Rule 606 is hopelessly outdated and fails to require disclosure of the vast majority of all routing

With all the yelling about order types and the complexity of the markets, you would think that there would be an angry mob calling for transparency. But that doesn't seem to be the case, despite 606, the existing disclosure rule, being hopelessly outdated and failing to require the disclosure of most routed orders. Recent surveys conducted by TABB Group, ConvergeEx, and Liquidnet show the industry's interest in more transparency in best execution practices, but the focus is typically on market centers, which is Rule 605. While we agree that Rule 605 should be overhauled as well, the more pressing problem is actually that modern routing practices are almost completely opaque, which can be remedied by changes to Rule 606. It is my contention that enhanced disclosure in Rule 606 reports will help to address broad concerns about broker and exchange conflicts of interest, as well as help restore investor confidence in the integrity of the equity market.

The biggest flaw in 606 is the complete lack of reporting on modern Smart Order Routers (SORs) that use high speed technology to seek liquidity. SORs are now ubiquitous; used by exchanges, brokers, and provided by vendors of Order Management systems. They have created a market structure characterized by a high level of integration of Exchanges, Alternative Trading Systems, Market Makers and other liquidity providers, which is poorly understood by the investing public. As I had a "front row seat" to the development of SORs, I thought it would be instructive to tell that story.

I first heard about Smart Order Routers when I met with the founders of Lava Trading in the café of what was One World Trade, where they had leased office space, in 1999. They explained their idea to build technology for NASDAQ traders to take advantage of the growing volume in Electronic Communication Networks (ECNs). By late 2000, they had built an integrated market data feed that combined the books of these systems, with NASDAQ market data, using it to guide a software component called a Smart Order Router. As the architect of the Salomon Smith Barney trading platform, I was interested to learn about their technology and see if we could leverage it.

For my visit*, the system was set up in a cubicle with a sweeping northern view of Manhattan. I distinctly remember looking at that view and the system and being impressed by both. The system had a calculator that predicted the exact dollar savings on typical institutional orders. The first order they showed me was for 50,000 shares of Microsoft, which was not an uncommon size for traders to execute at one time. That order, according to the calculator, would have been executed at more than six cents per share better, using the Lava router, than by Instinet or NASDAQ's quotes alone. I was surprised at the magnitude: more than $3000 on one trade alone was a lot of money. After confirming that their software could actually deliver comparable savings, we implemented the Lava router, called "Colorbook" into our new trading system.

During the following year, SEC Rule 11Ac1-6 (which became Rule 606) became effective, but the type of Smart Order Routing that Lava was developing wasn't taken into consideration by the rule. Orders at that time were usually sent to individual exchanges or market makers and it was rare that orders were re-routed by either. At that time, brokers were either using DOT or sent orders to the NYSE handheld for listed orders and either Instinet or NASDAQ systems to trade on behalf of customers. Exchanges only routed orders to other exchanges via an antique system called ITS, which was a slow system designed for manual entry of orders to and from regional exchanges.

Over the next couple of years, SOR volumes exploded. At one point, Lava Trading had built over 20% market share in routing of NASDAQ stocks and several of the large broker dealers that ran algorithmic trading businesses built their own platforms. ECNs also built SORs and gained market share.

In the middle of the decade, however, the game changed again. NASDAQ bought the BRUT ECN and subsequently decided to "compete" directly with broker dealers, routing companies and ECNs, by offering smart order routing for free.

NASDAQ was able to do this by virtue of three factors:

1. They routed so much volume, that they immediately earned volume discounts from other venues.
2. They paid much lower fees to their "external liquidity providers" and continued to charge their routing customers the full access fee for routing without disclosing the fee differential.
3. Clients were already connected to NASDAQ and it was cheaper for them to use their routing instead of connecting to a third party.

NASDAQ's free pricing destroyed the third party routing business model. For obvious reasons, a software company was unable to compete with free routing, so LAVA was bought by Citigroup and ultimately repackaged routing within an ECN (LavaFLOW) to offer a bundled service like NASDAQ.

The sad part of this story is that, for a long time, Lava and a bunch of other innovative companies had arguably better products than the exchange offerings, but it's hard to compete with free. I am defining "better" as accessing more liquidity at an advantageous price. In order to prove that a router was better, it required access to execution quality metrics from each router and there was not a lot of transparency or disclosure of the details of routing practices. Another issue was that many broker dealer customers of order routers were quite price sensitive due to continued pressure on their margins. This made competing with free routing almost impossible in many cases.

