Disclosure of Order Handling Information

Federal RegisterJul 27, 2016

Ask Donna

What actually matters in this document.

Text

SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 240 and 242

[Release No. 34-78309; File No. S7-14-16]

RIN 3235-AL67

Disclosure of Order Handling Information

AGENCY:

Securities and Exchange Commission.

ACTION:

Proposed rule.

SUMMARY:

The Securities and Exchange Commission (“Commission” or “SEC”) is proposing to amend Rules 600 and 606 of Regulation National Market System (“Regulation NMS”) under the Securities Exchange Act of 1934 (“Exchange Act”) to require additional disclosures by broker-dealers to customers about the routing of their orders. Specifically, with respect to institutional orders, the Commission is proposing to amend Rule 606 of Regulation NMS to require a broker-dealer, upon request of its customer, to provide specific disclosures related to the routing and execution of the customer's institutional orders for the prior six months. The Commission also is proposing to amend Rule 606 of Regulation NMS to require a broker-dealer to make publicly available aggregated information with respect to its handling of customers' institutional orders for each calendar quarter. With respect to retail orders, the Commission is proposing to make targeted enhancements to current order routing disclosures under Rule 606 by requiring limit order information to be broken down into marketable and non-marketable categories, requiring the disclosure of the net aggregate amount of any payment for order flow received, payment from any profit-sharing relationship received, transaction fees paid, and transaction rebates received by a broker-dealer from certain venues, requiring broker-dealers to describe any terms of payment for order flow arrangements and profit-sharing relationships with certain venues that may influence their order routing decisions, and eliminating the requirement to divide retail order routing information by listing market. In connection with these new requirements, the Commission is proposing to amend Rule 600 of Regulation NMS to include a number of newly defined terms which are used in the proposed amendments to Rule 606. The Commission is also proposing to amend Rules 605 and 606 of Regulation NMS to require that the public order execution and order routing reports be kept publicly available for a period of three years and to make conforming changes to Rule 607. Finally, the Commission is proposing to amend Rule 3a51-1(a) under the Exchange Act; Rule 13h-1(a)(5) of Regulation 13D-G; Rule 105(b)(1) of Regulation M; Rules 201(a) and 204(g) of Regulation SHO; Rules 600(b), 602(a)(5), 607(a)(1), and 611(c) of Regulation NMS; and Rule 1000 of Regulation SCI, to update cross-references as a result of this proposed rule.

DATES:

Comments should be received on or before September 26, 2016.

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/proposed.shtml

);

• Send an email to

rule-comments@sec.gov

. Please include File Number S7-14-16 on the subject line; or

• Use the Federal eRulemaking Portal (

http://www.regulations.gov

). Follow the instructions for submitting comments.

Paper Comments

• Send paper comments to Brent J. Fields, Secretary, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090.

All submissions should refer to File Number S7-14-16. This file number should be included on the subject line if email is used. To help us process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Internet Web site (

http://www.sec.gov/rules/proposed.shtml

). Comments are also available for Web site viewing and printing in the Commission's Public Reference Room, 100 F Street NE., Washington, DC 20549-1090 on official business days between the hours of 10:00 a.m. and 3:00 p.m. All comments received will be posted without change; we do not edit personal identifying information from 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 Web site. 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:

Theodore S. Venuti, Assistant Director, at (202) 551-5658, Arisa Tinaves Kettig, Senior Special Counsel, at (202) 551-5676, Steve Kuan, Special Counsel, at (202) 551-5624, Amir Katz, Special Counsel, at (202) 551-7653, Chris Grobbel, Special Counsel, at (202) 551-5491, or Andrew Sioson, Attorney-Advisor, at (202) 551-7186 Division of Trading and Markets, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549.

SUPPLEMENTARY INFORMATION:

The Commission is proposing: (1) Amendments to Rules 600 and 606 under the Exchange Act [17 CFR 242.600 and 202.606] to require additional disclosures by broker-dealers to customers about the routing of their orders; (2) amendments to Rule 605 [17 CFR 242.605] to require that the public order execution and order routing reports be kept publicly available for a period of three years; and (3) conforming changes and updating cross-references in Rule 3a51-1(a) under the Exchange Act [17 CFR 240.3a51-1(a)], Rule 13h-1(a)(5) of Regulation 13D-G [17 CFR 240.13h-1(a)(5)], Rule 105(b)(1) of Regulation M [17 CFR 242.105(b)(1)] Rules 201(a) and 204(g) of Regulation SHO [17 CFR 242.201(a) and 242.204(g)], Rules 600(b), 602(a)(5), 605, 607(a)(1), and 611(c) of Regulation NMS [17 CFR 242.600(b), 242.602(a)(5), 242.605, 242.607(a)(1), and 242.611(c)], and Rule 1000 of Regulation SCI [17 CFR 242.1000].

Table of Contents

I. Introduction

II. Current Practices and Regulation and the Need for Enhanced Disclosures

A. Background on Rule 606

B. Changes in Order Handling Practices

C. Need for Enhanced Disclosures for Institutional Orders

1. Market Complexity

2. Assessing Best Execution

3. Conflicts of Interest

4. Information Leakage

D. Need for Public Reporting of Aggregated Institutional Order Information

E. Need for Enhanced Disclosures for Retail Orders

F. Comments on Equity Market Structure

1. General Need to Update Rule 606

2. Need for Rule 606 to be Modernized to Maintain Pace with Technological Advances

3. Requests for Specific Information and Standardized Disclosures

4. Requests for Specific Disclosures for Institutional Orders

5. Comments on Actionable Indications of Interest

III. Proposed Amendments to Rule 600, Rule 605, Rule 606, and Rule 607

A. Disclosures for Institutional Orders

1. Definition of Institutional Order in Proposed Rule 600(b)(31)

2. Definition of Actionable Indication of Interest in Proposed Rule 600(b)(1)

3. Scope and Format of Reports

4. Report Content

5. Public Report for Institutional Orders

B. Disclosures for Retail Orders

1. Marketable Limit Orders and Non-Marketable Limit Orders

2. Net Payment for Order Flow and Transaction Fees and Rebates by Specified Venue

3. Discussion of Arrangement Terms with a Specified Venue

4. Additional Amendments to Retail Disclosures

5. Amendment to Rule 600(b)(18) to rename “Customer Order” to “Retail Order”

C. Amendment to Disclosure of Order Execution Information

IV. Paperwork Reduction Act

A. Summary of Collection of Information

1. Customer Requests for Information on Institutional Orders

2. Public Aggregated Report on Institutional Orders

3. Requirement to Document Methodologies for Categorizing Institutional Order Routing Strategies

4. Amendment to Current Disclosures With Respect to Retail Orders

5. Amendment to Current Disclosures under Rule 605

B. Proposed Use of Information

1. Customer Requests for Information on Institutional Orders

2. Public Aggregated Report on Institutional Orders

3. Requirement to Document Methodologies for Categorizing Institutional Order Routing Strategies

4. Amendment to Current Disclosures With Respect to Retail Orders

5. Amendment to Current Disclosures under Rule 605

C. Respondents

D. Total Initial and Annual Reporting and Recordkeeping Burdens

1. Customer Requests for Information on Institutional Orders

2. Public Aggregated Report on Institutional Orders

3. Requirement to Document Methodologies for Categorizing Institutional Order Routing Strategies

4. Amendment to Current Disclosures With Respect to Retail Orders

5. Amendment to Current Disclosures under Rule 605

E. Collection of Information is Mandatory

F. Confidentiality of Responses to Collection of Information

G. Retention Period for Recordkeeping Requirements

H. Request for Comments

V. Economic Analysis

A. Introduction

B. Baseline

1. Ad Hoc Reports for Institutional Orders

2. Publication Period for Reports on Retail Orders Required by Current Rules 605 and 606

3. Available Information on Conflicts of Interest

4. Available Information on Execution Quality for Institutional and Retail Orders

5. Format of Current Reports for Institutional and Retail Orders

6. Quality of Broker-Dealer Routing Practices for Institutional Orders

7. Use of Actionable IOIs in Institutional Orders

8. Competition, Efficiency, and Capital Formation

9. Request for Comment

C. Costs and Benefits

1. Disclosures for Institutional Orders

2. Disclosures for Retail Orders

3. Disclosure of Order Execution Information

4. Structured Format of Reports

5. Other Definitions in Proposed Amendments to Rule 600

D. Alternatives Considered

1. Definition of Institutional Order in Proposed Rule 606(b)(31)

2. Limited or No Public Disclosure of Institutional Order Routing and Execution Quality (Proposed Rule 606(c))

3. More Frequent Public Disclosure of Institutional Order Routing and Execution Information (Proposed Rule 606(c))

4. Automatic Provision of Customer-Specific Institutional Order Handling Report (Proposed Rule 606(b)(3))

5. Submission of Institutional Order Handling Reports (Proposed Rules 606(b)(3) and 606(c))

6. Disaggregate Categories of NMS Stocks for Rule 606(a)

7. Disclosure of Additional Information about Institutional Order Routing and Execution

8. Institutional Order Handling Reports at the Stock Level (Proposed Rule 606(b)(3))

9. Alternative to Three-Year Posting Period (Proposed Amendments to Rules 605(a)(2) and 606(a)(1), and Proposed Rule 606(c))

10. Request for Comment

E. Economic Effects and Effects on Efficiency, Competition, and Capital Formation

1. Effects of Proposed Amendments on Efficiency and Competition

2. Effects of Proposed Amendments on Capital Formation

3. Request for Comment

VI. Consideration of Impact on the Economy

VII. Regulatory Flexibility Analysis

VIII. Statutory Authority and Text of the Proposed Rule Amendments

I. Introduction

Institutional customers have a compelling interest in the order handling decisions of their executing brokers as they monitor the execution quality of their orders, both from the standpoint of the price received and to evaluate the potential negative effects of information leakage and conflicts of interest.

This focus on order handling has intensified in recent years as routing and execution practices have evolved as markets have become more automated, dispersed, and complex.

Historically, there was a substantial manual component involved in the routing and execution of institutional customers' orders. Today, however, institutional orders tend to be routed and executed using sophisticated order execution algorithms developed by broker-dealers or others that break up large institutional orders into smaller “child” orders, and smart order routing systems to route those child orders to the full range of trading centers in the national market system, including exchanges, “dark pool” alternative trading systems (“ATSs”), other ATSs, and internalizing broker-dealers.

These order routing and execution algorithms use a wide variety of methods, ranging from non-time-sensitive passive strategies to aggressive liquidity-taking strategies, to achieve the trading goals of the institutional customer. Although certain advantages flow from technological advancements and the increase in number of venues, the Commission preliminarily believes that the complexity of order execution algorithms and smart order routing systems, and the multiplicity of venues to which broker-dealers may route orders or send actionable indications of interest, have made it increasingly difficult for institutional customers to assess the impact particular order routing strategies may have on the quality of their executions, or the risks presented by any resulting information leakage or broker-dealer conflicts of interest.

An institutional customer includes, for example, pension funds, mutual funds, investment advisers, insurance companies, investment banks, and hedge funds.

See

Securities Exchange Act Release No. 73639 (November 19, 2014), 79 FR 72252, 72397 (December 5, 2014) (“Regulation SCI Adopting Release”) (stating that markets have evolved “to become significantly more dependent on sophisticated, complex, and interconnected technology”);

see also

Securities Exchange Act Release No. 61358 (January 14, 2010), 75 FR 3594 (January 21, 2010) (“Concept Release on Equity Market Structure”) (stating that “the current market structure can be described as dispersed and complex: (1) Trading volume is dispersed among many highly automated trading centers that compete for order flow in the same stocks; and (2) trading centers offer a wide range of services that are designed to attract different types of market participants with varying trading needs”).

A “trading center” means a national securities exchange or national securities association that operates an SRO trading facility, an alternative trading system, an exchange market maker, an OTC market maker, or any other broker or dealer that executes orders internally by trading as principal or crossing orders as agent.

See

17 CFR 242.600(b)(78).

Changes to market structure and routing practices have led many institutional customers to demand more specific and detailed institutional order handling information from their broker-dealers. The Commission notes that for

purposes of this proposing release, the use of “institution” or “institutional” shall refer to an institutional order, as proposed to be defined in proposed Rule 600(b)(31),

and the term “institutional customer” shall refer to a sender of an institutional order.

See infra

Section III.A.1.

The Commission understands that institutional customer requests range from detailed information about the handling of specific institutional orders to more generic data about the order routing strategies pursued by the broker-dealer for institutional customers and the venues to which their orders are routed and executed. The level of detail of the information provided tends to vary by broker-dealer, as well as the particular institutional customer, some of whom may have the wherewithal and desire to digest and evaluate voluminous order handling information and some of whom may not.

The Commission preliminarily believes that market-based efforts to provide institutional order handling transparency may not be sufficient insofar as smaller institutional customers may lack the bargaining power or the resources to demand relevant order handling information from their broker-dealers. In addition, while many institutional customers regularly conduct, directly or through a third-party vendor, transaction cost analysis (“TCA”) of their orders to assess execution quality against various benchmarks, the Commission preliminarily believes that the comprehensiveness of such analysis could be enhanced with more granular order handling information. The Commission also preliminarily believes that standardizing the baseline information provided by broker-dealers could help ensure the wide availability of meaningful order handling information that may be produced in an efficient and cost-effective manner.

There have been recent efforts by representatives of broker-dealers and institutional customers to develop a template of baseline order routing disclosure, and these efforts are reflected in a letter from the Investment Company Institute, the Managed Funds Association, and the Securities Industry and Financial Markets Association (collectively, the “Associations”).

See

Letter to Mary Jo White, Chair, Commission, from Dorothy M. Donohue, Deputy General Counsel, Investment Company Institute, Stuart J. Kaswell, Executive Vice President & Managing Director, General Counsel, Managed Funds Association, and Randy Snook, Executive Vice President, Securities Industry and Financial Markets Association, dated October 23, 2014 (“Associations Letter”),

available at http://www.sec.gov/comments/s7-02-10/s70210-428.pdf

In light of the foregoing, the Commission preliminarily believes that standardized baseline institutional order handling information should be required to be made available to the institutional customer upon request so that the institutional customer can more effectively assess the impact of order routing decisions on the quality of their executions, including the risks of information leakage and potential conflicts of interest.

Further, the Commission preliminarily believes that public disclosure of institutional order handling information, on an aggregated basis, could assist market participants in comparing the routing services of multiple broker-dealers, and the relative merits of competing trading centers, and facilitate institutional customers' ability to make informed decisions when engaging the services of a broker-dealer. The Commission preliminarily believes that the proposal would further encourage broker-dealers to minimize information leakage when executing an institutional order. The Commission preliminarily believes that the potential benefits of public disclosure of aggregated institutional order handling information should justify any potential negative competitive impact such disclosure may have on broker-dealers.

See infra

Sections II.C.3. and II.C.4.

The changes to market structure have impacted the market for customer order routing and execution services. Currently, a “customer order” means an order to buy or sell an NMS security that is not for the account of a broker-dealer, but shall not include any order for a quantity of a security having a market value of at least $50,000 for an NMS security that is an option contract and a market value of at least $200,000 for any other NMS security.

