In December 2022 the SEC offered four market structure proposals. The proposal to modernize Rule 605 was met with broad-based industry support. In this week’s Oyster Stew Podcast, Frank Childress and guest Ted Karn, founder of The Karn Group, walk through what modernizing Rule 605 will mean for the industry, and what firms should be doing to prepare.
Transcript provided by TEMI
Bob Mooney: Welcome to the Oyster Stew podcast. I’m Bob Mooney, General Counsel for Oyster Consulting. In December 2022, the SEC presented four market structured proposals. The proposal to modernize SEC Rule 605 was met with broad industry support. In today’s podcast, Oyster consultant Frank Childress and guest Ted Karn, founder of The Karn Group, walk through what modernizing Rule 605 will mean for the industry and what firms should be doing to prepare. Let’s get started. Frank?
Frank Childress: Welcome. My name is Frank Childress, and I’m with Oyster Consulting, part of the Capital Markets and Trading part of the consulting group. We’re here today to discuss the recent SEC proposal to update and modernize SEC Rule 605. Joining us today is Ted Karn of The Karn Group. Ted has been an industry leader and pioneer in the field of best execution and market structure for both equities and fixed income securities. Initially with the founding of MSI in the mid-nineties, and more recently on the fixed income side with his founding of The Karn group, also known as TKG. As I’m sure you all know, the SEC proposed four market structure proposals in December. Comment periods have now concluded. Clearly there’s a wide spectrum of industry support for these four proposals raging from complete outrage to relative agreement.
From my perspective, there seems to be two areas of broad agreement. If more than one of these proposals is approved, the sequencing of the rollout is critical. If any more than one at a time is rolled out, I think the industry feels that that could be very dangerous or reckless. The second aspect is that there seems to be broad agreement that the modernization of Rule 605 makes very good sense. The industry’s been talking about this for five or 10 years, and I know different groups, SIFMA, FIF have been engaged in proposals. And today we’re here specifically to discuss the Rule 605 proposal, which clearly has the most broad-based support. In fact, much of the challenging ‘in the weeds’ work for this proposal was done by industry groups, as I mentioned, SIFMA, FIF and other industry practitioners. So we’re pleased today to have one of those practitioners with us.
Ted, Rule 605 and 606 and NMS were designed to provide transparency to the marketplace for both retail and institutional investors, and to monitor routing and execution quality, which would then ideally lead to fairness and ensure competitiveness in the marketplace. Now it’s more than 20 years old with no material updates, despite the fact that we’ve seen significant technology, trading and regulatory changes in the market. The industry and the SEC are finally getting around to proposing a modernization of the rule. So, to kick this off, and given that we want to maintain our audience’s interest in this, and we’ve got an amount of time, we’ll keep this relatively high level, but there are some details of this rule that I think are important. Can you kick us off with a brief overview of the primary goals of the proposal?
Oh, thank you for that introduction, Frank. I have a challenging question to begin with because it would be a brief overview of a massive regulation. It’s very technical, very involved, and dramatically updates the current 605 regulation. So I’ll try to touch the main points, which are several that are part of the new 605 proposal. And I should also mention before we get into this, that the industry comment letters in some cases diverge very significantly from the original proposal. So I can describe the original proposal, but the comments that indicated significant changes will have further follow up in terms of discussions between the regulators and industry groups. And there may be significant changes from what I’m describing right now. One component that is almost for sure going to be maintained is that the 605 disclosures, which originally only applied to market centers, will now apply to broker-dealers with more than a hundred thousand customer accounts.
There are some discussions about how you define customer accounts and so on. But the regulators believe that there are about 85 broker-dealers that will account for the vast majority of the order flow, and that will be covered by this. Further, the market centers and broker-dealers need to produce separate reports, and the market centers, when they receive an order that either could be routed externally or be part of qualified auctions houses, will have to produce two separate reports. So, the bodies making reports will now include broker-dealers and will also require, potentially, many market centers to produce two separate reports within these reports. There’s an expansion of the scope pre-opening and post-closing orders, stop orders when they’re triggered. Non-exempt short sales will also be added to covered orders for this statistical reporting. The orders, the statistics themselves will be changed.
