In late December 2022, the SEC announced various proposals intended to improve and bring Rule 605 of Regulation NMS into the 21st Century. Rule 605, which was adopted in 2000 and never updated, deals with the monthly reporting requirements for broker-dealers relating to the quality of trade executions. Specifically, the concern of the regulators is that the quality of executions may not bear close enough resemblance to the published bids and offers in place just prior to the order entry. Moreover, during the past 20 years since the original passage of Rule 605, the practice of “paying for order flow” has grown substantially and has the potential of creating a conflict of interest between market-makers and the retail investing public.
SEC Chairman Gary Gensler was quoted as follows: ”Current Rule 605 disclosures have not kept up with our markets and provide investors with an incomplete picture of execution quality. This proposal, if adopted, would increase transparency for investors and facilitate their ability to compare brokers. That helps make our markets more efficient, competitive, and fair.”
While the SEC, rightfully so, is always concerned with how the retail public is treated by the brokerage industry, the issue of best execution has become much more critical to many hedge fund managers due to the emergence of actively traded, algorithm-based, high-frequency trading strategies. Obviously, a retail customer who makes two or three trades per month should be entitled to best execution, but for a hedge fund making hundreds, if not thousands, of trades per month, best execution can mean the difference between generating a profit or a loss for its investors.
Among other things, the proposal will require:
- Broker-dealers to establish written procedures which conform to best execution standards, enforce those procedures and review such polices at least annually and report to their governing body
- Times of order receipt and order execution to be measured in increments of a millisecond (much significance to algo-driven trading)
- Statistical measures of execution quality, including average effective over spread, as a percentage-based metric
All entities subject to the rule would have to make summary reports available to the public. (While these reports may not be useful to the investing public, high-frequency trading hedge funds probably will need to use them.)
Perhaps most importantly, if brokers receive payment for order flow from a wholesaler, those brokers would need to have policies in effect that require enhanced diligence in seeking best execution, including documentation that the conflicted transactions comply with best execution requirements.
With extensive experience in both the front and back office of hedge funds, Grassi’s Financial Services team can assist fund managers in their evaluations of various Prime Broker offerings, especially as they relate to the critical topic of best trade execution. For more information on how this proposal could impact your compliance policies and procedures, please contact your Grassi advisor or John Zoraian, Fund Administration Principal.