As such, the term “customer order,” when used in Regulation NMS, only refers to smaller-sized orders. As discussed in more detail below, the Commission is proposing to rename “customer order” to “retail order” and for purposes of this proposing release, the term “retail customer” shall refer to a sender of a retail order.

See

17 CFR 242.600(b)(18).

As discussed below, the rise in the number of trading centers and the introduction of new fee models for execution services have intensified competition for retail order flow and created new potential conflicts of interest for broker-dealers. The Commission preliminarily believes that simplified and enhanced disclosures for retail orders, particularly with respect to financial inducements from trading centers, should assist retail customers in evaluating better the order routing services of their broker-dealers. Additionally, public transparency of retail orders should drive competition as broker-dealers seek to compete on the basis of the quality of their order routing and execution services as well as their ability to manage conflicts of interest.

The Commission therefore is proposing amendments to Rules 600

and 606

of Regulation NMS to require, for the first time, disclosures by broker-dealers about their handling of institutional orders, and enhancements to existing disclosures with respect to retail orders.

Specifically, with respect to institutional orders, the Commission is proposing to amend Rule 606 of Regulation NMS to require a broker-dealer, upon request of its customer, to provide specific disclosures, for the prior six months, broken down by calendar month, related to: (1) The handling of the customer's institutional orders at the broker-dealer; (2) the routing of the customer's institutional orders to various trading centers; (3) the execution of those orders, and the quality of execution; and (4) the extent to which such orders provided liquidity or removed liquidity, and the average transaction rebates received or fees paid by the broker-dealer. This information would be provided for each venue, and would

further

divided into

passive, neutral, and aggressive order routing strategies. In connection with this new requirement, the Commission is proposing to amend Rule 600 of Regulation NMS to include definitions of the terms “institutional order,” “actionable indication of interest,” “orders providing liquidity,” and “orders removing liquidity,” and to rename the defined term “customer order” to “retail order.” The Commission also is proposing to amend Rule 606 of Regulation NMS to require a broker-dealer to make publicly available the foregoing information, on an aggregated basis, for all of its customers' institutional orders, for each calendar quarter, broken down by calendar month, and keep such reports posted on an Internet Web site that is free and readily accessible to the public for a period of three years from the initial date of posting on the Internet Web site.

17 CFR 242.600.

17 CFR 242.606.

The Commission notes that the proposed amendments to Rule 606, if adopted, would not limit any other obligations that the broker-dealer may have under applicable federal securities laws, rules, or regulations, including the anti-fraud provisions of the federal securities laws.

Further, with respect to retail orders, the Commission preliminarily believes that the existing Rule 606 disclosures should be updated to require that more relevant routing information is provided

to retail customers. Specifically, the Commission is proposing to: (1) Require limit order information to be split into marketable

and non-marketable

categories; (2) require more detailed disclosure of the net aggregate amount of any payments received from or paid to certain trading centers; (3) require broker-dealers to describe any terms of payment for order flow arrangements and profit-sharing relationships with certain venues that may influence its order routing decisions; (4) require that broker-dealers keep retail order routing reports posted on an Internet Web site that is free and readily accessible to the public for a period of three years from the initial date of posting on the Internet Web site; and (5) eliminate the requirement to group retail order routing information by listing market.

A “marketable limit order” is 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. 17 CFR 242.600(b)(39). “National best bid and national best offer” means, with respect to quotations for an NMS security, the best bid and best offer for such security that are calculated and disseminated on a current and continuing basis by a plan processor pursuant to an effective national market system plan; provided, that in the event two or more market centers transmit to the plan processor pursuant to such plan identical bids or offers for an NMS security, the best bid or best offer (as the case may be) shall be determined by ranking all such identical bids or offers (as the case may be) first by size (giving the highest ranking to the bid or offer associated with the largest size), and then by time (giving the highest ranking to the bid or offer received first in time). 17 CFR 242.600(b)(42).

The Commission is proposing in new Rule 600(b)(51) to define “non-marketable limit order” to mean “any limit order other than a marketable limit order”, as discussed in more detail below.

See infra

Section III.B.1.

Finally, consistent with the proposed amendments to Rule 606, the Commission is proposing to amend Rule 605 to require market centers

to keep execution reports required by the rule posted on an Internet Web site that is free of charge and readily accessible to the public for a period of three years from the initial date of posting on the Internet Web site. With respect to Rule 607, the Commission is proposing to amend the rule text to reflect the renaming of the defined term “customer order” to “retail order,” but is making no substantive changes to the defined term. As noted above, the Commission is proposing amendments to other rules to update cross-references as a result of this proposal.

A “market center” means any exchange market maker, OTC market maker, alternative trading system, national securities exchange, or national securities association.

See

17 CFR 242.600(b)(38).

The Commission is proposing to amend Rule 3a51-1(a) under the Exchange Act; Rule 13h-1(a)(5) of Regulation 13D-G; Rule 105(b)(1) of Regulation M; Rules 201(a) and 204(g) of Regulation SHO; Rules 600(b), 602(a)(5), 607(a)(1), and 611(c) of Regulation NMS; and Rule 1000 of Regulation SCI.

The release first provides relevant background on Rule 606 and then discusses the technological advances and regulatory changes that have prompted the proposal. The release then discusses, in detail, the proposed amendments to Rules 600, 605, 606, and 607 including the new institutional order handling disclosures that would be required from broker-dealers.

II. Current Practices and Regulation and the Need for Enhanced Disclosures

A. Background on Rule 606

The Commission proposed and adopted Rule 11Ac1-6,

now known as Rule 606 of Regulation NMS,

in 2000, to improve public disclosure of order routing practices. Rule 606 arose out of the Commission's extended inquiry into market fragmentation, defined at the time as the trading of orders in multiple locations without interaction among those orders.

In adopting Rule 606, the Commission stated that “[i]n a fragmented market structure with many different market centers trading the same security, the order routing decision is critically important, both to the individual investor whose order is routed and to the efficiency of the market structure as a whole. The decision must be well-informed and fully subject to competitive forces.”

The Commission further stated that public disclosure of order routing practices “could provoke more vigorous competition on . . . order routing performance.”

See

Securities Exchange Act Release Nos. 43084 (July 28, 2000), 65 FR 48406 (August 8, 2000) (“Rule 606 Predecessor Proposing Release”) and 43590 (November 17, 2000), 65 FR 75414 (December 1, 2000) (“Rule 606 Predecessor Adopting Release”).

The Commission re-designated Rule 11Ac1-6 as Rule 606 when adopting Regulation NMS in 2005.

See

Securities Exchange Act Release No. 51808 (June 9, 2005), 70 FR 37496, 37538 (June 29, 2005) (“Regulation NMS Adopting Release”). For clarity, when this release discusses the proposal of Rule 606 or the adoption of Rule 606, it is referring to the Rule 606 Predecessor Proposing Release and Rule 606 Predecessor Adopting Release,

supra

note 15, respectively.

See

Securities Exchange Act Release No. 42450 (February 23, 2000), 65 FR 10577 (February 28, 2000) (Commission request for comment, included in a notice of a proposed self-regulatory organization (“SRO”) rule change) (“Fragmentation Release”).

See

Rule 606 Predecessor Adopting Release,

supra

note 15, at 75415.

Id.

at 75417. Industry participants commenting in response to the Concept Release on Equity Market Structure,

supra

note 2, have expressed the view that increased order routing transparency has led to increased competition.

See, e.g.,

Letters to Secretary, Commission, from Joan C. Conley, Senior Vice President and Corporate Secretary, The NASDAQ OMX Group, Inc., dated April 30, 2010 (“NASDAQ Letter”), at 21 (stating that NASDAQ shares the Commission's belief that transparency promotes competition); from Christopher Nagy, Managing Director Order Strategy, Co-Head of Government Relations, TD Ameritrade and John S. Markle, Deputy General Counsel, Co-Head of Government Relations, TD Ameritrade, dated April 21, 2010 (“TD Ameritrade Letter”), at 3-4 (stating that added transparency has driven brokers to continuously seek better executions for clients).

In adopting Rule 606, the Commission limited its scope to smaller orders.

Larger orders were excluded in recognition of the fact that, at the time, generalized information for order routing practices would be more useful for smaller orders, which tended to be handled in a more homogenous manner.

Because institutional orders required more individualized, manual handling, they were excluded from Rule 606 in recognition of the fact that, at that time, providing standardized order handling statistics would be neither practical nor useful in this context.

The Commission limited the scope of Rule 606 to smaller orders by defining a customer order as an order to buy or sell an NMS security that is not for the account of a broker or dealer, but shall not include any order for a quantity of a security having a market value of at least $50,000 for an NMS security that is an option contract and a market value of at least $200,000 for any other NMS security.

See

17 CFR 242.600(b)(18).

See

Rule 606 Predecessor Adopting Release,

supra

note 15, at 75426.

See id.

Thus, in its current form, Rule 606(a) applies only to retail-sized orders, and requires every broker-dealer to publicly provide a quarterly report on its routing of non-directed orders

in NMS securities.

Currently, the report includes the following information, separated by listing market for NMS stocks,

and in the aggregate for NMS securities that are option contracts: (1) The percentage of total retail orders that were non-directed orders, and the percentages of total non-directed orders that were market orders, limit orders, and other orders; (2) the identity of the ten venues to which the largest number of total non-directed orders were routed for execution and of any venue to which

five percent or more of such orders were routed (collectively, “Specified Venues”) and the percentage of total non-directed orders routed to each Specified Venue, and the percentages of total non-directed market orders, total non-directed limit orders, and total non-directed other orders that were routed to each Specified Venue; and (3) a discussion of the material aspects of the broker-dealer's relationship with each Specified Venue, including a description of any payment for order flow

or profit-sharing relationship arrangements.

A “non-directed order” means any customer order other than a directed order.

See

17 CFR 242.600(b)(48). A “directed order” means a customer order that the customer specifically instructed the broker or dealer to route to a particular venue for execution.

See

17 CFR 242.600(b)(19).

See also

supra

note 7 and accompanying text. The Commission is proposing to rename “customer order” as “retail order,” which would carry through to these two definitions.

See infra

Section III.B.5.

An “NMS security” is any security or class of securities for which transaction reports are collected, processed, and made available pursuant to an effective transaction reporting plan, or an effective national market system plan for reporting transactions in listed options.

See

17 CFR 242.600(b)(46).

An “NMS stock” is any NMS security other than an option.

See

17 CFR 242.600(b)(47).

“Payment for order flow” has the meaning provided in 17 CFR 240.10b-10.

See

17 CFR 242.600(b)(54). “Payment for order flow” means any monetary payment, service, property, or other benefit that results in remuneration, compensation, or consideration to a broker or dealer from any broker or dealer, national securities exchange, registered securities association, or exchange member in return for the routing of customer orders by such broker or dealer to any broker or dealer, national securities exchange, registered securities association, or exchange member for execution, including but not limited to: research, clearance, custody, products or services; reciprocal agreements for the provision of order flow; adjustment of a broker or dealer's unfavorable trading errors; offers to participate as underwriter in public offerings; stock loans or shared interest accrued thereon; discounts, rebates, or any other reductions of or credits against any fee to, or expense or other financial obligation of, the broker or dealer routing a customer order that exceeds that fee, expense or financial obligation.

See

17 CFR 240.10b-10(d)(8).

A “profit-sharing relationship” means any ownership or other type of affiliation under which the broker or dealer, directly or indirectly, may share in any profits that may be derived from the execution of non-directed orders.

See

17 CFR 242.600(b)(56).

Rule 606(b) currently requires every broker-dealer to provide customers, upon request, specific information about the routing of their orders. Specifically, upon request, every broker-dealer shall: (1) Disclose to its customer the identity of the venue to which the customer's orders were routed for execution in the six months prior to the request, whether the orders were directed orders or non-directed orders, and the time of the transactions, if any, that resulted from such orders; and (2) notify customers in writing at least annually of the availability of this information upon request.

B. Changes in Order Handling Practices

U.S. equity market structure has changed significantly since the adoption of Rule 606. Today it is highly automated, dispersed among myriad trading centers, and more complex than it was in 2000.

The primary drivers of this market transformation have been the rapid and ongoing evolution of technologies for generating, routing, and executing orders, and the impact of regulatory changes.

In 2000, a large proportion of order flow in listed equity securities was routed to a few, mostly manual, trading centers, and it was rare that such orders would be re-routed to other venues.

In contrast, today, trading in the U.S. equity markets is spread among a number of highly automated trading centers: 12 registered exchanges, more than 40 ATSs,

and over 200 over-the-counter (“OTC”) market-makers,

and the routing and re-routing of orders to multiple venues is common. These venues offer a wide range of services and pricing structures that are designed to attract different types of market participants with varying trading needs.

See

Concept Release on Equity Market Structure,

supra

note 2, at 3594.

See also

Regulation SCI Adopting Release,

supra

note 2, at 72397.

See

Concept Release on Equity Market Structure,

supra

note 2, at 3594 (“Changes in market structure also reflect the markets' response to regulatory actions such as Regulation NMS, adopted in 2005, the Order Handling Rules, adopted in 1996, as well as enforcement actions, such as those addressing anti-competitive behavior by market makers in NASDAQ stocks”).

See

Fragmentation Release,

supra

note 17.

Data compiled from Forms ATS-R filed with the Commission as of the end the fourth quarter of 2014.

More than 200 broker-dealers (excluding ATSs) have identified themselves to the Financial Industry Regulatory Authority (“FINRA”) as market centers that must provide monthly reports on order execution quality under Rule 605 of Regulation NMS (list

available at

http://apps.finra.org/datadirectory/1/marketmaker.aspx

See

Concept Release on Equity Market Structure,

supra

note 2, at 3594.

According to a staff report published in 1994, prior to the emergence and growth of electronic markets, institutional customers would rely primarily on exchange floor brokers or upstairs block positioners to execute their large orders.

Typically, exchange floor brokers or upstairs block positioners would negotiate large trades off the exchange (often referred to as “upstairs”) and subsequently execute or “print” on the exchange—subject to auction market procedures allowing the limit order book or the trading crowd to participate in the trade and exposing the order to the market.

The nature of floor trading activity and upstairs block positioning allowed broker-dealers to manually exercise judgment and expertise to achieve best execution, and typically involved strategies that were designed to conceal information about an institutional customer's trading interest to potential counterparties to

minimize price impact.

See

Division of Market Regulation, SEC, Market 2000: An Examination of Current Equity Market Developments, at II-14 (January 1994).

Id.

at II-14-15.

In today's electronic markets, however, the manual handling of institutional orders is increasingly rare, and has been replaced by sophisticated institutional order execution algorithms and smart order routing systems. These sophisticated algorithms and systems decide the timing, pricing, and quantity of orders routed to the various trading centers.

Broker-dealers often use order execution algorithms to divide a large “parent” order of an institutional customer into many smaller “child” orders, and route the child orders over time to different trading centers in accordance with a particular strategy.