In terms of order categorizations, this is one area where the SEC may make a major change. They propose doing round lot reporting. The reaction the industry was to go to the nominal value of orders when you categorize orders, and they would be creating, multiple benchmark intervals for nominal values for reporting. This is to address the fact that stock prices very so dramatically from pennies into thousands or tens of thousands of dollars per share. And that distorts statistics when they’re aggregated order type categories are increased, in addition to markets and marketable limit orders that were there before marketable IOCs are being added. Concept called beyond the midpoint limit orders are being added, executable non-market orders will be added to this. So we’re talking many additional order types will be included in this analysis. Timestamps will move into milliseconds.
This is a very significant change, but obviously needs to reflect the fact of the speed of executions that have changed in the last 20 years. Requested additional timestamp stats. One is that the SEC has proposed to add median and outliers in terms of the timestamp reports. The way they were proposed, they would not be able to be aggregated across all the different reports. So the FIF has requested a modification of that request so that they’ll be able to aggregate timestamp statistics across different orders. All order types now will have calculations. The realized spread, effective spread percentage of effective over quoted and, uh, size improvements. And finally, there’ll be a new report, which has garnered a lot of attention by the industry. The reports as they exist now will be literally 360 different types of report records per stock symbol. So, we’re talking tens of thousands of entries into a report that would be produced by a broker-dealer or a market center. What’s being introduced is the concept of a summary execution quality report. And since this is going to be a single report that will aggregate all the activity of either the market center or the broker-dealer, there’s a lot of concern about how the statistics will be aggregated, and we’ll get into that a little bit more as we have this conversation.
Frank Childress: Great, Ted, that’s a great way to kick it off. Needless to say, although there is mostly consensus, this is one of the proposals that needs to get done. In many ways it’s also the most complicated and it has the most layers of detail. And again, there was a lot of consensus to this needing to be updated. Clearly there was not a lot of consensus with the way it was proposed. So, you talked about some of the aspects of the proposal that will stand. What did you see in the comment letters from other broker-dealers that seems to raise the most level of interest, or seems to be most level of concern?
Ted Karn: Well, I would say, probably the most critical one is the definition of order time. So, the regulation as presented is that the order time for a broker-dealer would be when the order is first received and electronically registered by that broker-dealer. It’s been proposed by a couple of the major market participants that they use the time that orders are routed to market centers. Now, this raises a conflict essentially with what I believe the intent of the proposal was to introduce that broker-dealers start doing these reports. And that is, if you take the route time out of the broker-dealers as the basis for the benchmark, it would converge very closely to what the actual market center reports are. So you really are creating a whole new reporting requirement by broker-dealers without creating much difference in terms of the results set.
I believe that undermines the intent of the SEC, and I don’t think they’ll accept that. I believe broker-dealers will have to use the time of order receipt into their front-end electronic systems, and that’s going to cause a significant time spread between the broker-dealer analysis of an order and the end market center. The other issue that has gotten a lot of attention is the waiting of effective over quoted spread that has been discussed, and there’s been a lot of talk about spread weighting versus share weighting as a different alternative. Now, I actually think the industry has made a difference that was not necessary because, in effect, share weighting and spread weighting can be viewed as just a different version of share waiting. This is a little bit technical, but basically if you weight the effective spread and the quoted spread separately by shares, and then take the ratio, you get to the same result that you would have if you did spread waiting.
Frank Childress: So that’s math. We call that math <laugh>.
Ted Karn: That’s called math. And that’s caused a lot of calculations. But anyway, what I think should be presented to the SEC and has not yet been presented as such, is that they should view what’s called spread weighting as just a different flavor of share weighting. The reason why there is some contention in that is that they’re worried that the aggregate statistic will cause bias in terms of how execution quality will be distributed among different stocks. So basically, the alternative method proposed by the SEC would result in executing venues benefiting from selecting which stocks that they apply price improvement to in net aggregate. Their financial position would be the same, but they would be able to change the quality statistics by where they apply price improvement.
Frank Childress: That’s great. That’s a helpful overview and hopefully in a way that most people that are involved in this can grasp. As we talked about at the beginning and going back to the genesis of the rule in the early 2000’s when Reg NMS, the purpose was to provide some transparency with the thought that the transparency would ensure competitiveness. Is there a particular aspect of the rule that really lends itself to helping to accomplish being more beneficial towards those goals of greater transparency and competition?
