SEC Rule 605 is Final, But More is Pending with Market Structure

Sell-side firms will need to revamp their execution quality reports.

With the SEC approving updates to Rule 605 on order disclosure for stock trading, the clock will soon begin ticking on a new compliance project with more granular execution quality data. But industry observers are speculating that the SEC could move forward with other equity market structure reforms, resulting in overlapping timelines. 

On March 6, the SEC adopted amendments to disclosure requirements under Rule 605 of Regulation NMS for order executions in national market system stocks which are listed on a national securities exchange 

Firms will need to revamp their execution quality reporting over an 18-month implementation timeline from the effective date on June 15, 2024, making the compliance date Dec. 15, 2025. 

The amended Rule 605 covers more order types and different categories of order and execution quality statistics. The intent is to give retail investors more transparency into order execution across broker-dealers, with time-based metrics which reflect current market speed.  

“There’s a whole bunch of new dimensions to the reporting that didn’t exist before.  Whether it’s notional groups, the non-marketable flow, or odd lots, and there’s a lot more metrics that we can use to think about execution quality,” said Eric Stockland, Managing Director, Co-Head of Electronic Trading at BMO Capital Markets.  

Rule 605 is the least controversial of the SEC’s equity market structure proposals published on Dec. 14, 2022, but it significantly increases the number of firms that are in scope for reporting. 

Large broker-dealers which introduce or carry 100,000 or more customer accounts and single dealer platforms (SDPs) will need to file monthly execution quality reports.  Currently, only market centers (i.e., market makers, securities exchanges and alternative trading systems), that execute investor orders are required to make monthly disclosures.   

It breaks down order-size categories based on both a notional dollar value and whether an order is for a fractional share, odd-lot, or for a round lot or larger-sized orders. In addition, Rule 605 will require new statistical measures, such as average effective divided by quoted spread (EFQ) and provide measurement for price improvement received by orders.  

In addition, it expands the definition of “covered order” to include some orders submitted outside of regular trading hours, certain orders submitted with stop prices and non-exempt short sale orders. 

Another change is that time-to-execution reporting buckets will be made more granular with a timestamp of a millisecond or finer. 

To make the execution quality information more accessible, firms are required to prepare human readable summary reports for the public.  

Why Update 605?

The industry has widely supported updating Rule 605, as it had not been refreshed since its adoption in 2000. Over the past 24 years, U.S. equity market structure has evolved through regulations such as Regulation NMS, and advances in technology changing the speed and nature of trading. 

Investors can use the reports to compare their execution results across broker-dealers based on different order size and order type categories. They can also compare time-to-execution across reporting entities how much of the aggregated liquidity available on exchanges they received.  

While it’s uncertain whether retail investors will read the reports, they are expected to help independent analysts, brokers, the financial press, and market centers in analyzing the disclosures and producing more digestible information using data from the reports. “The big winners will be academics who will have access to better metrics and data,” said Stockland. “Academics will use this as a tool to ask hard questions. Through that, the benefits will trickle down to other groups in the industry and potentially [impact] order routing practices,” he suggested. 

Broker dealers will be able to show their clients how much size improvement they received. “There is a size benchmark relative to the full availability at the NBBO (national best bid and offer) price point,” said Mark Davies, founder and CEO of S3, a data and analytics firm, who spoke on the STA’s Open Call about the nuances of Rule 605 in March.  

Implementation Challenges

However, implementing the new execution reporting regime is not without its challenges and costs.  

In April, SIFMA published research from its annual C&L [compliance and legal] seminar, in which panelists indicated that the amount of information requested is “enormous” and the rule expanded the universe of reporting firms. According to SIFMA’s panelists, the SEC did not provide a standardized template for sample 605 reports and said that an FAQ [frequently asked questions) guidance would be necessary.  

Sell-side firms will need to program their systems to handle new categories of orders and calculations of execution quality statistics. “There’s a lot of code that needs to be written and a lot of new processes that must be put in place to comply with the rule,” said Stockland. 

“It’s going to be a big lift.  It may impact what retail brokers do to drive their business forward,” he said. “They’re going to have to spend a lot of resources coping with this new regulatory regime,” he said.  On the other hand, many firms will work with third party vendors who specialize in data analytics and the 605 execution quality reports. 