Such algorithms may be “aggressive,” and generally seek to take liquidity quickly at many different trading centers, or they may be “passive,” and generally submit resting orders at one or more trading centers and await executions at favorable prices, or they may be “neutral,” and seek to take liquidity or submit resting orders depending on market conditions.

In addition, some broker-dealers utilize indications of interest to notify external liquidity providers of trading interest at that broker-dealer.

See, e.g.,

Terrence Hendershott, Charles Jones, and Albert Menkveld,

Does Algorithmic Trading Improve Liquidity,

66 Journal of Finance 1 (February 2011).

See

Concept Release on Equity Market Structure,

supra

note 2, at 3602.

See id.

C. Need for Enhanced Disclosures for Institutional Orders

1. Market Complexity

Institutional customers have long focused on the execution quality of their large orders, and the potential impacts from information leakage and conflicts of interest faced by their broker-dealers. While there is some indication that enhancements to electronic order routing systems and processes generally have led to improved execution quality in many cases,

the operation of order routing systems and processes often is opaque to customers placing institutional orders, who may not have sufficient information to understand how, where, and why their orders are routed to specific venues, and whether particular order routing and execution strategies, whether or not selected by

the customer, are consistent with the customer's expectations.

See, e.g.,

Letter to Secretary, Commission, from Greg O'Connor, Compliance Manager, Wolverine Trading, LLC, dated April 21, 2010 (“Wolverine Trading Letter”), at 5 (stating that technological advancements have led to improved markets and executions as indicated by tighter spreads, lower trading costs, and more liquidity).

See also

Thierry Foucault and Albert J. Menkveld,

Competition for Order Flow and Order Routing Systems,

63 Journal of Finance 119, 121 (February 2008) (discussing that utilization of smart order routers reduces the incidence of trade-throughs and may encourage provision of liquidity).

As noted above, at the time of adoption of Rule 606, institutional orders generally were handled by an exchange floor broker or upstairs block positioner. The risks of information leakage and broker-dealer conflicts of interest existed with manual order handling, but because the execution alternatives were fewer and simpler, less data was necessary for institutional customers to evaluate those risks and evaluate broker-dealer performance. Now, however, because of the complexity of order execution algorithms and smart order routing systems, and the wide variety of venues to which broker-dealers may route institutional orders or send actionable indications of interest, access to data is important for institutional customers to assess the impact a broker-dealer's order routing strategies may have on the quality of their executions and the risks presented by any resulting information leakage or broker-dealer conflicts of interest.

Institutional customers increasingly have been expressing concerns regarding the difficulty in obtaining and comparing certain information across broker-dealers and venues, and understanding how their institutional orders are handled by broker-dealers, and have called for enhanced order handling disclosures.

Institutional customers have cited concerns, among other things, about the extent to which broker-dealer routing decisions are influenced by incentives offered by trading centers to attract order flow, that inefficiencies in order execution algorithms and smart order routing systems may lead to information leakage, and that the complexity and opacity of order routing practices frustrate the ability to monitor execution quality. Importantly, a variety of other market participants, including broker-dealers, also have expressed support for enhanced and consistent disclosure of institutional order handling information.

See

Associations Letter,

supra

note 5, at 2.

The Commission received letters addressing these issues in response to requests for comment on the Concept Release on Equity Market Structure,

supra

note 2 (comment letters

available at

http://www.sec.gov/comments/s7-02-10/s70210.shtml

See

Letters to Secretary, Commission, from Christopher Nagy, CEO, and Dave Lauer, President, KOR Group LLC, dated September 23, 2014 (“KOR Trading Letter II”), at 1-2 (stating Rule 606 is severely outdated, has no coverage of large orders, and should be updated to cover all orders); from Richie Prager, Managing Director, Head of Trading & Liquidity Strategies, et al., BlackRock, Inc., dated September 12, 2014 (“BlackRock Letter”), at 3 (stating broker-dealers should be required to provide periodic standardized reports on order routing and execution metrics to both retail and institutional investors); from Christopher Nagy, CEO, and Dave Lauer, President, KOR Trading LLC, dated April 4, 2014 (“KOR Trading Letter I”), at 2 (stating Rule 606 has become increasingly outdated as a result of the increasing complexity of order-types as well as the speed of routing and routing practices and Rule 606 should be updated to cover 100% of order flow received, including block transactions); from Kimberly Unger, Esq., Executive Director, Security Traders Association of New York, Inc., dated April 30, 2010 (“STA Letter”), at 8 (stating that since the adoption of Rule 606 in 2000, technological advancements have made some of the measurements in the Rule less meaningful and suggesting that 606 metrics be reviewed, amended, and updated, as needed); NASDAQ Letter,

supra

note 19, at 20 (stating Rule 606 has lagged behind technological advances that enhance market quality, which consequently renders the metrics utilized in Rule 606 less useful to investors, and further suggesting new metrics for inclusion on reports and refinements to current metrics); from Ann Vlcek, Managing Director and Associate General Counsel, Securities Industry and Financial Markets Association, dated April 29, 2010 (“SIFMA Letter I”), at 13 (stating that the Commission should direct broker-dealers to provide institutional clients with standardized execution venue statistical analysis reports); from O. Mason Hawkins, Richard W. Hussey, Deborah L. Craddock, Jeffrey D. Engelberg, and W. Douglas Schrank, Southeastern Asset Management, Inc., dated April 28, 2010 (“SAM Letter”), at 7 (stating increased complexity in the marketplace has clouded order handling to the point where even educated customers are not completely confident as to how or why their orders are routed to specific venues in a specific way); from Janet M. Kissane, SVP—Legal & Corporate Secretary, Office of the General Counsel, NYSE Euronext, dated April 23, 2010 (“NYSE Euronext Letter”), at 12, Appendix I at 3-4 (stating that U.S. equity market structure has changed substantially resulting in Rule 606 becoming outdated, and that Rule 606 reports do not capture information concerning block transactions and that the rule should be amended to include such information); Wolverine Trading Letter,

supra

note 39, at 4 (stating that the firm believes information currently required by Rule 606 reports is not as meaningful in the context of today's markets and that Commission staff should determine the types of statistics to add in order to improve usefulness of the reports); from Dan Mathisson, Managing Director, Credit Suisse Securities (USA) LLC, dated April 21, 2010 (“Credit Suisse Letter”), at 9 (stating that equity markets have changed unequivocally since 2000 when Rule 606 was adopted resulting in a need to update the Rule 606 reports); from Karrie McMillan, General Counsel, Investment Company Institute, dated April 21, 2010 (“ICI Letter”), at 8 (stating that currently institutional investors do not have ready access to complete information about their orders and the Commission should consider means to require new disclosures or enhance existing disclosures); from Michael Gitlin, Head of Global Trading, T. Rowe Price Associates, Inc.; David Oestreicher, Chief Legal Counsel, T. Rowe Price Associates, Inc.; and Christopher P. Hayes, Sr. Legal Counsel, T. Rowe Price Associates, Inc., dated April 21, 2010 (“T. Rowe Price Letter”), at 3 (supporting interest in revamping Rule 606 reports to provide additional data related to trading volumes and venues to both large and small investors); from Jennifer S. Choi, Assistant General Counsel, Investment Adviser Association, dated April 20, 2010 (“IAA Letter”), at 4 (stating the exclusion of large orders from Rule 606 reports limits the value of such reports to institutional investors); from Seth Merrin, Chief Executive Officer, Liquidnet; Howard Meyerson, General Counsel, Liquidnet; and Vlad Khandros, Corporate Strategy, Liquidnet, dated March 26, 2010 (“Liquidnet Letter”), at 2 (stating that institutional and retail investors do not have sufficient information regarding how their orders are handled, and empowering institutional traders with appropriate disclosures regarding the handling of large orders will empower institutions to make the best decisions for their customers). The Commission also received one letter relevant to this proposal in response to requests for comment on Securities Exchange Act Release No. 76474 (November 18, 2015), 80 FR 80997 (December 28, 2015) (File No. S7-23-15) (“NMS Stock ATS Proposing Release”) (comment letter

available at

http://www.sec.gov/comments/s7-23-15/s72315.shtml

See

Letter to Secretary, Commission, from David M. Weisberger, Managing Director, Markit, dated April 15, 2016 (“Markit Letter”), at 6-7 (stating order routing statistics required under Rule 606 should be enhanced to include basic metrics of execution quality for all categories of executed orders, separately report on routed and executed orders broken down by marketability, report on unexecuted routed orders, quantify net fees paid and rebates received by marketability category, and standardize the interpretation of “directed order”). A discussion of the letters relevant to this proposal is below.

See infra

Section II.F.

In the absence of a Commission rule, some institutional customers today have taken steps to acquire more information about the nature and number of venues to which their orders are routed or exposed.

For example, some institutional customers, using detailed questionnaires, request and receive information regarding order routing strategies used by their broker-dealers and the venues to which their broker-dealers route orders. In addition, more sophisticated institutional customers often request and receive granular data about the handling of individual orders.

The level of detail of the information provided by broker-dealers tends to vary depending on both the broker-dealer and the particular institutional customer, some of which may have the ability and desire to digest and evaluate voluminous individual order handling information and some of which may not. Of concern to the Commission, however, is the risk that some smaller institutional customers may not have the bargaining power to demand relevant order handling information from their broker-dealers. The Commission also understands that while some broker-dealers are willing and able to provide order handling information, the non-standardized and non-transparent nature of the data limits its effectiveness. Moreover, from the standpoint of the broker-dealers, responding to different institutional customers could be time-consuming and costly, as the broker-dealers typically need to prepare custom responses to

different questions from each institutional customer who requests order handling information.

Accordingly, the Commission preliminarily believes that by requiring standardization of such reports, order handling data could potentially be generated in a more efficient and cost-effective manner, and provided as a matter of course to the benefit of all institutional customers.

See

Associations Letter,

supra

note 5, at 2.

See, e.g.,

Memorandum from the Division of Trading and Markets regarding a March 4, 2011, meeting with representatives of Morgan Stanley with regard to the Concept Release on Equity Market Structure, dated May 7, 2011 (“TM Memo re Morgan Stanley I”).

The Commission acknowledges that some institutional customers, particularly those that are larger and more sophisticated, may continue to request a customized report, even with the availability of standardized reports. The Commission understands that broker-dealers may respond to such requests for competitive reasons or provide such benefits as a service to its customers. Accordingly, the potential cost and time savings benefits of standardized reports would be reduced for these broker-dealers.

2. Assessing Best Execution

Broker-dealers have a variety of types of institutional customers that use their order routing services, including pension funds, mutual funds, investment advisers, insurance companies, investment banks, and hedge funds.

Due to the large size in which they trade, institutional customers generally are focused on ensuring that their broker-dealers are achieving best execution for their orders. Broker-dealers are legally required to obtain best execution of all customers' orders.

FINRA rules specifically require FINRA members to use reasonable diligence to ascertain the best market for the security, and to buy or sell in that market so that the resultant price to the customer is as favorable as possible under prevailing market conditions.

Under FINRA's rules, some of the factors a FINRA member must consider in determining whether it has used “reasonable diligence” are: (1) The character of the market for the security, such as the price, volatility, relative liquidity, and pressure on available communications; (2) the size and type of transaction; (3) the number of markets checked; (4) the accessibility of the quotation; and (5) the terms and conditions of the order which result in the transaction.

See supra

note 1.

A broker-dealer's duty of best execution derives from common law agency principles and fiduciary obligations, and is incorporated in self-regulatory organization rules and, through judicial and SEC decisions, the antifraud provisions of the federal securities laws.

See

Regulation NMS Adopting Release,

supra

note 16, at 37538. FINRA has codified a duty of best execution into its rules.

See

FINRA Rule 5310. Accordingly, violations by a broker of its duty of best execution expose the broker to potential liability under the antifraud provisions of the Exchange Act as well as potential discipline under applicable self-regulatory organization rules.

See

FINRA Rule 5310(a)(1) (Best Execution and Interpositioning).

Id.

Some institutional customers have direct relationships with their broker-dealers, whereas other institutional customers, such as mutual funds and pension funds, often employ investment advisers to buy and sell securities on their behalf. Investment advisers are fiduciaries to their clients (

e.g.,

mutual funds, pension funds) and have an obligation to act in the best interests of their clients.

Several obligations flow from an investment adviser's fiduciary duties, including, among other things, the obligation to seek best execution of clients' transactions where the investment adviser has the authority to select broker-dealers to execute client transactions.

As discussed above, however, the Commission preliminarily believes it has become more challenging in today's highly automated, complex, and dispersed markets for institutional customers and their advisers, in the absence of additional, standardized disclosure, to monitor the extent to which their broker-dealers are achieving best execution.

See, e.g.,

Section 206(2) of the Investment Advisers Act of 1940 that prohibits an investment adviser from engaging in any transaction, practice, or course of business, which operates as a fraud or deceit upon any client or prospective client. As such, investment advisers must act in “utmost good faith,” provide full and fair disclosure of all material facts, and employ reasonable care to avoid misleading clients and prospective clients.

SEC

Capital Gains Research Bureau, Inc.,

375 U.S. 180, 194, 201 (1963).

See

Interpretive Release Concerning the Scope of Section 28(e) of the Securities Exchange Act of 1934 and Related Matters, Securities Exchange Act Release No. 23170 (April 23, 1986). An investment adviser must seek to obtain the execution of client transactions in such a manner that the client's total cost or proceeds are the most favorable under the circumstances. In particular, when seeking best execution, an adviser should consider the full range and quality of a broker's services when selecting broker-dealers to execute client trades, including, among other things, the broker's execution capability, commission rate, financial responsibility, responsiveness to the adviser, and the value of any research provided.

See id.

See also

Delaware Mgmt. Co.,

43 SEC 392, 396 (1967).

Today, broker-dealers are not required by rule to disclose specific order handling information regarding institutional orders. Instead, as noted above, the order handling information obtained by institutional customers is the subject of individualized negotiations with their broker-dealers, with the result that only a subset of institutional customers obtain order handling information and the scope of the information received varies widely. Accordingly, institutional customers and their advisers today monitor broker-dealers for best execution with substantially different levels of information, and potentially with varying degrees of effectiveness. For example, larger institutional customers may be better able to leverage their market size and position to obtain more detailed and complete disclosures from their broker-dealers, whereas smaller institutional customers may lack sufficient bargaining power to do so.

The Commission preliminarily believes that requiring enhanced order handling disclosures for all institutional orders would not only place small institutional customers on a more level playing field with large institutional customers, but also would create a uniform baseline for all institutional customers to obtain information on how large orders are handled. Widespread institutional access to standardized information could help institutional customers to more effectively assess the performance of their broker-dealers in handling their orders. This, in turn, could help improve the quality of broker-dealer routing practices, by, among other things, introducing more competitive forces so that broker-dealers are actively competing with each other to offer routing services that minimize information leakage and mitigate conflicts of interest.

3. Conflicts of Interest

The Commission has recognized that in a market structure with many competing trading centers, broker-dealers play a critical role in deciding where to route a customer's non-directed orders.

The Commission also has noted that a competitive environment may spur a trading center to offer economic incentives to broker-dealers to induce the routing of order flow to that trading center.

