On December 14, 2022, the U.S. Securities and Exchange Commission (SEC) proposed amendments to update the disclosures required under Rule 605 of Regulation NMS for order executions in national market system (NMS) stocks (the Proposal).1 The Proposal seeks to modernize and enhance execution quality reporting and would, among other things, (i) expand the scope of entities subject to Rule 605 to include certain broker-dealers, (ii) modify information required to be reported, and (iii) change how orders are categorized.
The comment deadline is March 31, 2023, or 60 days after publication of the Proposal in the Federal Register, whichever is later. The Proposal was made concurrently with three other SEC proposals that are interrelated and could significantly change practices related to securities order handling and executions.2 The proposals collectively appear to advance the SEC’s view that better prices for investors may result through encouragement of competition between trading venues and greater trading through certain exchanges and alternative trading systems that disseminate quotations and transaction reports rather than through over-the-counter (OTC) market makers.3
Key Takeaways
If adopted, the Proposal would increase data made available under Rule 605 to the public about securities transaction execution quality. Affected entities should review the Proposal and consider the mechanisms by which they can capture and report the newly proposed information. Under the Proposal, all broker-dealers would need to develop processes for determining how many customer accounts they introduce or carry to determine whether they are subject to Rule 605 disclosure requirements. The Proposal would modify existing order size categories to base them on round lots rather than number of shares and include additional order size categories for fractional shares, odd lots, and larger-sized orders.
Certain aspects of the Proposal also raise interpretive questions and operational challenges for broker-dealers. For example, under the Proposal, broker-dealers that execute fractional share transactions on behalf of their customers may be considered OTC market makers subject to Rule 605 — potentially subjecting such broker-dealers to Rule 605 even if they do not qualify as a “larger” broker-dealer (as described in detail below). Additionally, OTC market makers would be required to provide separate Rule 605 disclosures with respect to their single-dealer platform activities, as distinct from their OTC market-making activities. The Proposal, however, does not set forth a definition of a single-dealer platform or provide clear guidance as to how OTC market-making activity should be distinguished from single-dealer platform activity.
Background
Rule 605 provides visibility into the execution quality among different market centers, but it has not been substantively updated since its adoption in 2000.4 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, including specified measures of execution quality such as effective spread, average amount of price improvement, number of shares executed, and speed of execution.
Since Rule 605’s adoption, equity markets have evolved with new technologies and business models. Yet according to SEC Chair Gary Gensler, current disclosures under Rule 605 “have not kept up with our markets and provide investors with an incomplete picture of execution quality.” The Proposal seeks to modernize and enhance execution quality reporting to increase transparency and information available to investors as well as to help promote competition among market centers and broker-dealers.
Proposed Amendments to Rule 605
Expanding Entities Subject to Rule 605 to Cover Large Broker-Dealers
If adopted, the Proposal would expand the scope of entities subject to Rule 605, including by requiring monthly execution quality reporting from “larger” broker-dealers — meaning broker-dealers that introduce or carry 100,000 or more customer accounts.
Currently, broker-dealers are not included within the scope of Rule 605 unless they are also market centers. Although Rule 606 of Regulation NMS requires broker-dealers to provide certain information regarding customer orders they route, those reports do not include comprehensive information about the execution quality achieved by such routing broker-dealers. The Proposal would therefore require broker-dealers that introduce or carry more than 100,000 customer accounts to provide execution quality disclosures under Rule 605.5
The Proposal would also expand the scope of Rule 605 to include reporting by single-dealer platforms and entities that would operate qualified auctions pursuant to the proposed Rule 615 under Regulation NMS (the order competition rule proposal), which the SEC proposed on the same day as this Proposal.6
Amending Form and Content of Rule 605 Monthly Reports
The Proposal also includes updates to the scope and content of Rule 605 monthly reports.
First, the Proposal seeks to expand the definition of “covered order”7 subject to Rule 605 to include
- orders submitted outside of regular trading hours — the definition would include certain nonmarketable limit orders (NMLOs) submitted outside of regular trading hours if they become executable after the opening or reopening of trading during regular hours
- orders submitted with stop prices — orders with special handling instructions, including orders submitted with stop prices, are currently excluded from the definition of “covered order”; under the Proposal, stop orders would be required to be reported if they become executable8
- nonexempt short sale orders – under the Proposal, a nonexempt short sale order would be a covered order unless the nonexempt short sale order is subject to a short sale price test restriction, in which case it would be considered special handling and excluded from Rule 605 reporting.
Second, current Rule 605 reports group orders by order size and order type, and the Proposal would modify order size categories. Specifically, the Proposal would modify existing order size categories to base them on round lots rather than number of shares and include additional order size categories for fractional shares, odd lots, and larger-sized orders. The Proposal would also modify reportable order type categories for order types as follows:
`
|
Existing Order Type Category |
Order Type Category as Proposed |
|
Market |
Market |
|
Marketable limit |
Marketable limit |
|
Inside-the-quote limit |
Beyond-the-midpoint limit |
|
At-the-quote limit |
Executable NMLO |
|
Near-the-quote limit |
Executable NMLO |
|
[Not included] |
Executable NMLO |
Third, the Proposal would amend the content of Rule 605 monthly reports to include
- average time to execution, median time to execution, and 99th percentile time to execution statistics, measured in increments of a millisecond or finer, in lieu of the current time-to-execution reporting categories, which are currently measured in seconds
- average realized spread9 statistics as calculated after 15 seconds and one minute
- new statistical measures of execution quality, including
- average effective over quoted spread (a percentage-based metric that represents how much price improvement an order received)
- percentage effective and realized spread statistics (designed to make it easier to compare dollar-based statistics across stocks)
- size improvement benchmark that could be used to calculate whether orders received an execution of more than the displayed size at the quote
- certain statistical measures that could be used to measure execution quality of nonmarketable orders, and additional price improvement statistics for market and marketable orders showing price improvement relative to the best available price in the market
Summary Reports
Finally, the Proposal would require all entities subject to Rule 605 to make available a summary report formatted in the most recent versions of the XML and PDF formats published on the SEC’s website. Currently, the required format of 605 reports is only machine-readable. Requiring summary reports, in addition to the detailed reports, would allow for a human-readable format that could be more readily used by investors.
1Exchange Act Release No. 34-96493 (December 14, 2022), https://www.sec.gov/rules/proposed/2022/34-96493.pdf.
2See Sidley updates: SEC Proposes Comprehensive Best Execution Framework for Broker-Dealers; SEC Proposes Rule to Enhance Competition for Certain Individual Investor Orders; and SEC Proposes Rules Related to Minimum Pricing Increments, Access Fee Caps, and Transparency of Better Priced Orders.
3See Chair Gary Gensler, Competition and the Two SECs, address before the SIFMA Annual Meeting (October 24, 2022), https://www.sec.gov/news/speech/gensler-sifma-speech-102422.
4Regulation NMS defines a “market center” to include any exchange market maker, OTC market maker, alternative trading system, national securities exchange, or national securities association.
5According to the SEC’s analysis, approximately 85 broker-dealers introduce or carry more than 100,000 customer accounts, and they collectively handle over 98% of customer accounts.
6For more information on the SEC’s Order Competition Rule, see Sidley’s client alert here: https://www.sidley.com/en/insights/newsupdates/2022/12/sec-proposes-rule-to-enhance-competition-for-certain-individual-investor-orders.
7A “covered order” currently includes any market order or any limit order (including immediate-or-cancel orders (IOCs)) 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. See17 CFR 242.600(b)(22).
8The proposed definition of “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.
9See17 CFR 242.600(b)(9) (defining average realized spread).
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