the input of introducing and executing brokers, it favors introducing brokers, according to some operations managers at executing brokers who spoke with FinOps Report. Their gripe: executing brokers must do far more work than introducing brokers. However, Davies counters that there is plenty of work to go around on both sides. Executing brokers need to create the right file transmittals while introducing brokers must interpret the data into the new 606(b)3 report.

No executing broker wants to tell an introducing broker it cannot help it comply with the amended Rule 606. Executing brokers will ultimately have to decide just how much they are willing to accommodate their introducing brokers or face the consequences of potentially losing their business. “Introducing brokers need to start talking with executing brokers and their trade execution reporting vendors over which data formats they will use,” recommends IHS Markit’s Jannes. “Asking are you ready to comply with the amended Rule 606 isn’t good enough.” IHS Markit will adopt the FIF format while also accommodating clients wanting any other amalgamated format or even raw data.

Jannes believes that some executing brokers will prefer to send aggregated data to introducing brokers, thinking that using raw data will reveal proprietary trading strategies. However, there will be still be plenty of executing brokers willing to share raw data to ease their data processing requirements. Using common data formats does make data processing easier, but is unnecessary for raw data because it is already in fairly standardized and familiar formats.

“We are in discussions with introducing brokers about the data fields we need to populate and how they want to receive the data,” says Venu Palaparthi, chief compliance officer for Dash Financial Technologies, a New York-based executing broker offering real-time order routing and trade analytics. “We need to strike a balance between providing the data in a common format and in more broadly accepted formats.” He could not verify whether his introducing broker clients were providing the firm with the format designed by S3 and FIF or their own formats.

It remains to be seen whether the FIF format gains widespread acceptance and just how fund managers will react at the first glimpse of their new Rule 606(b)3 reports. Chances are they will require far more hand-holding from introducing brokers to decipher all of the data.

“We expect fund managers will be asking introducing brokers plenty of questions once they read their first 606(b)3 reports,” says Palaparthi. “The largest ones might be familiar with the new data requirements, but others are still likely getting up to speed.” Because the data is being presented at an aggregate level, fund managers may need more guidance to not understand the figures but also the roles and responsibilities of primary routing venues and additional downstream routing and execution venues. “There might be more granular algorithm level or symbol-level nuances that come into play which are not immediately discernable from the aggregate data,” says Palaparthi.

Davies acknowledges that fund managers will have a hard time grasping conflicts of interest because information from multiple sources will be merged into a single row on their report. Case in point: if an introducing broker routes an order to an exchange and that introducing broker also uses an executing broker which routes an order to that same exchange, the row in the new 606(b)3 report will be conflated. “Fund managers will need to ask their introducing brokers to break out fees and rebates in each row in the report,” says Davies. That’s easier said than done.

The STA’s Toes also recommends that fund managers take the time to do some comparative analysis. “Fund managers will also need to understand the nuance differences in the workflows of introducing broker-dealers and executing broker-dealers as they review reports,” he says.

Ask the right questions and hope to get the right answers will likely become the industry mantra for Rule 606(b)3 reports. Even the best-crafted industry formats might not be enough to do the trick when it comes to discerning conflicts of interest in order routing decisions. As usual, the SEC’s good intentions come with some difficult practical ramifications to solve.