The Commission has recognized that broker-dealer order routing practices can significantly affect the competition among markets, and in adopting Rule 606 noted that the purpose of requiring disclosures concerning the relationships between a broker-dealer and the venues to which it routes orders was to inform customers to potential conflicts of interest that may influence the broker-dealer's order routing practices.

The Commission further explained that providing quantitative data to customers would provide them a clearer

understanding of a broker-dealer's order routing practices.

While these previous statements were made in the context of retail order routing, the Commission preliminarily believes they are equally applicable to institutional order routing in today's equity market.

See

Fragmentation Release,

supra

note 17, at 10582.

Id.

See

Rule 606 Predecessor Adopting Release,

supra

note 15, at 75427. The Commission has historically taken a disclosure-based approach when addressing conflicts of interest that arise from economic and other incentives provided to broker-dealers to induce the routing of order flow to a trading center, rather than prohibiting such incentives.

See, e.g.,

id.

See id.

There are a number of potential conflicts of interest that arise for broker-dealers in the handling of institutional orders that may influence their order routing practices. One potential conflict of interest a broker-dealer may face in the handling of institutional orders involves the different pricing structures of trading centers. A prevalent pricing model in the current market structure is the so-called “maker-taker” model, which involves the use of access fees and rebates.

To incentivize market participants to provide liquidity, a trading center employing a maker-taker fee structure generally pays a per-share rebate to its members or participants to encourage them to display non-marketable liquidity-providing orders on its limit order book. If an execution occurs, the broker-dealer placing the liquidity-providing order (the “maker”) generally receives a rebate. In contrast, the marketable order that removes liquidity (the “taker”) generally is charged a slightly higher fee, to fund the rebate to the maker and provide a profit for the trading center.

See, e.g.,

Memorandum from the SEC Division of Trading and Markets to the SEC Equity Market Structure Advisory Committee (October 20, 2015) (“Maker-Taker Memo”),

available at

https://www.sec.gov/spotlight/emsac/memo-maker-taker-fees-on-equities-exchanges.pdf

See also

Stanislav Dolgopolov,

The Maker-Taker Pricing Model and Its Impact on Securities Market Structure,

8 Va. L. & Bus. Rev. 231, 232-33 (June 27, 2014) (“Dolgopolov”),

available at

http://bit.ly/1mfme9M

In contrast to the widespread typical maker-taker model described above, a few trading venues have adopted an inverted taker-maker pricing model, in which market participants are

assessed

a fee to provide liquidity in securities and provided a rebate to remove liquidity in securities.

See, e.g.,

NASDAQ OMX BX Fee Schedule (as of September 2015).

Broker-dealers that are members of an exchange or participants of an ATS with a maker-taker model pay fees to, and receive rebates from, the venue for each order, including an institutional order, that is executed on it, but generally do not directly pass those fees or rebates back to their institutional customers.

In situations where a broker-dealer can earn a rebate or pay a lesser fee for routing its customer's orders to a particular venue, a conflict of interest may exist between the broker-dealer's duty of best execution and its own direct economic interest.

Understanding how a broker-dealer manages this conflict of interest to ensure that its own self-interest does not compromise its best execution obligations is pertinent to institutional customers in evaluating execution quality.

See, e.g.,

Robert Battalio, Shane A. Corwin, and Robert Jennings,

Can Brokers Have it All? On the Relation between Make-Take Fees and Limit Order Execution Quality,

at 3 (March 31, 2015) (“Battalio, Corwin, and Jennings Paper”),

available at

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2367462

See, e.g.,

Maker-Taker Memo,

supra

note 55, at 16. Finance professors Robert Battalio, Shane Corwin, and Robert Jennings' analysis of selected market data has suggested that a significant number of retail firms route non-marketable orders to the venue offering the highest rebate, and do so in a manner that the authors felt might not be consistent with the brokers' duty of best execution.

See

Battalio, Corwin, and Jennings Paper,

supra

note 57, at 31. Payment for order flow, including payments made to retail brokers from wholesale broker-dealers, presents a similar conflict of interest. The sale of order flow has been described by some industry participants as a revenue center that permits firms to receive payments from market makers for such order flow when they would otherwise have to pay taker fees.

See, e.g.,

Letter to Joseph Dear, Chairman, Investor Advisory Committee, SEC from Joseph Saluzzi and Sal Arnuk, Partners and Co-founders, Themis Trading LLC, dated January 27, 2014,

available at

https://www.sec.gov/comments/265-28/26528-55.pdf

, at 2.

See, e.g.,

Maker-Taker Memo,

supra

note 55, at 18. This conflict may present itself despite the obligation of FINRA members to conduct a regular and rigorous review of their order routing to evaluate which trading venues offer the most favorable terms of execution, including execution price, execution speed, and the likelihood that the trade will be executed.

See, e.g.,

FINRA Rule 5310, Supplementary Material .09(b).

For example, with respect to non-marketable orders, the trading centers that pay the highest rebate for providing liquidity generally charge the highest fee for removing liquidity.

These venues are generally lower on the routing table

for broker-dealers seeking to remove liquidity due to the high take fee.

Thus, if a broker-dealer places an order seeking to provide liquidity at such a venue, the order may not receive an execution (or receive an execution only when the market moves against the order) due to the venue's low position on routing tables for removing liquidity because of the venue's high take fee. High rebate venues also are likely to attract a large number of non-marketable orders, so that the customer queue position, and likelihood of execution, may be lower than on low rebate venues.

See, e.g.,

Maker-Taker Memo,

supra

note 55, at 18.

Routing table refers to a broker-dealer's automated process for determining the specific trading venues to which a broker-dealer routes orders and the sequence in which the orders are routed.

See, e.g.,

Battalio, Corwin, and Jennings Paper,

supra

note 57, at 1; Maker-Taker Memo,

supra

note 55, at 18.

A similar conflict of interest may exist for marketable orders.

Broker-dealers may seek to minimize trading costs by first routing orders to trading centers with the lowest take fees. However, these venues are likely to offer liquidity providers relatively low rebates so the available liquidity may be less than at a high rebate venue. Accordingly, the liquidity available to a marketable order routed to a low rebate venue may offer less size or fewer opportunities for price improvement than may be available at high rebate venues. Even where the broker-dealer ultimately routes a marketable order to other high take fee venues, prices can move quickly in today's highly automated, electronic markets, and broker-dealers may miss trading opportunities for an institutional customer by prioritizing low take fee venues in their routing tables.

See, e.g.,

Maker-Taker Memo,

supra

note 55, at 19.

Another potential conflict of interest may arise when a broker-dealer internalizes order flow,

routes order flow to affiliated venues, or routes order flow to venues with which it has payment for order flow arrangements. While constrained by its best execution obligation, a broker-dealer still may be incentivized to internalize customer order flow or route to an affiliated venue so that it can benefit from the execution by, among other things, capturing the trading profits or transaction fees. Internalization or execution at affiliated venues, however, may not offer the most favorable terms of execution. Likewise, a broker-dealer may be incentivized to first route customer order flow to venues with which it receives payment for order flow. Again, execution at such venues may not maximize the best execution opportunities of institutional orders. Accordingly, opportunities for internalization, or execution at affiliated venues or those with which the broker-dealers has payment for order flow arrangements, create additional potential conflicts of interest between the broker-dealer's duty of best execution and its own direct economic interest.

Internalization is the process in which a broker-dealer fills an order to buy a security from its own inventory, or fills an order to sell by taking a security into its inventory.

The Commission notes that it recently proposed amendments to the regulatory requirements in Regulation ATS of the Exchange Act applicable to certain ATSs that would require detailed public disclosures about the trading operations of the ATS and the activities of the broker-dealer that operates the ATS and its affiliates.

See

NMS Stock ATS Proposing Release,

supra

note 41.

As discussed further below, the Commission preliminarily believes

these conflicts of interest could be better evaluated if institutional customers had access to additional information about their broker-dealers' order handling practices.

4. Information Leakage

The Commission has acknowledged “the need of investors executing large size trades to control the information flow concerning their transactions.”

Executing a large order in today's complex electronic markets poses many of the same issues and risks for institutional customers as existed in the manual markets they replaced, but also poses new challenges because of the variety of ways in which information leakage can occur in today's equity market structure. As a result, it continues to be challenging for institutional customers to trade in large size while minimizing the risks from information leakage. As noted above, institutional customers historically would use exchange floor brokers or upstairs block positioners to execute large orders.

In today's electronic markets, however, the manual handling of institutional orders is increasingly rare, and has been replaced by sophisticated institutional order execution algorithms and smart order routing systems. At the same time, sophisticated market participants closely monitor order and execution activity throughout the markets, looking for patterns that signal the existence of a large institutional order, so that they can use that information to their trading advantage.

See

Securities Exchange Act Release No. 60997 (November 13, 2009), 74 FR 61208, 61219 (November 23, 2009) (“Regulation of Non-Public Trading Interest Proposing Release”). For example, Rule 604(b) of Regulation NMS exempts specialists and over-the-counter market makers from displaying customer block size orders.

See

17 CFR 242.604(b)(4). A block size order is an order of at least 10,000 shares or for a quantity of stock having a market value of at least $200,000. 17 CFR 242.600(b)(9).

See supra

notes 34-35 and accompanying text.

Each time an order is routed to a venue, and each time an actionable indication of interest is sent to a market participant, information is revealed about that order and the potential existence of a larger institutional order from which it may be derived. Accordingly, broker-dealers must balance the need to sufficiently expose the customer's trading interest to achieve execution, with the risk that such exposure might cause prices to move in a less favorable direction to the detriment of execution quality. Indeed, institutional customers have expressed concern that excessive routing

of their orders may increase the risk of information leakage without a commensurate benefit to execution quality.

Because information leakage may lead to higher execution costs for large size orders, the Commission preliminarily believes that additional disclosure would inform investors as to whether a broker-dealer's order routing strategy is potentially resulting in excessive routing and information leakage. As noted above, the Commission preliminarily believes that institutional order handling now has become more susceptible to the type of standard disclosures originally contemplated by Rule 606, and technological developments have made it easier for broker-dealers to produce it. Accordingly, standardized order handling disclosures should improve the ability of institutional customers to assess the potential risk of information leakage of their orders through a more detailed assessment of the number and types of venues to which their broker-dealers are routing their orders or transmitting actionable indications of interest, and the quality of executions that result therefrom.

In this context, excessive routing occurs when an order is routed more than may be necessary to obtain full execution of the order. Each additional route of an order reveals information about that order.

See, e.g.,

Jacob Bunge,

A Suspect Emerges in Stock-Trade Hiccups: Regulation NMS,

Wall Street Journal, January 27, 2014 (“Bunge Article”),

available at

http://www.wsj.com/articles/SB10001424052702303281504579219962494432336

(noting that in order to purchase 2.5 million shares of a stock, an institutional investor's brokers had to offer to purchase 750 million shares of the stock).

The Commission preliminarily believes that the amendments to Rule 606 it is proposing today would help institutional customers more efficiently and effectively operate in the current equity market structure. As discussed in more detail below, the required disclosures would provide standardized information for institutional customers so that they can better: (1) Discern where their orders are exposed, routed, and executed; (2) assess their broker-dealers for best execution by examining order execution statistics; (3) monitor conflicts of interest of their broker-dealers with the additional financial incentives disclosures; and (4) assess information leakage with the routing of their orders.

D. Need for Public Reporting of Aggregated Institutional Order Information

As discussed above, there are no legal requirements for a broker-dealer to disclose institutional order handling information to its customers, either privately or publicly. The Commission preliminarily believes that the dearth of public information about each broker-dealer's institutional order handling practices may make efficient and effective comparisons about the nature and quality of services offered by broker-dealers more difficult. Without required public disclosure of aggregated institutional order handling information, institutional customers do not have information that could be used to evaluate, among other things, the venues to which broker-dealers route orders, the execution quality achieved at such venues, and the overall fees paid and rebates received for such executions. Public information on a broker-dealer's institutional order handling practices could both assist institutional customers in selecting one or more broker-dealers for order routing services and foster increased competition among broker-dealers to provide order routing services. Indeed, if institutional order handling information were publicly available to review and analyze, the Commission preliminarily believes that additional competitive forces could be brought to bear on broker-dealer institutional order routing services, thereby potentially enhancing the quality of such services.

In adopting Rule 606 in 2000, the Commission stated that public disclosure of order execution and order routing information could provoke more vigorous competition on execution quality and order routing performance.

See

Rule 606 Predecessor Adopting Release,

supra

note 15, at 75417.

E. Need for Enhanced Disclosures for Retail Orders

As discussed above, the U.S. equity markets have evolved in recent years to become more automated, dispersed, and complex, and the resulting competition among trading centers has intensified practices to attract order flow, including retail order flow. Historically, trading centers have offered payment for order flow or other financial inducements to broker-dealers based upon whether the retail order flow is marketable or non-marketable. As a result, broker-dealers generally handle marketable and non-marketable retail orders differently. Indeed, whether a retail order is marketable or non-marketable will often determine where the broker-dealer routes the order. Certain broker-dealers route a large portion of marketable retail orders to OTC market makers with whom they have payment for order flow or other arrangements.

Non-

marketable retail orders, on the other hand, are more frequently routed to exchanges with a “maker-taker” fee schedule, to capture a rebate when the non-marketable order is executed.

See

Concept Release on Equity Market Structure,

supra

note 2, at 3606 (noting that Rule

606 statistics reveal that brokers with significant retail customer accounts send the great majority of non-directed marketable orders to OTC market makers that internalize executions, often pursuant to payment for order flow arrangements).

As an example, during a fiscal quarter one large retail broker-dealer routed all non-marketable orders to one of two venues that “offered the highest rebates available in the market.”

See Conflicts of Interest, Investor Loss of Confidence, and High Speed Trading in U.S. Stock Markets: Hearing Before the Permanent Subcommittee on Investigations of the Committee on Homeland Security and Governmental Affairs,

U.S. Senate, 113th Cong. 48 (2014) (“Senate PSI Hearing”) (testimony of Steven Quirk, Senior Vice President, TD Ameritrade). In addition to fee incentives that may affect routing decisions, another reason non-marketable retail orders may be routed to exchanges is the requirements of Rule 604 of Regulation NMS. Rule 604 of Regulation NMS requires, among other things, exchange specialists and OTC market makers to immediately display in their bid or offer both the price and the full size of each customer limit order that would improve their quoted price in a particular security.

See

17 CFR 242.604.

Currently, Rule 606(a) does not require broker-dealers to segment their quarterly disclosures for limit orders between marketable and non-marketable orders. By only showing

aggregated

data on retail limit orders, customers have less visibility into the extent to which broker-dealers differentiate between marketable and non-marketable limit orders in their routing practices, and, if so, the potential impact of such practices. Accordingly, the Commission preliminarily believes that customers could better evaluate execution quality and potential conflicts of interest if broker-dealers were required to separately disclose more comprehensive information about how they route marketable and non-marketable limit orders to individual trading centers.

In addition, financial inducements to attract order flow from broker-dealers that handle retail orders have become more prevalent and for some broker-dealers such inducements may be a significant source of revenue.