Ted Karn: Well, I think the summary report, which has been introduced as a new concept, is an effort in order to do this. I think the regulators have recognized the fact that the current statistical regime, which is essentially very large files of flat records. And when I say large, we’re talking tens of thousands, hundreds of thousands of records, by stock, by symbol, by order type, and so on, was not able to be consumed by the public. Some firms chose to do their own aggregation of quality statistics off of those. But I’m not sure how much that has actually influenced the retail investor, how much it’s been absorbed. My own impression is the primary consumer of all these statistics has actually been the regulators, and they’ve been using it for examination purposes and analysis of the market. And in fact, if you look at the proposed rules on the 605, you can see they actually referenced that in effect, in terms of they’re using measures such as effective spread, realized spread and so on, in order to analyze what’s going on in the marketplace. And in fact, those statistics in part, were being referenced to, for some of the other proposals, especially the auction proposal, where there was selective bias in terms of where, certain orders were being executed.
Frank Childress: Right. And I guess the other consumers that I’ve seen in the past have been some academics and certainly the wholesalers and in some cases industry groups like a tab or somebody that would follow the industry. If we talk about the historical consumers, how do you view this changing going forward? I think it seems to me the SEC is trying to make this more available, what do you think the future consumer looks like?
Ted Karn: Well, getting back to that summary report, it’s now getting condensed enough and it’s being done by broker-dealer as opposed to destination. I could see financial reporters, for instance, starting to do ranking and so on, on broker-dealers in terms of execution quality. So it becomes technically much, easier for them. So, I and other vendors that have 605 type capabilities have systems that can produce these types of reports, but we don’t have financial news reporters and so on as our customers. There are customers or compliance departments and order routing people and things of that nature. So I do think that this does potentially open the window for the end retail customer getting this type of information. But, we’ll have to see how that works out. This would be new territory if this actually became one of the decision points of retail investors about where they want to send their order flow.
Frank Childress: Right. And I think it will be interesting how it rolls out, and I know the summary as they’ve referenced it, there’s some pushback just because not all business models are the same, and to try and push them all into the same type of summary report may or may not be a fair comparison, but I think you need to start somewhere, right?
Ted Karn: Mm-hmm. <affirmative>
Frank Childress: As we look forward to implementing, there’s agreement that this is one that the SEC certainly will be pushing forward with likely some changes based on comments that have been made. But what do you think the most challenging aspect of the proposal is going to be? And now that we’re opening it up to potentially hundreds of broker-dealers that haven’t previously been exposed to 605, and these are essentially your customers and my customers, the broker-dealer community. What’s going to be their biggest challenge with respect to how they adapt to it?
Ted Karn: I think, actually construction of the source data sets are going to be the challenge. So, from a technical viewpoint to produce this, I expect very few broker-dealers to actually produce these 605 reports on their own, whether they’ve done it in the past or not. In the future here, I think it’ll represent a very small component, if any, of them are doing that. However, collecting and creating uniform source data for this analysis may be very challenging. So when you think about a dealer, let’s say they have an online component of their business, they have a phone component, they have a high touch, they have, advisors also, you put these all together. They may be using different OMS order management systems. They may have different ways of being directed for routing.
And so you now have all this disparate data that needs to be aggregated, made in a uniform format, and then is put into the analysis system. I find that my own firm and others spend a great deal of time, in fact probably the majority of our time, working on the integrity of the source data. And I think that by moving this into the broker-dealers, that problem will become even greater. We often do this now in order to create a single view for our customers, but at the end of the day, there isn’t a required regulated report that comes out so that there can still be certain components and separation between where they produce reports in terms of different components of the broker-dealer, but now it’ll have to be a single uniform view. I think this will be very challenging both to the broker-dealers and the vendors.
Frank Childress: Ted, that’s all great insight and certainly greatly appreciated. As we wrap this up, what else should our broker-dealers introducing, and clearing firms, be thinking about as this proposed rule moves its way through the rulemaking process?
