New Order Routing Disclosure Rules Will Not Fix Market Fragmentation

After almost ten years of Rule 605 and Rule 606 disclosure rules, the SEC is set to propose new order routing disclosure rules today.  This move has been talked about for years by the SEC and we’re glad to see they are finally acting.  If you recall back in June 2014, SEC Chair White gave a major speech titled “Enhancing Our Equity Market Structure” where she spoke about the SEC’s plans on order routing disclosures:

“Most investors rightly rely on their brokers to navigate the dispersed market ecosystem on their behalf. But monitoring the execution quality and costs of orders can be difficult for even the most sophisticated investors, given the number of trading venues and order types available to brokers.

As one step to more generally address these issues, I have asked the staff to prepare a recommendation to the Commission for a rule that would enhance order routing disclosures. Rule 606 of Regulation NMS currently requires some public disclosure of broker order routing practices, but it does not cover the large orders typically used by institutional investors. The rule proposal would address this gap by requiring disclosure of the customer-specific information that a broker is expected to provide to each institutional customer on request. While some brokers already voluntarily provide some of this information, a rule is necessary to ensure that the disclosed information is useful, reliable, and uniformly available on request to all institutional customers.”

While we’re happy to see the SEC finally demand more transparency, we think that these new rules will still be addressing the symptoms rather than the disease.  The main reason why there are so many conflicts with broker routing is because of unnecessary market venue fragmentation.  This is the real problem that the SEC helped create with Reg NMS and has failed to properly address.  Fragmentation is the root cause of latency arbitrage. Fragmentation is the reason why the average trade size is less than 200 shares.  Fragmentation has helped create venues that offer nothing new but creative fee schedules.  Chair White knows this and addressed it in her 2014 speech:

Another market structure concern is fragmentation. Order flow in exchange-listed equities is divided among many trading venues — 11 exchanges, more than 40 alternative trading systems, and more than 250 broker-dealers. 

This proliferation of venues, however, also raises issues. One is their interconnectedness — the potential for one or more systems to malfunction and disrupt other systems, or to interact with other systems in unexpected ways. Another is the increase in the percentage of order flow that is handled and executed by dark trading venues.”

Rather than tinkering around the edges or diving into a complete Reg NMS overhaul, we believe the SEC can address fragmentation in three manageable  steps:

1) Introduce a Protected Quote Market Share Threshold Rule – this rule would require that a venue maintain at least a minimum market share percentage (we recommend 3%) to maintain their protected quote status.  Using 3% would reduce the number of protected quote venues to 6 from 12.

2) Introduce a Non-Public (ATS) Venue Market Share Threshold Rule – similar to the above, this rule would require that an ATS maintain a minimum market share percentage (again, we recommend using 3%) to keep their ATS status. This percentage would be the market share that the ATS has amongst all ATS’s (last week, the number one ATS was UBS with a 15% share followed by CSFB  and IEX who were tied with 12% market share).   Using a 3% level would eliminate dozens of unproductive ATS’s and leave only 12.

3) Eliminate payment for order flow – this includes rebates as well as payments made by internalizers to retail brokerage firms.

By doing the above, we think fragmentation and economic conflicts could be dramatically reduced.  Reducing fragmentation while still maintaining enough venues for redundancy will enhance liquidity and lessen the opportunity for unnecessary venue arbitrage.   Of course, we would expect the industry to vigorously fight all three of these recommendations which is why we don’t see the SEC tackling them any time soon.