The Commission understands that most broker-dealers that handle a significant amount of retail orders receive payment for order flow in connection with the routing of retail orders or are affiliated with an OTC market maker that executes the orders.

The Commission preliminarily believes that providing market participants with greater disclosure regarding the specific financial inducements received by a broker-dealer from various trading centers would enable market participants to better assess potential conflicts of interest its broker-dealers face when routing retail orders.

See, e.g.,

Bradley Hope and Julie Steinberg,

Payments to Big Brokers Under Fresh Scrutiny,

Wall Street Journal, June 13, 2014,

available at

http://blogs.wsj.com/moneybeat/2014/06/13/payments-to-big-brokers-under-fresh-scrutiny/

(stating that TD Ameritrade received $236 million in payment for order flow in 2013; that a spokesman for Charles Schwab Corporation estimated payment for order flow revenues of $100 million in 2013; and that E*Trade Financial Corporation stated in a regulatory filing it received $72.5 million in such revenues in 2013).

Id.

Under the quarterly disclosure obligations in current Rule 606(a), broker-dealers are required to discuss the material aspects of their relationship with each Specified Venue, including a description of any arrangement for payment for order flow or profit-sharing relationship. The current disclosure informs the market participants of a potential conflict of interest the broker-dealer may face, but the current rule does not require the broker-dealer to disclose specifics on the conflict, including financial inducements received from each Specified Venue, or transaction rebates received from exchanges and other trading centers.

The lack of detailed disclosure on the specifics of the financial inducements received from each Specified Venue make it more difficult for customers to assess a broker-dealer's management of any conflict of interest and the quality of its broker-dealer's routing and execution services.

See

Rule 606(a);

see also

Rule 606 Predecessor Adopting Release,

supra

note 15, at 75427.

Accordingly, the Commission preliminarily believes that requiring broker-dealers to report more detailed disclosure on the payments received and fees paid for marketable limit orders, non-marketable limit orders, and other order types at each Specified Venue would enable market participants to better assess the extent to which the broker-dealer is effectively managing the potential conflicts of interest, as well as the quality of their broker-dealer's retail order routing and execution services. The Commission also preliminarily believes that the description of any payment for order flow arrangements and profit-sharing relationships required to be disclosed in the quarterly report should be more comprehensive. As such, the Commission preliminarily believes that it would be appropriate to require broker-dealers to describe in their quarterly disclosure any terms of payment for order flow arrangements and profit-sharing relationships with each Specified Venue that may influence their order routing decisions.

Separately, in adopting Rule 606, the Commission required that retail routing reports be divided into three separate sections for NMS stocks listed on: NYSE, NASDAQ, and American Stock Exchange LLC.

The listing markets are now dominated by electronic trading and the handling of NMS stocks no longer varies materially based on the primary listing market.

As such, the Commission preliminarily believes that the requirement to separate the retail routing reports by primary listing market is outdated and does not provide useful information to customers. Accordingly, the Commission preliminarily believes that requiring retail routing reports to disclose the required information for NMS stocks as a whole would better inform market participants about the manner in which retail orders are routed in today's markets and should simplify the burdens to comply with the rule.

See

Rule 606 Predecessor Adopting Release,

supra

note 15. The American Stock Exchange is now known as NYSE MKT LLC. In October 2008, the American Stock Exchange LLC was renamed “NYSE Alternext US LLC.”

See

Securities Exchange Act Release No. 58673 (September 29, 2008), 73 FR 57707 (October 3, 2008) (SR-Amex-2008-62). In March 2009, NYSE Alternext US LLC was renamed “NYSE Amex LLC.”

See

Securities Exchange Act Release No. 59575 (March 13, 2009), 74 FR 11803 (March 19, 2009) (SR-NYSEALTR-2009-24). In May 2012, NYSE Amex LLC was renamed “NYSE MKT LLC.”

See

Securities Exchange Act Release No. 67037 (May 21, 2012), 77 FR 31415 (May 25, 2012) (SR-NYSEAmex-2012-32).

See

Letter to Secretary, Commission, from Manisha Kimmel, Managing Director, Financial Information Forum, dated October 22, 2014 (“FIF Letter”), at 3 (noting that with the introduction of automated trading centers and smart order routing as a result of Regulation NMS, order routing practices are no longer based on listing market).

F. Comments on Equity Market Structure

The Commission periodically has examined the regulatory regime for order routing disclosure. The Commission published the Concept Release on Equity Market Structure in 2010, which requested comment on a wide range of issues. Among the issues specifically highlighted for comment were: (1) Whether Rule 606 should be updated and, if so, in what respects; (2) whether Rule 606 reports continue to provide useful information for investors and their broker-dealers in assessing the quality of order execution and routing practices; (3) whether Rule 606 should be updated to address the interests of institutional customers in efficiently executing large orders and, if so, what metrics would be useful; (4) whether institutional customers have sufficient information about the smart order routing services and order execution algorithms offered by their broker-dealers; and (5) whether a regulatory initiative to improve disclosure of these broker-dealer services would be useful

and, if so, what type of initiative the Commission should pursue.

See

Concept Release on Equity Market Structure,

supra

note 2.

The Commission received twenty-eight comment letters

that directly addressed order routing disclosures. The commenters provided a wide range of recommendations and many commenters made multiple recommendations regarding order routing disclosures.

See

Letters to Secretary, Commission, from Michael J. Friedman, General Counsel & Chief Compliance Officer, Trillium, dated November 7, 2014 (“Trillium Letter”); from Theodore R. Lazo, Managing Director and Associate General Counsel, SIFMA, dated October 24, 2014 (“SIFMA Letter II”); Associations Letter,

supra

note 5; KOR Trading Letter II,

supra

note 41; FIF Letter,

supra

note 77; BlackRock Letter,

supra

note 41; from Micah Hauptman, Financial Services Counsel, Consumer Federation of America, dated September 9, 2014 (“CFA Letter”); KOR Trading Letter I,

supra

note 41; from Senator Edward E. Kaufman, United States Senate, dated August 5, 2010 (“Kaufman Letter”); from Greg Tusar, Managing Director, Goldman Sachs Execution & Clearing, L.P and Matthew Lavicka, Managing Director, Goldman, Sachs & Co., dated June 25, 2010 (“Goldman Sachs Letter II”); from James J. Angel, Ph.D., CFA, Associate Professor of Finance, Georgetown University, McDonough School of Business, dated April 30, 2010 (“Angel Letter II”); STA Letter,

supra

note 41; NASDAQ Letter,

supra

note 19; SIFMA Letter I,

supra

note 41; SAM Letter,

supra

note 41; from Eric W. Hess, Esq., General Counsel for Direct Edge, dated April 28, 2010 (“Direct Edge Letter”); NYSE Euronext Letter,

supra

note 41; from Jonathan D. Corpina, President, Organization of Independent Floor Brokers; Jennifer Lee, Vice President, Organization of Independent Floor Brokers; and Stephen O'Shaughnessy, Director, Organization of Independent Floor Brokers, dated April 21, 2010 (“IFB Letter”); Wolverine Trading Letter,

supra

note 39; Credit Suisse Letter,

supra

note 41; ICI Letter,

supra

note 41; T. Rowe Price Letter,

supra

note 41; TD Ameritrade Letter,

supra

note 19; IAA Letter,

supra

note 41; from Alan R. Shapiro, President and Chairman, The Transaction Auditing Group, Inc., dated April 19, 2010 (“TAG Letter”); Liquidnet Letter,

supra

note 41; from James J. Angel, Associate Professor, McDonough School of Business, Georgetown University; Lawrence E. Harris, Fred V. Keenan Chair in Finance, Professor of Finance and Business Economics, Marshall School of Business, University of Southern California; Chester S. Spatt, Pamela R. and Kenneth B. Dunn Professor of Finance, Director, Center for Financial Markets, Tepper School of Business, Carnegie Mellon University, dated February 23, 2010 (“Angel Letter I”).

See also

TM Memo re Morgan Stanley I,

supra

note 43; Memorandum from the Division of Trading and Markets regarding a May 22, 2013, meeting with representatives of Morgan Stanley, dated May 22, 2013 (“TM Memo re Morgan Stanley II”); Memorandum from the Division of Trading and Markets regarding an October 1, 2015, meeting with representatives of Morgan Stanley, dated October 1, 2015 (“TM Memo re Morgan Stanley III”); Memorandum from the Office of Commissioner Walter regarding a June 30, 2010, meeting with representatives of the Managed Funds Association, dated July 19, 2010 (“Walter Memo”). The Commission also received one letter relevant to this proposal in response to requests for comment on the NMS Stock ATS Proposing Release,

supra

note 41.

See

Markit Letter,

supra

note 41.

1. General Need to Update Rule 606

A few commenters referred generally to existing drawbacks in Rule 606 and the need for improvements to Rule 606 without making specific recommendations. These commenters raised concerns regarding certain conflicts of interest present in order routing practices and the sufficiency of current disclosures under Rule 606, and stated that improvements to Rule 606 would provide more insight to investors and that the utility of Rule 606 was limited by a lack of disclosure.

Most commenters focused on specific recommendations to update various aspects of Rule 606.

See

IFB Letter,

supra

note 79, at 2 (questioning the existing inherent conflicts in the payment for order flow practice and asking whether disclosure requirements under existing Rule 606 are legally sufficient, and also noting that the required disclosures under Rule 606 do not shed light on fiduciary duties); Direct Edge Letter,

supra

note 79, at 2 (stating that “improvements to existing Rules 605 and 606 can be made to provide more detailed insight to investors”); TAG Letter,

supra

note 79, at 3 (stating “utility of the combination of Rules 605 and 606 to the individual investor is limited since the Rule 606 routing percentages coupled with the overall execution quality statistics in Rule 605 only give a general indication as to the results an individual investor can expect,” and “[r]outing information and the associated material aspects of the relationship concerning the broker's arrangements, if any, with the various trading centers to which they route does not provide sufficient data to assess and compare”).

2. Need for Rule 606 to be Modernized to Maintain Pace with Technological Advances

Many commenters cited technological changes in market structure as the basis for updating Rule 606.

These commenters touched upon the common theme that the disclosures required by Rule 606 had not kept pace with the technological advances that had taken place since the Rule's inception.

See, e.g.,

NASDAQ Letter,

supra

note 19, at 20-21 (noting that Rule 606 has “never been amended despite changes that have revolutionized trading and the national market system, including the advent of decimal trading, the demise of trading floors and other manual trading, proliferation of private linkages, adoption of Regulation NMS, refinement of smart routers, modernization of high frequency trading and automation of dark pools,” stating that 605 and 606 have “lagged behind technological advances that enhance market quality and consequently render the metrics utilized in Rule 605 and 606 less useful to investors,” and questioning whether Rule 606 continues “to provide the level of transparency necessary to exert meaningful pressure on market centers to provide superior execution quality and routing practices.”); NYSE Euronext Letter,

supra

note 41, at 12 (commenting that “as detailed in the Concept Release [on Equity Market Structure], the U.S. equity market structure has changed substantially and, as a result, we believe [Rule 606 has] become outdated”);

see also

KOR Trading Letter II,

supra

note 41, at 2, 5 (commenting that “[o]ver time and in particular with the adoption of Regulation NMS, [Rules 605 and 606] became increasingly outdated,” and that Rule 606 has “eroded due to the increasing complexity of order-types as well as speed and routing practices in today's marketplace”); BlackRock Letter,

supra

note 41, at 3 (commenting that “rising complexity in market structure has made the existing reporting inadequate”); CFA Letter,

supra

note 79, at 21 (stating “it is unreasonable to expect that given the changes in speed, technology, complexity, and dark trading in our markets, retail investors would ever utilize them productively”); KOR Trading Letter I,

supra

note 41, at 1 (noting that while outdated, Rule 606 serves as the only current means to analyze routing behavior); STA Letter,

supra

note 41, at 8 (commenting that “technological advances have made some of the measurements in the rule less meaningful” and suggesting that Rule 606 metrics be reviewed, amended, and updated, as needed); SIFMA Letter I,

supra

note 41, at 16 (commenting that in its current form, Rule 606 does not provide “useful and meaningful comparative information to market participants, particularly individual investors, or regulators, and that the [rule] should be either modified or rescinded in light of market developments”); SAM Letter,

supra

note 41, at 7 (noting that while order handling used to be a transparent and simple process, “transparency has been sacrificed in the name of technological advancement and the evolution of market microstructure,” and stating that the “enormous complexity introduced by this process has clouded order handling to the point where even educated customers are never completely confident how or why their orders are routed to specific venues in a specific way”); Wolverine Trading Letter,

supra

note 39, at 4 (noting that “the information currently required by [Rule 606] reports is not as meaningful in the context of today's markets” and that Commission staff should determine the types of statistics to add in order to improve usefulness of the reports); Credit Suisse Letter,

supra

note 41, at 9 (stating with regard to Rule 606 that “equity markets have unequivocally changed since 2000 when the rules were adopted, resulting in the need to update the reports,” and providing the example that “the shortest execution report time category in the reports is 0-9 seconds. In today's trading, where market centers have begun clocking their executions in microseconds (millionths of a second) because milliseconds (thousandths of a second) were too slow, categorizing a 9 second execution in the top speed category renders the reports less meaningful than intended”); ICI Letter,

supra

note 41, at 7 (noting that “complexities in the current market structure and the associated difficulties in assessing market performance for investors”); TM Memo re Morgan Stanley III,

supra

note 79 (noting that “Order Handling and Execution Disclosure Rules have not been updated to address technological advances”).

3. Requests for Specific Information and Standardized Disclosures

Most commenters identified specific metrics that broker-dealers should disclose, proposed model templates for disclosure, or called for disclosures to be made in a standardized fashion. Commenters generally requested additional information regarding order type usage and fill rates, marketable and non-marketable limit orders, and the use of indications of interest (“IOI”). Many commenters also requested more detailed disclosure of payment for order flow, including fees paid and rebates received.

See, e.g.

, Markit Letter,

supra

note 41, at 6 (Rule 606 statistics should be enhanced to include basic metrics of execution quality for all categories of executed orders, separately report on routed and executed orders broken down by marketability, and quantify net fees paid and rebates received by marketability category); Associations Letter,

supra

note 5, at Annex A (attaching proposed template for

enumerated, customer-specific institutional order routing disclosure); BlackRock Letter,

supra

note 41, at 3 (stating that revised Rule 605/606 “disclosures should provide greater transparency on marketable and non-marketable limit orders, order fill rates, sub-second execution horizons, pre-/post-trade price movement, alternative order type usage and total fees/rebates paid or received” and that such “metrics should also be available in a standardized template for individual customer activity, not just at an aggregate level by broker-dealer”); KOR Trading Letter I,

supra

note 41, at 5 (proposing a list of updates to Rule 606 including,

et al.

, information on marketable limit orders, total payments or charges to broker-dealers, reporting of the execution venue of all orders, and require average payments to be reported out to one one-hundredth of one penny (

i.e.