On the STA Open Call, Davies noted that the SEC, in the paperwork reduction area, minimized the amount of effort this will entail for brokers or market centers that have not done a 605 report before. “They said it would be very little effort for a market center to do the reports in-house,” said Davies. “I think this is an unfair assertion,” he said. “Handling 605 previously was a point in time rule.  When you received the order, you assigned its marketability and then when it was executed, you looked at the quote. Effectively, you had to look at 2 quotes – the quote when it started and the quote when it ended,” he explained. 

“Because of the concept of executability that they have incorporated into the limit determination, which is really when the time starts – instead of simply taking two points in time, firms are now going to have to basically do a market replay to identify when that order became executable rather than when it was received,” said Davies. 

Concerns about Overlapping Times

Now that the Rule 605 amendments have been adopted, many in the industry expect the SEC to move forward with the other market-structure proposals this year. “It’s the appetizer before the main course,” said one sell-side executive. 

In the SIFMA C&L survey of its equity market structure panel, 85.2% had concerns about the timelines for implementation of the multiple proposals and the need for a lookback process to assess impacts and costs.  This was followed by 55.6% who had concerns about the SEC best execution rule. 

Meanwhile, 11.1% were specifically concerned about updating the Rule 605 disclosure, which tied with those concerned over the minimum quoting increment tick changes and the access fee cap changes, while 7.4% cited the minimum trading increment tick changes. 

Despite the work involved with 605, industry sources expect the SEC to forge ahead with the other proposals. 

What’s Next?

Speaking on TabbForum video interview in late April, Larry Tabb, Head of Market Structure Research at Bloomberg Intelligence, said he expected the final market structure rules to be released in the next couple of weeks.  He noted that Rule 605 was approved in a 5-0 vote, while most rules are passed 3-2. 

Industry leaders anticipate decisions from the SEC in a matter of weeks, predicting the staff is going to advance the proposed rules before year-end. With the US presidential election in November, there is uncertainty and the potential for regime change at the SEC depending on which candidate wins. 

Of the remaining market structure proposals, Stockland said he expects that the Reg NMS proposal with variable tick sizes and access fees and the SEC’s Best Execution rule could be next. Stockland said he anticipates that the SEC will need to put forth the final rules by the end of this summer. This would avoid a risk with the Congressional Review Act (CRA), whereby Congress can overturn rules issued by federal agencies in a prior administration. For example, there is a look-back period where all rules get 60 days of consideration before the end of a session of Congress through the beginning of the next session of Congress. 

If adopted, the tick-size and access-fee rule could introduce odd lots into the best bid-and-offer; reduce access fee caps from 30 mils to 10 mils or lower and bring new tick size standards for NMS stocks.  

A spokesman for BLOX Markets, which is planning a retail focused trading venue, anticipates the tick size and access fee proposal to be finalized soon. “The potential changes could put pressure on wholesale market maker’s PFOF relationship with retail brokers, resulting in more open competition for retail order flow,” said the spokesman. 

Capping access fees at 10 or 5 mils would reduce the rebates that exchanges use to incentivize market makers. This, in turn, could limit the payment-for-order flow (PFOF) that many retail brokers use to help manage commission-free trading for retail investors. 

On tick sizes, the commission had proposed an elaborate rule with three different tiers with different tick size buckets, and names shifting buckets every quarter. If they choose to go with half-penny ticks in a subset of names and more minor reforms in NMS (access-fee rule), the Commission could avoid the risk of litigation and survive a potential regime change, suggested the sell-side source. 

If spreads are narrowed and access fees are reduced, some predict that more retail flow will be directed toward the public exchanges.  

 However, industry sources do not expect the SEC to approve the order competition rule (OCR), which requires that retail orders are to be routed to mandatory auctions with midpoint prices. According to SIFMA’s report, “Best execution remains a top SEC priority and panelists believe auctions may be encouraged, not mandated.” 

Meanwhile, Rule 605 is finalized, and entities eligible for reporting will need to digest the details of the rule and work with their third-party analytics providers to prepare for compliance. “The amended 605 will put a wealth of information into the market about retail order flow,” said BMO Capital Market’s Stockland. 

“To the extent that 605 reporting leads to evaluation and iteration in retail order routing practices, that could translate into more opportunities for institutions to trade with retail and vice versa,” said Stockland. “Most institutions will trade with retail at the midpoint of the NBBO,” said Stockland. It’s a very low-impact trade for institutions. It truly is a win, win.”