Ted Karn: Well, I think first, you should view this regulation as the most likely to be adopted of the four proposals. That this is most likely to be the first adopted, and that, in my opinion, it’s almost for certain that it will be adopted. It depends on how much runway the broker-dealer community has in terms of implementation. The SEC seems to be interested in taking an aggressive track on this. My own suggestion is that the new reporting elements, which are the broker-dealer communities, need to start early and focus resources on doing this. I think this is going to be a challenging implementation.
Frank Childress: But do you think it’s fair to say that given the nature of this with reports and with data and with consumable information, it seems to me that from a regulatory compliance standpoint, this would be the sort of easiest target for FINRA, the SEC to look at for monitoring to make sure people were in compliance with respect to any of the other proposals. Certainly the best execution has some regulatory requirements. Those are a little bit more subjective. This one’s going to be seemingly very objective.
Ted Karn: Right. You know, I think auditors love numbers and this is all about numbers and auditing and making sure all orders are being captured correctly, if they’re being categorized correctly, or the statistics are being calculated correctly. And that combined with the complexity means it’s basically fertile ground to find problems. Frankly, the current 605s, which are significantly simpler, have rampant mistakes in them, quite frankly. And when you aggregate them in order to produce reports, you’ll find that even the current regime is not fully compliant in terms of doing everything correctly. So this shall continue. Maybe something of a model of the attitude of the SEC and the examiners is that the 606 order routing regulation, which came in in the last couple of years, is being very aggressively audited right now. So my expectation is the new 605 will likewise get a lot of attention.
And from my perspective, as we look at these broker-dealers that are going to be added to this sort of community of filing, I think it’s critically important that they get on this. With any change in regulation, that they get on it early and follow this throughout the process, and make sure that they’re buttoned down as the rule actually moves towards implementation. I think for us, Oyster as a consulting firm, our role really is working with them to identify and work on those policies and procedures to make sure that they’re locked down. From your standpoint, it’s going to really be more on the data side and building the tools and managing the data and creating the goodies or the product that actually manages this for the clients. So can you expand on that a little bit?
Ted Karn: Well, the systems currently in use, and this is for broker-dealer customers I’m talking about, specifically allowed our customers in order to have a 605-style view of their own data based upon their order receipt. So to some degree, they were already, for internal purposes doing this type of report. That’s part of this new regulation. Also because of examinations, they’ve been driven in many cases to start looking at categories of orders that are now becoming part of the public. So reports, for instance, pre-trade and post-trade orders, how stop orders are being handled, things of that nature. Many of the links and types of analysis that’s necessary in order to support the new regulation had already been developed in order to support broker-dealers through the examination and the auditing type of process that they were already in. So, the extension of the system into new order types and new calculations is not an insignificant effort, but is part of a continuation of the extensions of the systems that we’ve been doing over the years.
As more and more order categories and types and so on have had to be included in the process, my bigger concern is actually on the data collection side. So I can make an engine in order to calculate things correctly, and you can audit it and, you know, they’re proven methods and so on to do that. But for instance, if there are holes in the data collection, if there are emissions of various kinds, if there’s misinterpretation of order types and so on, because there are differences between different order management systems that can be challenging. And I would see that would be areas that consulting function may provide a lot of value added because many firms are not well-equipped in order to do that type of review of all the data sources and in terms of, are things being categorized correctly, and so on.
Frank Childress: Yeah, that’s great. I think clearly this rule hasn’t been implemented yet, and there’s still a ways to go, but it’s never too early to get started. And as firms think about mapping out their internal resources for future budget years, I think it’s critical that they get started on this early on. Well, Ted, this has been great. I can’t thank you enough for your thoughts and perspectives on this and if it warrants, I think once we hear more from the SEC on the finalization of the rule, perhaps we do this again.
Ted Karn: That’d be great. Thank you for having me, Frank and have a wonderful rest of the day.
Frank Childress: Great. Well, thanks everyone for listening. If you’d like to learn more, you can reach TED through the TKG website at karngroupgroup.com, or you can reach me and my colleagues at Oyster at our website, oysterllc.com. If you like what you’ve heard today, follow us on whatever platform you listen to and give us a review. Have a great day.
Bob Mooney: Thanks everyone for listening. If you’d like to learn more about our experts and how Oyster can help your firm, visit our website at oysterllc.com. If you like what you heard today, follow us on whatever platform you listen to and give us a review. Reviews make it easier for people to find us. Have a great day.