, four decimal places)); Goldman Sachs Letter II,

supra

note 79, at 10-11 (proposing disclosure of order routing information for orders that do not receive execution); Angel Letter II,

supra

note 79, at 7-9 (providing sample broker “report card” with eight metrics including percentage of orders executed inside the bid-ask spread); SAM Letter,

supra

note 41, at 7 (proposing eight categories of information that brokers/venues should disclose, including aggregate broker-level detail regarding specific venue market share based on both shares routed and shares executed and “payments, rebates, fees and fee breakpoints (all costs and payment for order flow arrangements) related to execution venues (routing broker or routing venue to venue)”); ICI Letter,

supra

note 41, at 7 (proposing the Commission require improved disclosure regarding order routing, including policies and procedures regarding the dissemination of information about a customer's order and trade information to facilitate a trade, including the use of IOIs, “external venues to which a broker routes, . . . the percentage of shares executed at each external venue, any ownership and other affiliations between the broker and any venues to which the broker routes orders,” and “payments and other incentives provided or received (such as rebates) to direct order flow to particular trading venues”); TD Ameritrade Letter,

supra

note 19, at 7-8 (recommending, among other things, that Rule 606 disclosures include order type categories for ” “Opening,” “Marketable Limit,” “Odd-lot,” “Mixed Lot,” “Stop Orders” and “IOC/IOI” and “Spreads” for Options,” and “require brokers that internalize order-flow to include additional disclosure of payments made and overall profitability generated by the internalizing subsidiary internalizing that order-flow”);

see also

Trillium Letter,

supra

note 79, at 3 (suggesting that “Rule 606(b) should be enhanced to simply require brokers to disclose the unabridged order logs of requesting customers”); SIFMA Letter II,

supra

note 79, at 13 (suggesting that the Commission should consider a rule to “require broker-dealers to publish on their Web sites, on a monthly basis, a standardized disclosure report that provides an overview of key macro issues that are of interest to clients, potentially including: (i) Venues accessed, (ii) order types used on exchanges, (iii) order types supported on the broker-dealer's ATS (if applicable), (iv) fill rates (including internalization numbers, if applicable), (v) location of ATS/co-location footprint, and (vi) market data structure”); FIF Letter,

supra

note 77, at 3 (suggesting that market open, market close, stop orders, and odd lots be removed from the “other” category and listed in their own categories); KOR Trading Letter II,

supra

note 41, at 2 (suggesting Rule 606 should be expanded to mandate uniform disclosure); CFA Letter,

supra

note 79, at 21 (suggesting the reporting metrics in Rule 606 “should be modernized to provide the most relevant information that will allow market participants, regulators, and third-party analysts to assess the quality of order execution practices”); TM Memo re Morgan Stanley II,

supra

note 79, PowerPoint at 6 (suggesting Rule 606 should be modified to require standardized reports providing an “order life cycle audit trail, not just ultimate execution or first route venue”); Walter Memo,

supra

note 79, at 50-51 (the MFA suggested that Rule 606 could be updated to require a brokerage firm to “provide statistics giving execution times along with the percentages of orders filled at the quote, better than the quote, and worse than the quote, for different size buckets including odd lots”); STA Letter,

supra

note 41, at 8 (suggesting a “standardized set of metrics which might include revised speed of execution data, linkages and access to markets and other measurable data the disclosure of which will provide investors and traders with adequate information upon which to make execution and routing decisions”); NYSE Euronext Letter,

supra

note 41, at Appendix I (suggesting that the “percentage of volume routed and executed internally by a broker-dealer should be indicated, and the criteria used in order routing decisions should be identified”); IAA Letter,

supra

note 41, at 3-4 (noting the format and the presentation of information in 606 reports make the information difficult to analyze); Liquidnet Letter,

supra

note 41, Annex F, at F-1 to F-3 (suggesting the Commission consider modifying Rule 606 reports to “include data on execution quality for orders received and handled by the routing broker, in particular, data regarding execution time and price improvement”); Kaufman Letter,

supra

note 79, at 6 (suggesting generally that “brokers should be required to provide detailed descriptions of their order-routing procedures, including information on payments and rebates received”); TM Memo re Morgan Stanley III,

supra

note 79 (including a proposed venue analysis template with enumerated, specific disclosures to be reported).

Some commenters expressed concern regarding information leakage and identified various metrics that could help customers determine whether a broker-dealer's routing strategy leaves orders vulnerable to information leakage.

Additionally, several industry commenters recommended disclosing separately routing statistics for marketable and non-marketable orders.

See, e.g.

, ICI Letter,

supra

note 41, at 8-9 (stating that broker-dealers should be required to disclose policies and procedures to control leakage of information regarding a customer's order and other confidential information and policies and procedures regarding the dissemination of information about a customer's order and trade information to facilitate a trade, including the use of indications of interest); Liquidnet Letter,

supra

note 41, at 2 (stating that if institutional investors are appropriately informed as to how broker-dealers route their orders, they will make the best decisions as to how their large orders should be handled).

See

BlackRock Letter,

supra

note 41, at 3 (stating that revised Rule 605/606 disclosures should provide greater transparency on, among other things, marketable and non-marketable limit orders and order fill rates); KOR Trading Letter I,

supra

note 41, at 5 (proposing a list of updates to Rule 606 including requiring disclosure of statistics on marketable limit orders and greater transparency around broker-dealer internal order routing practices and decisions); TD Ameritrade Letter,

supra

note 19, at 6-7 (proposing to change the order classification in Rule 606 disclosures to include, among other things “Marketable Limit”).

4. Requests for Specific Disclosures for Institutional Orders

A number of commenters recommended specific order routing disclosures for institutional customers or questioned the usefulness of the current disclosure requirements to retail or institutional customers given that large orders are excluded from the rule.

Many commenters called specifically for the disclosure of order routing information to institutional customers, noting in various ways that the existing Rule 606 disclosures do not cover large orders and as a result institutional customers may not receive meaningful information about how their orders are routed.

See

Associations Letter,

supra

note 5 (calling for customer-specific order routing disclosures for institutional investors); SIFMA Letter II,

supra

note 79, at 13 (stating that the Commission should require broker-dealers to provide standardized reports to institutional clients); KOR Trading Letter II,

supra

note 41, at 1 (stating that the public would be well served by “expanding Rule 606 to cover all orders and mandating uniform disclosure”); BlackRock Letter,

supra

note 41, at 3 (stating that “[b]roker-dealers should be required to provide periodic standardized reports on order routing and execution metrics to retail and institutional investors”); NYSE Euronext Letter,

supra

note 41, at 12 (noting that “Rule 606 reports do not capture information concerning large block transactions”); ICI Letter,

supra

note 41, at 10 (noting that Rule 606 was drafted primarily with the interests of individual investors in mind and large-sized orders are excluded from the rule); T. Rowe Price Letter,

supra

note 41, at 3 (opining that Rule 606 reports are “rarely used by institutional investors”); IAA Letter,

supra

note 41, at 4 (stating that the “exclusion of large orders in these [Rule 606] reports limits the value of these reports to institutional investors”); Liquidnet Letter,

supra

note 41, at 2 (stating that “[i]nstitutional and retail investors do not have sufficient information regarding how their orders are handled” and suggesting Rule 606 be modified to “[m]andate disclosure of specific order routing practices by institutional brokers”); TM Memo re Morgan Stanley III,

supra

note 79 (suggesting that broker-dealers should be required to “[p]rovide institutional clients with mandated transparency around order handling practices in today's environment” including an “objective and meaningful standardized venue analysis template”).

5. Comments on Actionable Indications of Interest

As noted above, some comments on the Concept Release on Equity Market Structure called for the disclosure of information relating to a broker-dealer's use of IOIs.

The Commission has considered these comments, in addition to comments noted above on the Regulation of Non-Public Trading Interest Proposing Release, and is proposing to define actionable IOI.

See

TD Ameritrade Letter,

supra

note 19, at 6 (stating that the order classification status should be changed to include IOIs); ICI Letter,

supra

note 41, at 8 (suggesting the Commission consider requiring disclosure of policies and procedures regarding the dissemination of information about a customer's order and trade information to facilitate a trade, including the use of “indications of interest” or “IOIs”); KOR Trading Letter II,

supra

note 41, at 1 (stating Rule 606 should be expanded to include information on IOIs on dark pools).

See infra

Section III.A.10.

As discussed below, the Commission proposes to define the term “actionable

indication of interest” (“actionable IOI”).

In 2009, the Commission proposed rules to regulate non-public trading interest,

which described characteristics of actionable IOI.

The Commission received a number of comment letters that addressed the characteristics.

Most of these commenters either noted in some form that the proposal did not expressly define “actionable IOI” or criticized the guidance.

A few of these commenters offered their own definitions or understanding of an actionable IOI.

See

proposed Rule 600(b)(1).

See

Regulation of Non-Public Trading Interest Proposing Release,

supra

note 66, at 61219. Among other things, the Commission proposed to amend the Exchange Act quoting requirements to apply expressly to actionable IOIs.

See id.,

at 61211.

“[A]n IOI would be actionable if it effectively alerted the recipient that the dark pool currently has trading interest in a particular symbol, side (buy or sell), size (minimum of a round lot of trading interest), and price (equal to or better than the national best bid for buying interest and the national best offer for selling interest).”

Id.,

at 61226.

See

Letters to Elizabeth M. Murphy, Secretary, Commission, from Senior Vice President—Legal & Corporate Secretary Office of the General Counsel, NYSE Euronext, dated February 22, 2010 (“NYSE Euronext IOI Letter”); from John A. McCarthy, General Counsel, GETCO, LLC, dated February 22, 2010 (“GETCO Letter”); from P. Mats Goebels, Managing Director and General Counsel, Investment Technology Group, Inc., dated February 22, 2010 (“ITG Letter”); from Vivian A. Maese, Esq., General Counsel and Corporate Secretary, BIDS Trading, LP, New York, New York, dated February 18, 2010 (“BIDS Trading Letter”); from Greg Tusar, Managing Director, Goldman Sachs Execution & Clearing, L.P. and Matthew Lavicka, Managing Director, Goldman Sachs & Co., dated February 17, 2010 (“Goldman Sachs Letter”); from Kimberly Unger, Esq., Executive Director, Security Traders Association of New York, Inc., New York, New York, dated February 17, 2010 (“STA IOI Letter”); from Patrick D. Armstrong, Co-President, Alliance of Floor Brokers, New York, New York, dated January 29, 2010 (“AFB Letter”); from Matthew K. Samelson, Principal, Woodbine Associates, Stamford, Connecticut, dated October 23, 2009 (“Woodbine Letter”).

See

NYSE Euronext IOI Letter,

supra

note 91, at 4 (stating that the Commission should provide clear guidance as to what constitutes an actionable IOI, perhaps in the form of a non-exclusive list of examples); ITG Letter,

supra

note 91, at 3 (stating that that the Commission should provide a more precise and predictable definition of “actionable IOI”); BIDS Trading Letter,

supra

note 91, at 2 (noting the uncertainty regarding the definition of an “actionable” IOI); Goldman Sachs Letter,

supra

note 91, at 2 (expressing concern that an explicit definition of actionable IOIs will not be sufficiently broad to encompass the evolving range of messaging and communications that might satisfy the definition of an actionable IOI); STA IOI Letter,

supra

note 91, at 2 (stating that the proposed guidance appears to deem an IOI actionable with specific mention of price, size, or side, and that such a definition is too broad); AFB Letter,

supra

note 91, at 2 (noting that the Commission's proposal does not specifically define “actionable IOI”); Woodbine Letter,

supra

note 91, at 2-3 (stating that the Commission's guidance on what constitutes an “actionable IOI” is not clear).

See

GETCO Letter,

supra

note 91, at 3 (actionable IOIs explicitly or implicitly convey information that there is actionable trading interest in a symbol); AFB Letter,

supra

note 91, at 2 (an actionable IOI is a bid or offer that can be accessed by one set of market participants that is not publicly disseminated).

The Commission has considered these comments discussed in this Section II.F., and, for the reasons set forth throughout this release, is proposing the amendments to Rules 600, 605, 606, and 607 as described herein. Moreover, as noted earlier, the Commission is proposing amendments to other rules to update cross-references as a result of this proposal.

III. Proposed Amendments to Rule 600, Rule 605, Rule 606, and Rule 607

A. Disclosures for Institutional Orders

The Commission proposes to amend Rule 606 to require a broker-dealer that receives institutional orders in NMS stocks to, upon request, provide customer-specific reports regarding the venues to which the institutional orders are either routed or exposed through an actionable IOI.

Such disclosures would provide a broad range of statistical data regarding the broker-dealer's handling of institutional orders, including order routing and execution information for those orders at each trading center in the aggregate and by order routing strategy. The disclosure of such information would provide customers with standardized information about institutional order routing and order execution quality and serve as a baseline for further analysis and comparison of broker-dealers. In addition, the disclosures would assist customers in reviewing order routing practices, assessing execution quality, managing potential conflicts of interest, and handling information leakage. The Commission preliminarily believes that increased, uniform transparency should assist customers in determining the quality of their broker-dealer's services.

See

proposed Rule 606(b)(3).

1. Definition of Institutional Order in Proposed Rule 600(b)(31)

Currently, Rule 606 of Regulation NMS limits the required public disclosure of a broker-dealer's order routing information to non-directed orders in NMS securities that are in amounts less than (i) $200,000 for NMS stocks, and (ii) $50,000 for option contracts.

In proposing Rule 606, the Commission discussed the thresholds in connection with its proposed definition of “customer order”

and noted that “[l]arge orders are excluded in recognition of the fact that statistics for where orders are routed and general descriptions of order routing practices are more useful for smaller orders that tend to be homogenous.”

Thus, while customers and market participants have access to publicly-available order execution quality statistics and order routing information for small orders pursuant to Rule 605 and 606 of Regulation NMS,

institutional customers have observed that there is a lack of corresponding information for larger orders.

See

17 CFR 242.606.

See also

supra

note 7 and accompanying text.

See supra

note 7 and accompanying text.

See

Rule 606 Predecessor Proposing Release,

supra

note 15, at 48417. The Commission cited the heterogeneity of larger orders, and the difficulty in effectively reducing that heterogeneous universe into summary statistics, as the primary reason for excluding those orders from the coverage of the Rule.

See supra

notes 21 and 22 and accompanying text. Today, institutional orders are still not homogenous; however the manner in which they are handled has become increasingly systematized, thus making it more practical to categorize them. The Commission preliminarily believes that the current market structure and advances in routing and execution technology, which automatically and electronically record order routing information, have made statistics for where institutional orders are routed more useful and disclosure of such statistics more practicable.

17 CFR 242.605-606.

To facilitate enhanced transparency around the handling of larger orders in NMS stocks, the Commission is proposing to amend Rule 600 to include a definition of “institutional order.”

100

Specifically, under proposed Rule 600(b)(31) of Regulation NMS, an institutional order would be defined as an order to buy or sell a quantity of an NMS stock having a market value of at least $200,000, provided that such order is not for the account of a broker-dealer.

101

100

See

proposed Rule 600(b)(31).

