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SEC Staff Report Identifies Issues with Execution-Quality Reports

A recently released report from the SEC’s Division of Trading and Markets reviews issues of stop orders, payments for order flow, and execution quality reports. The report, prepared for a recent meeting of the SEC’s Equity Market Structure Advisory Committee, focuses primarily on the effect of current market structure issues on retail customers, but has implications for institutional investors as well.

Addressing the practice of payment for order flow, the paper notes that “[t]o date, the Commission has pursued an approach based primarily on disclosure to address concerns about the potential conflicts of interest caused by payment-for-order-flow arrangements.” The staff suggests that the economic benefits received by brokers “create potential conflicts with a broker’s duty of best execution and may cause observers to question the rigor with which a broker seeks to obtain the best execution for its customer orders.” The paper identifies possible resolutions including banning the practice, requiring brokers to pass the payment received to customers, enhancing guidance on best execution, or enhancing disclosure to retail customers.

Regarding reports of execution quality, the paper suggests that retail investors may benefit from a report that combines broker-level reporting (the current Rule 606 report) and exchange-level reporting (the current Rule 605 report). The report also suggested that the Commission may want to consider updating reporting requirements in areas such as execution speed.  Currently, market centers are only required to report the amount of time between order receipt and execution in one of six buckets, the fastest of which is 0 to 9 seconds.

The staff also notes that Rule 605 and 606 exclude institutional-sized orders. These orders were excluded when the rules were imposed due to the lack of homogeneity in “the type of institution or individual representing contra-side interest, the appetite for risk at a given time, and the specific rules governing the exchange on which the order was printed.” However, the report suggests that these idiosyncrasies have faded and now “institutional orders are treated in a more uniform fashion.” As with retail orders, institutional orders “tend to be handled by sophisticated order-execution algorithms.” The report argues that “[t]he complexity of these order-execution algorithms and smart order-routing systems has made it difficult for institutional customers to assess the impact that particular order-routing strategies may have on the quality of their executions.” The report notes that the Chair Mary Jo White tasked the SEC staff with developing a proposal to “enhance the disclosures required of brokers with respect to their routing of institutional orders.”

The report also addressed the use of stop orders, identified as a potential amplifying factor in the August 24 volatility by some advisory committee members. The staff suggests potential ways to address the risks caused by stop orders, including increased investor education, requiring the use of a limit price, and outright limits or prohibitions on their use.