The next change was the rise of external liquidity providers. Market makers and trading firms that did not deal directly with order flow providers started to work with exchanges and other order routers directly. The first "wave" of this activity was the infamous "flash" order, which rose to prominence when implemented by Direct Edge ECN. That program essentially broadcast unfilled customer orders to a private network of liquidity providers receiving the venue's proprietary data feed. The ECN waited for a short time for one or more of those liquidity providers to send an order into their system, where it would match against the original order. If no match resulted from the broadcast, their system would continue by routing to other venues to be filled. After years of debate, a lot of opposition the practice was stopped because of the furor it provoked. Many were concerned about potentially unfair information advantages for the liquidity providers and the SEC's reaction was intense enough to threaten Direct Edge's pending exchange application. Despite the reaction to flash orders, the more general concept of external liquidity providers has flourished. All of the exchange groups access both ATS and non-ATS dark pools in their routing programs and most broker dealers operate systems that do the same. These liquidity pools are typically accessed by Immediate or Cancel (IOC) orders, sent in rapid succession, from a variety of SORs. The full extent of this routing activity is poorly understood since Rule 606 does not require disclosure in most of the cases. In particular, Rule 606 does not require disclosure by Exchanges, and they do not voluntarily disclose how many orders are routed to these venues, what the precise mechanism is, or any statistics on fill rates from the venues they route to.

Considering the repeated criticisms leveled at "dark" liquidity and the glaring lack of Exchange disclosures of how they access it, I find the market structure rhetoric of some of the Exchanges disingenuous. For example, the NYSE management team continually stresses both the complexity of the current market structure created by too many order types and too many venues. At the same time, however, many of their own popular order types use sophisticated routing strategies and access a wide variety of the venues that they criticize.

That said, while the rhetoric is somewhat hypocritical, the order routing practices of the Exchanges are likely adding value to their clients. The problem is that there is a general climate of mistrust and a lack of transparency that should certainly be addressed.

It has been almost 15 years since the SEC addressed the issue of best execution via rulemaking and the time to act is way overdue. When the rules, now known as Rule 605 and 606, were passed, the market was just becoming decimalized and rate of technology change was starting to accelerate. As I just described, the use of SORs, now ubiquitous, was in its infancy. The failure of these rules to have kept up with these changes means that routing practices are essentially opaque. This obscures potential issues with trading quality and also leads directly to fear and mistrust among investors.

The point of this comment is not to regulate or impede SOR development, but rather, to force disclosure of how routing actually works. It is my belief that SORs have directly led to improved execution quality in many cases, but not in all. The only way that investors can tell the difference, will be to truly learn how and where their orders are routed. To accomplish this, we recently delivered a plan to the SEC that explains both the key principles and proposed reforms for both Rule 606, as well as, Rule 605, the market center best execution reporting rule. The principles are fairly basic, but would make a tremendous difference if implemented:

• Show All Routing - Require all routing firms to report on all of the order routing that is being done including unfilled IOC orders.
• Disclose Order Handling - Require firms acting in an agency (or riskless) capacity to disclose the ratio of aggregate routing of orders to the orders they received.
• Disclose Fees and Basic Execution Quality - Add disclosure of net fees / rebates, as well as, basic metrics of execution quality in the aggregate.
• Categorize Routing Statistically - Split the reporting of routed and executed orders into categories that facilitate comparison of execution quality and fee disclosure statistics.

These basic principles, if followed, would guide the overhaul of Rule 606 into a valuable vehicle for people to understand modern market structure.

Unfortunately, some in the industry are resistant and are lobbying the SEC to rely exclusively upon industry disclosures, such as those produced by the Investment Company Institute (ICI). Sadly, that template falls far short of the level of disclosure required to understand routing practices and is really just another example of "check the box" disclosure. It does not call for disclosure by Exchanges or smart order routing vendors, except for those that execute directly for buy-side firms. Their template provides no method for comparative quality analysis, since nothing is public, nor is the data aggregated in a meaningful way.

Our belief is that one of the reasons that retail investors are getting such a "great deal" today is the competition spurred on by Rule 605 and the public disclosures required and derived from it. If Rule 606 were modernized to include public disclosure of all routing practices, fees and execution quality, including those of Exchanges, it could do the same for institutional investors.

** Like everyone else, September 11, 2001, I stood stunned, looking at the smoking hole in the side of One World Trade. At that moment, I flashed back to my Lava demo and the spectacular view. I tried to call the Lava offices but there was no answer. We were all evacuated and cellphones weren't working, so like everyone else, I spent that long journey home wondering if my friends and colleagues were alive. Seven hours later, I was finally able to get in touch with people from Lava. The first plane had hit several floors above the very same window I had looked out of the year before. All Lava employees made it out of the building before it collapsed.

David Weisberger, Managing Director, Trading Services at Markit
Posted 7 April 2015

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This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.