101

As proposed, the definition of institutional order would only apply to orders for NMS stocks, and, therefore, would not include orders in NMS securities that are options contracts. Due to differences in the current market structure for NMS securities that are options contracts, in particular the lack of an over-the-counter market in listed options, the Commission preliminarily believes that the same market structure complexities do not exist at this time to warrant the institutional order handling disclosures proposed herein.

See

Securities Exchange Act Release No. 61902 (April 14, 2010), 75 FR 20738, 20740 (April 20, 2010) (stating that all orders in the listed options market are currently executed on registered national securities exchanges). Specifically, since listed options are limited to trading on the 14 registered options exchanges, the number of venues to which listed options could be routed and executed is significantly less than the over 253 venues for NMS stocks.

See supra

notes 31-32 and accompanying text. In addition, the broker-dealer ownership and affiliation concerns with over-the-counter venues do not exist in the listed options market. The Commission preliminarily believes that at this time

the current listed options market structure does not present the same concerns regarding fiduciary responsibilities, information leakage, and conflicts of interest as the market structure for NMS stocks.

The proposed definition of “institutional order” is intended to complement the current definition of “customer order.”

102

The proposed dollar threshold for an institutional order would dovetail with the definition of “customer order” such that all orders in NMS stocks routed by broker-dealers for their customers, whether retail- or institutional-sized, would be encompassed by order routing disclosure rules.

103

As noted above, institutional orders are generally divided into smaller orders and routed to various trading centers. The Commission notes that, as discussed below, the proposed institutional order handling reports would include the routing of all smaller orders derived from institutional orders.

102

See infra

Section III.A.1.

103

See id.

The Commission notes that the proposed definition of “institutional order” was referred to as “large orders” in the Rule 606 Predecessor Proposing Release and Rule 606 Predecessor Adopting Release.

See supra

note 15.

The Commission preliminarily believes that defining institutional order in relation to the dollar amount of the order is an appropriate means to differentiate between small orders that are typically characterized as orders of $200,000 or less and larger-sized orders that are generally categorized as orders of $200,000 or more.

104

Since “customer order” is currently defined using $200,000 as an upper threshold, the Commission preliminarily believes that market participants are accustomed to considering an order of $200,000 or more as an institutional order rather than a customer order. In addition, the Commission preliminarily believes that rather than proposing a new monetary value to define large-sized orders generally placed by institutional customers, administration would be more straightforward for broker-dealers using a defined standard that is commonly recognized in the industry. Therefore, the Commission preliminarily believes that the $200,000 threshold continues to be a reasonable threshold to accommodate such distinction between small orders and large orders, which are generally handled in a different manner by broker-dealers.

105

104

See, e.g.

, 17 CFR 242.606 (defining block size with respect to an order to include an order for a quantity of stock having a market value of at least $200,000).

105

As detailed below, the Commission is proposing new disclosures in Rule 606 that would apply to institutional orders.

The Commission requests comment on the expansion of Rule 606 to include institutional orders and the definition of “institutional order” in proposed Rule 600(b)(31). In particular, the Commission solicits comment on the following:

1. Do commenters believe Rule 606 should be expanded to include institutional orders? Why or why not? Should the Commission consider an alternative approach? Why or why not?

2. Do commenters believe it is useful or necessary to define an institutional order? Do commenters believe that the proposed definition of institutional order should include securities other than NMS stocks? For example, should NMS securities that are options contracts be included? Why or why not? Should non-NMS securities, such as securities traded only in the OTC market, be included? Why or why not? Would including these types of securities in the definition of institutional order be useful to institutional customers? If so, how? Please explain and provide support for your view.

3. Do commenters believe that dollar value is the proper criterion for defining an institutional order? If so, is $200,000 the appropriate amount? Why or why not? If not, should it be higher or lower? If so, what amount? Are there other order characteristics the Commission should consider to distinguish between retail and institutional orders, in addition to, or instead of, a dollar threshold? Should the criteria be different for different types of stocks? For example, would $200,000 capture large-sized orders for liquid or illiquid stocks, high-priced or low-priced stocks, large capitalization or small capitalization stocks? Please explain and provide data to support your argument.

4. Should the Commission define an institutional order based on the number of shares instead of a market value? Why or why not? For example, would 10,000 shares be an appropriate criterion for defining an institutional order, regardless of dollar value? Should it be more or less? Please explain and provide data.

5. Should the Commission require broker-dealers to make the disclosures proposed in Rule 606(b)-(c) for all orders, irrespective of dollar amount? Why or why not? Please explain.

6. Should the definition of institutional order reflect a different threshold, such as order size or market value, for various types of NMS stocks, such as common stock and exchange-traded products? If so, what thresholds are appropriate and for which NMS stocks? If possible, please provide data and analysis to support your view.

7. Should the definition of institutional order incorporate multiple metrics, such as a certain market value of the order plus a certain number of shares for the order? If possible, please provide data and analysis to support your view.

8. Do commenters believe that customers should be able to designate which orders qualify as an institutional order? For example, should a customer be able to designate smaller orders sent to a broker-dealer as an institutional order? If so, how would that be done? Should institutional order be defined as a combination of customers designating institutional orders and a threshold,

i.e.

, if either requirement is satisfied, it would then be defined as an institutional order? Please provide support for your arguments.

9. Do commenters have alternative definitions for an institutional order, or modifications to the proposed definition? Please explain and provide supporting data, if possible.

10. Instead of defining institutional order, do commenters believe that there are alternative approaches that the Commission should consider in structuring order handling disclosures for large orders? If so, please explain the approach in detail, including the benefits and costs of the approach.

2. Definition of Actionable Indication of Interest in Proposed Rule 600(b)(1)

To further facilitate the institutional order disclosure regime, the Commission proposes to amend Rule 600 to include a definition of “actionable indication of interest.”

106

As the Commission indicated in 2009, an actionable IOI is a privately transmitted message by certain trading centers, such as an ATS or an internalizing broker-dealer, to selected market participants to attract immediately executable order flow to such trading centers, and functions in some respects similarly to a displayed order or a quotation.

107

As such, actionable IOIs can be used by: (1) A trading center to generate trading volume, which in turn could prompt market participants to send more orders to such venue; (2) market participants that submit orders to a trading center to receive executions through the use of actionable IOIs to attract contra side liquidity; and (3) a trading center to

generate transaction fees from the executions.

106

See

proposed Rule 600(b)(1).

107

See

Regulation of Non-Public Trading Interest Proposing Release,

supra

note 66, at 61210 (describing actionable IOIs as privately transmitted messages to selected market participants intended to “attract immediately executable order flow” and comparing their function to “displayed quotations”).

Under proposed Rule 600(b)(1) of Regulation NMS, an actionable IOI would be defined as “any indication of interest that explicitly or implicitly conveys all of the following information with respect to any order available at the venue sending the indication of interest: (1) Symbol; (2) side (buy or sell); (3) a price that is equal to or better than the national best bid for buy orders and the national best offer for sell orders; and (4) a size that is at least equal to one round lot.”

108

The Commission preliminarily believes that for an IOI to be actionable it must contain information sufficient to attract immediately executable orders to the venue sending the indication of interest. The Commission preliminarily believes that the four elements contained in the proposed definition of actionable IOI (symbol, side, price, and size) are all necessary pieces of information for an external liquidity provider to respond with an order to execute against the order at the venue sending the indication of interest. Indeed, if one of the four elements is not explicitly or implicitly conveyed, an external liquidity provider would not have sufficient information to decide whether to respond to the IOI or to ensure the order it sends in response to the IOI would be immediately executable.

109

Without the symbol, an external liquidity provider would not know the security for which to send an order. Without the side, an external liquidity provider would not know whether to send a buy order or a sell order. Without the price, an external liquidity provider would not know where to price its order to ensure the order is immediately executable. Without the size, an external liquidity provider would not know the number of shares it could expect to receive from responding to the IOI.

108

See

proposed Rule 600(b)(1).

109

See

Regulation of Non-Public Trading Interest Proposing Release,

supra

note 66, at 61210-11 (discussing the four elements of an actionable IOI and the inferences a trader can make to reasonably conclude that the order it sends in response to the indication of interest will result in an execution).

A determination of whether an IOI implicitly conveys information—and thus contains each of the four elements to make such IOI actionable—involves a consideration of all of the facts and circumstances, including the course of dealing between the IOI sender and the recipient. For example, a message that alerts the recipient that there is trading interest in a particular symbol and side at the venue sending the IOI generally would be considered “actionable” even though it does not explicitly specify the price and size if, through the course of dealings, the recipient could expect to respond and receive an execution equal to or better than the applicable national best bid or offer for at least one round lot. The Commission notes that the proposed definition is substantively similar to the Commission's description of actionable IOIs in the Regulation of Non-Public Trading Release in 2009.

110

See

Regulation of Non-Public Trading Interest Proposing Release,

supra

note 66.

See also

supra

Section II.F.5. discussing comments received and discussion relating to actionable IOI.

When used in the context of the proposed institutional order handling report, the proposed definition of actionable IOI would require a broker-dealer to disclose its activity that communicates to external liquidity providers to send an order to the broker-dealer in response to a customer's institutional order. The Commission preliminarily believes information about a broker-dealer's use of actionable IOIs in executing institutional orders will be useful to customers assessing the broker-dealer's order handling decisions, particularly in regards to analyzing information leakage because, when “actionable IOIs are intended to attract immediately executable order flow to the trading venue,”

111

actionable IOIs “function quite similarly to displayed quotations”

112

and thus have the capacity to communicate information about the existence of an institutional order. In addition, as discussed in greater detail above,

113

the Commission notes that certain commenters on the Concept Release on Equity Market Structure specifically requested that Rule 606 be expanded to require the disclosure of information related to the use of actionable IOIs.

114

The Commission also notes that some commenters on the Regulation of Non-Public Trading Interest Release raised concerns about the Commission's description of an actionable IOI, including whether the description of an actionable IOI could be clearer and more precise.

115

A few commenters also differed on whether the Commission's description of an actionable IOI was too broad or not broad enough to encompass all intended messaging activity that could result in an execution.

116

The Commission has considered these comments. The Commission preliminarily believes on balance that, in the context of the reporting regime proposed in this release, it remains appropriate to look to the description of actionable IOI contained in the Regulation of Non-Public Trading Interest Release and preliminarily believes that description would capture the necessary information to make an IOI actionable and therefore the functional equivalent of an order. Accordingly, the Commission is using the description of an actionable IOI contained in the Regulation of Non-Public Trading Interest Release as the basis for the proposed definition of actionable IOI in Rule 600(b)(1) of Regulation NMS. In addition, for the reasons stated below, the Commission preliminarily believes that the proposed definition of actionable IOI captures the types of activity that would be pertinent for customers in evaluating how a broker-dealer handles its institutional orders.

111

See

Regulation of Non-Public Trading Interest Proposing Release,

supra

note 66, at 61210.

112

Id.

113

See supra

Section II.F.5.

114

See supra

note 92.

115

See id.

116

See id.

One purpose of the proposed amendments to Rule 606 is to reflect how large orders are handled and how information is shared and dispersed among the marketplace. The Commission has previously noted that because actionable IOIs convey similar information as an order, a response to an actionable IOI may result in an execution at the venue of the IOI sender.

117

As such, the Commission preliminarily believes that actionable IOIs, as proposed to be defined, function quite similarly to an order or a displayed quotation.

118

Given this similarity, the Commission preliminarily believes that a rule that did not capture information related to the use of actionable IOIs in this manner would leave customers without information that could help them have a more complete understanding of how broker-dealers handle their institutional orders. If an IOI contains, explicitly or implicitly, the four criteria of the proposed definition of actionable IOI, then it is the functional equivalent to an order or a quotation. Because of this, the Commission preliminarily believes that the proposed definition of actionable IOI will capture information that could be used by customers to better understand how broker-dealers handle their institutional orders, particularly in regards to information leakage, and will be important to customers in evaluating the order handling and execution practices of their broker-dealers.

117

See

Regulation of Non-Public Trading Interest Proposing Release,

supra

note 66, at 61210-11.

118

See id.

Separately, the Commission notes that as a result of the Commission proposing both the definitions of institutional order and actionable indications of

interest, the Commission is also proposing to renumber the existing definitions in Rule 600(b) accordingly, and update other rules to change cross-references.

The Commission requests comment on the proposed definition of “actionable indication of interest,” as well as the other proposed changes to Rule 600(b) noted above. In particular, the Commission solicits comment on the following:

11. Do commenters believe that a symbol is a necessary element to include in the definition of actionable IOI? Is the side (buy or sell) a necessary element to include in the definition of actionable IOI? Should price be an element in the definition of actionable IOI or is it assumed that it would be equal to or better than the applicable national best bid or offer? Is size a necessary element to define an actionable IOI? Should an actionable IOI be defined to require only a subset of these elements, or should any of the proposed elements be modified? If so, which elements and why? Are there alternative definitions that would capture the activity of a broker-dealer communicating to external liquidity providers that should be included as part of the required disclosure? Are there other elements or factors that the Commission should consider in the definition of actionable IOI? Should any of the proposed elements be omitted? Why or why not?

12. Do commenters believe that an IOI can be “actionable” even if a subset of the elements (symbol, side, price, and size) is conveyed implicitly? Should broker-dealers be required to disclose information about actionable IOIs where one, some, or all of the elements are conveyed implicitly? Why or why not? Would broker-dealers be able to program automated systems to identify as actionable IOIs instances in which information is being conveyed implicitly, such as through a course of dealing between a liquidity provider and the broker-dealer?

13. Do commenters believe there are other types of indications of interest that should be required to be disclosed? If so, what types and how would they be defined?

14. Do commenters believe actionable IOIs are linked to specific orders at the broker-dealer, such that when the external liquidity provider responds to an actionable IOI with a contra-side order, the broker-dealer will be able to match both sides of the trade?

15. Do commenters believe that there are alternative approaches to defining an actionable IOI? If so, please explain each approach in detail, including the benefits and costs of the approach.

3. Scope and Format of Reports

The Commission understands that customers increasingly are requesting institutional order handling information to better understand and assess order routing strategies, best execution, potential conflicts of interest, and the risk of information leakage. The Commission understands that many broker-dealers currently respond to such requests by providing reports on their institutional order handling to customers. However, the Commission understands that these reports often contain non-standardized terms, and often are not presented in a uniform manner to allow for effective comparison across different broker-dealers and trading centers.

119

See

Associations Letter,

supra

note 5, at 2.

The Commission preliminarily believes that requiring broker-dealers to disclose standardized customer-specific institutional order handling information to their customers would facilitate the ability for such customers to assess broker-dealers' order handling practices and how such practices affect best execution, potential conflicts of interest, the potential for information leakage, and execution quality generally. The proposed disclosures described below effectively would set a baseline for disclosure of customer-specific institutional order handling information that all customers, regardless of size, could receive from their broker-dealers upon request. The Commission preliminarily believes that the proposed disclosures would provide needed transparency into broker-dealer institutional order handling practices, and would promote discussions between broker-dealers and customers regarding the broker-dealer's institutional order handling practices and the effect such practices have on execution quality. In addition, the Commission preliminarily believes that the proposed disclosures would allow customers to better compare institutional order handling practices across multiple broker-dealers, which should provide a basis for more informed decision making when customers engage the order routing services of broker-dealers.

Specifically, the Commission is proposing to amend Rule 606(b) of Regulation NMS to require that a broker-dealer, on request of a customer that places, directly or indirectly, an institutional order with it, disclose to such customer within seven business days of receiving the request, a report on its handling of institutional orders for that customer that contains information for the prior six months, broken down by calendar month.

120

The Commission preliminarily believes that requiring broker-dealers to provide the customer-specific reports within seven business days will ensure that all institutional customers, regardless of size, receive their order handling information in a timeframe that would allow them to act in a timely fashion in response to the information contained in the report. The Commission also preliminarily believes that broker-dealers will develop technical processes to produce these reports in an automated manner,

121

and as such, requiring a response to an individual customer request within seven business days would not be unduly burdensome and should provide a sufficient amount of time for broker-dealers to generate the required disclosure and respond to customer requests. Separately, the Commission notes that the proposed requirement to provide customer-specific institutional order handling information for the prior six months is consistent with the reporting period currently required for customer-specific reports on retail order routing.

122

The Commission preliminarily believes that a six-month reporting period is also appropriate for institutional orders, as it would provide individual customers with the most recent months of institutional order handling data and would cover the full period contained in the broker-dealer's last public aggregated institutional order handling report.

123

120

See

proposed Rule 606(b)(3).

121

See infra

Section IV.A.1.

122

See

Rule 606(b)(1).

123

See

proposed Rule 606(c).

See also

Rule 606 Predecessor Adopting Release,

supra

note 15, at 75430 n.81 (discussing the six-month reporting period for reports on customer-specific retail order routing).

The proposed report would cover instances where an institutional order is handled either directly by the broker-dealer or indirectly through systems provided by the broker-dealer. For example, an institutional order would have been placed with a broker-dealer if a broker-dealer receives an institutional order directly from a customer and works to execute the order itself, as well as if a broker-dealer receives an institutional order indirectly from a customer, where the customer self-directs its institutional order by entering it into a routing system or execution algorithm provided by the broker-dealer.

The Commission notes that the proposal would require a broker-dealer to provide a report “on request of a customer that places, directly or

indirectly, an institutional order with the broker or dealer . . . .”

124

Accordingly, a broker-dealer must provide a report under the proposed rule to the customer placing the order with the broker-dealer, who may be acting on behalf of others and thus not be the ultimate beneficiary of any resulting transactions.

125

The Commission preliminarily believes that requiring the reports to be provided to the customer that places an institutional order with the broker-dealer is appropriate because it would require the broker-dealer to provide the report to the person that is responsible for making the routing and execution decisions for such institutional order. For example, if an investment adviser, as the customer of a broker-dealer, places institutional orders with a broker-dealer that represents trading interest from multiple underlying clients of the investment adviser, the investment adviser, as the customer of the broker-dealer, would be the sole entity to whom the broker-dealer is required to provide a report under the proposed rule; and not the multiple underlying clients of the investment adviser.

124

See id.

125

The Commission notes that “customer” is broadly defined as “any person that is not a broker or dealer” in Rule 600(b)(16). However, for the purposes of the proposed amendments to Rule 606, which are to provide detailed information about order routing and execution quality to the person responsible for assuring the effectiveness of this function, the Commission preliminarily believes that it is appropriate to view the customer placing the order with the broker-dealer, whether the account holder or an investment adviser or other fiduciary, as the “customer.”

Separately, the Commission notes that while the proposed rule would allow a customer that places, directly or indirectly, an institutional order with a broker-dealer to request and receive its institutional order handling report, it would not limit the number of times a customer could place a request. The proposed rule also would not preclude a customer from making a standing request to its broker-dealer, whereby the customer would automatically receive a recurring report on an periodic basis without the need to make repeated requests for its institutional order handling reports. However, the Commission does not intend for the proposed rule to duplicate information the broker-dealer has previously provided the customer pursuant to a prior request under the proposed rule. For example, if a broker-dealer provides a report to a customer for the prior six months, and that customer requests an additional report the following month, the broker-dealer would only need to provide a report for the latest month. In addition, the Commission acknowledges that broker-dealers may need to configure their systems to capture the information necessary to produce the proposed institutional order handling reports and, therefore, may not have the ability to produce historical reports about the routing of orders and executions that occurred before such systems are updated. Accordingly, the Commission would not require broker-dealers to produce institutional handling reports containing information to cover months before broker-dealers are required to comply with such rule, if adopted.

For purposes of the report, the handling of an institutional order would include the handling of all smaller orders derived from the institutional orders.

126

As noted above, institutional orders are generally divided into smaller orders and routed to various trading centers. For the disclosure to be meaningful and complete, the Commission preliminarily believes that the routing of each child order derived from an institutional parent order should be required to be included in the report. The Commission understands that current technologies employed by broker-dealers typically are able to track child orders and link such child orders back to the parent order,

127

thus minimizing burdens associated with this component of the proposed rule.

126

See

proposed Rule 606(b)(3). The Commission notes that an order would only be required to be included in the proposed report if it met the definition, and thus the size threshold, of an institutional order when received by the broker-dealer.

127

Broker-dealers have developed their own systems allowing for tracking and linking of child orders to parent orders. Third-party software enables this, as well.

See, e.g.

Advanced Orders Panel

, Interactive Brokers,

available at

https://www.interactivebrokers.com/en/software/tws/usersguidebook/mosaic/advanced_orders_panel.htm

;

Viewing Child Orders

, Trading Technologies,

available at

https://www.tradingtechnologies.com/help/xtrader/viewing-child-orders/

;

Smart Order Routing

, StreamBase,

available at

http://www.streambase.com/industries/capitalmarkets/smart-order-routing/

The Commission is further proposing to require that the report be made available using an eXtensible Markup Language (XML) schema and associated PDF renderer to be published on the Commission's Web site.

128

Requiring the report to be provided in XML should result in the data in the report being provided in a consistent, structured format. XML is an open standard

129

that defines, or “tags,” data 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. The Commission preliminarily believes that requiring the report be provided in in an XML format would provide the customers and the public (in the case of public reports) with data about order handling practices in a format that would facilitate search capabilities, and statistical and comparative analyses across broker-dealers and date ranges. Absent this requirement, any customers or members of the public seeking to use the information would need either to spend time manually collecting the data and manually entering the data into a format that allows for analysis, thus increasing the time needed to analyze the data, or incur the cost of subscribing to a financial service provider that specializes in this data aggregation and comparison process. Further, manual entering of data may lead to errors, thereby potentially reducing data quality and usability. By proposing to require the use of an XML format so that the information would be more readily available, customers might be able to better use the information to compare execution quality of broker-dealers, thereby allowing them to select broker-dealers that are a better match to their preferences. The Commission is also proposing that the report be provided in PDF format using the associated PDF renderer published on the Commission's Web site so that the report would also be provided in a human-readable format for those customers who prefer only to review individual reports and not necessarily aggregate or conduct large-scale analysis on the data. Like XML, PDF is also an open standard. By using the associated PDF renderer published on the Commission's Web site, the XML data will be instantly presentable in a PDF format and consistently presented across filings.

128

See

proposed Rule 606(b)(3). The Commission's schema is a set of custom XML tags and XML restrictions designed by the Commission to reflect the proposed disclosures in Rule 606.

129

The term “open standard” is generally applied to technological specifications that are widely available to the public, royalty-free, at no cost.

The Commission seeks comment generally on the report format proposed in Rule 606(b)(3). In particular, the Commission solicits comment on the following:

16. Do commenters believe the proposed scope of the institutional order handling report is practicable and appropriate? Why or why not? Please explain and provide data, if possible.

17. Do commenters believe that it is appropriate to view the customer placing the order with the broker-dealer, whether the account holder or an investment adviser or other fiduciary, as the “customer” for purposes of the proposed amendments to Rule 606? Should entities other than the customer placing the order with the broker-dealer be entitled to receive the report? For example, if an investment adviser represents multiple underlying clients, should each underlying client be entitled to receive the report? Please explain.

18. Do commenters believe that broker-dealers should be required to provide the customer-specific report on institutional order handling in the proposed format? Why or why not? Do commenters believe broker-dealers should be required to provide the report in a structured XML format? Would such a format facilitate comparison of the data across broker-dealers? If not, why not? Do commenters believe broker-dealers should be required to also provide the report in an instantly readable PDF format? If not, why not? Are there other formats or alternative methods to provide the customer-specific reports that the Commission should consider? If so, please explain and provide data.

19. Do commenters believe that seven business days is a reasonable amount of time for a broker-dealer to respond to a customer request for institutional order handling information? If not, what would be a reasonable amount of time?

20. The Commission notes that Rule 606(b)(2) requires that broker-dealers notify their customers annually, in writing, of the availability of a report on the routing of retail orders. Should the Commission include a similar requirement for a report on the handling of institutional orders?

21. Do commenters believe that the rule should include a de minimis exemption for broker-dealers that receive, in the aggregate, less than a certain threshold number or dollar value of institutional orders? Why or why not? If so, what would be the appropriate threshold number or dollar value of institutional orders a broker-dealer should need to receive from all customers in the aggregate before it would be required to provide customer-specific order handling disclosures to any customer? Please explain and provide data, if possible.

22. Do commenters believe that the rule should be applicable, with respect to disclosures to any particular customer, only if a broker-dealer receives greater than a certain threshold number or dollar value of institutional orders from that customer? Why or why not? What would be the appropriate threshold number or dollar value of institutional orders from a particular customer before a broker-dealer should be required to provide customer-specific order handling disclosures to the particular customer? Please explain and provide data, if possible.

23. Do commenters believe that the required disclosure regarding the handling of an institutional order should include the handling of all smaller (child) orders derived from the institutional order? Why or why not?

24. Do commenters believe that the rule should cover institutional orders placed both directly and indirectly with a broker-dealer? Should the rule only cover orders placed directly with a broker-dealer? Why or why not?

25. Do commenters believe that the rule should specify the number of times a broker-dealer is required by the rule to respond to a customer request for a report on the handling of its institutional orders? Why or why not? If yes, what should the number of times be? Alternatively, do commenters believe that broker-dealers should be required to provide customers with institutional orders ongoing access to order handling reports through a secure portal on their Web sites? Why or why not? How would this impact broker-dealers' compliance costs, or the accessibility to customers of order handling reports? Please explain.

26. As noted above, the proposed rule would not preclude customers from making standing requests for their broker-dealers to provide them order handling reports on a specified regular basis. Do commenters believe broker-dealers should be required to automatically provide reports to customers with respect to their institutional orders, without the customer making a specific request? If so, how frequently should this information be provided (

e.g.,

every month, three months, six months, annually)? Please explain. To what extent would automatically providing reports facilitate the dissemination of order handling information to customers that might not otherwise take the time to request it? On the other hand, to what extent would automatically providing reports require order handling information to be provided to customers that they might not want or use? If order handling reports are required to be automatically provided, should customers be permitted to opt out from receiving certain information or reports in their entirety? Should a requirement to automatically provide reports exclude customers with only a de minimis number of institutional orders? If so, what would be an appropriate de minimis level? How would a requirement to automatically provide customers with reports rather than provide them upon request change the costs for broker-dealers? Considering that broker-dealers that handle institutional orders would need to be prepared to provide reports to customers on request, and therefore would need to develop the technology to produce such reports in an automated manner, what would be the incremental costs for them to run the reports for all customers on a periodic basis? Would there be any benefits from broker-dealers running the reports for all customers on a periodic basis? Would the broker-dealer experience lower costs from manually providing the reports solely upon request? Would other costs be involved? Please explain and provide data.

As noted above, the Commission is proposing to require that the institutional order handling reports be broken down by calendar month.

130

The Commission understands that trading centers frequently change their fee structures, including the amount of fees and rebates, to attract order flow, and such changes typically occur at the beginning of a calendar month. The Commission preliminarily believes these changes in fee structures at trading centers may affect a broker-dealer's routing decisions. The Commission therefore preliminarily believes that if customer-specific reports on institutional order handling reflected data over a longer period of time, the aggregated information contained in the reports may not be as illustrative or as useful in informing customers as to how fee structures potentially affected the broker-dealer's routing behavior.

130

See id.

For example, if a change in a trading center's pricing structure occurs at the beginning of a calendar month, and the report on a customer's institutional order handling reflected aggregated data for the past six months, then any change in broker-dealer routing behavior as a result of the change in trading center pricing would be harder to detect as the change in data would be diluted and averaged over a period of months. The Commission preliminarily believes that by requiring the reports to be broken down by calendar month would enable

customers to better assess a broker-dealer's institutional order handling practices and any changes in routing behavior in response to internal or external factors. In addition, for those with a fiduciary responsibility to monitor for best execution, monthly detail would help facilitate regular and more precise review to evaluate whether their selected broker-dealers are providing satisfactory execution quality.

As proposed, Rule 606(b)(3) requires that the broker-dealer's report reflect aggregated information regarding the handling of a customer's institutional orders for the prior six months, broken down by calendar month. Additionally, the Commission preliminarily believes that, if a customer places an institutional order that identifies the particular account for which the order was submitted, the broker-dealer would be well-positioned to provide the customer, upon request, a report broken down by account. The Commission preliminarily believes that, because the proposed disclosures will aggregate information to be disclosed to a specific customer across all of the customer's institutional orders, the risk that such disclosures would reveal sensitive, proprietary information about broker-dealers' order handling techniques should be minimal. The Commission is cognizant of the concerns broker-dealers would have if such disclosures revealed proprietary order handling techniques, and preliminarily believes that aggregated customer-specific order handling information would not enable a customer to reverse-engineer proprietary order handling techniques.

The Commission requests comment on this proposed requirement. In particular, the Commission solicits comment on the following:

27. Is six months an appropriate timeframe for the reporting period for customer-specific order handling information? Would a longer or shorter time period (

e.g.,

quarterly) be more appropriate? How soon after month-end should the customer-specific order handling report be provided (

e.g.

, two-weeks after the end of the preceding month)? Please explain.

28. Do commenters believe that aggregated information, broken down by calendar month, is a useful format for the customer? Should the data be required to be provided in a more granular or broader manner? For example, would it be more useful for institutional customers to receive data about the handling of their institutional orders on a stock-by-stock basis rather than aggregated? Please provide support for your arguments and describe any costs and benefits associated with an alternative format.

29. Does aggregating of all of a customer's institutional orders into a single report adequately prevent sensitive, proprietary information from being revealed? If not, why not? Could aggregated institutional order disclosures allow a customer or competitors to reverse engineer a broker-dealer's order handling techniques?

30. As noted above, the Commission preliminarily believes that, if a customer places an institutional order that identifies the particular account for which the order was submitted, the broker-dealer would be well-positioned to provide the customer, upon request, a report broken down by account. Do commenters believe that the rule should require a broker-dealer to provide, upon request, a report broken down by account, if the customer identifies the particular account for which the order was submitted? Why or why not? Please discuss the benefits and costs with such an

This text is long and has been trimmed here. Open the source document for the complete record.

This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.