September 22, 2000
Mr. Jonathan G. Katz
U.S. Securities and Exchange Commission
450 Fifth Street N.W.
Washington, D.C. 20549-0609
RE: Disclosure of Order Routing and Execution Practices (File No. S7-16-00)
The U.S. Advocacy Committee (USAC) of the Association for Investment Management and Research (AIMR)1 is pleased to comment on the proposed Disclosure of Order Routing (11Ac1-5) and Execution Practices (11Ac1-6) rules. The USAC is a standing committee of AIMR charged with reviewing and responding to major new regulatory, legislative, and other developments that may affect AIMR's U.S. membership and the efficiency and integrity of financial markets.
The USAC strongly supports the premise behind both proposals: namely (1) to promote the fair and vigorous competition between broker/dealers and (2) to educate investors as to the execution quality of their trades. In particular, we support rule proposal 11Ac1-6, Execution Practices. Like the U.S. Securities and Exchange Commission (SEC), we too believe that requiring broker/dealers to disclose their order routing procedures and agreements may (1) alert customers to potential conflict of interests that may influence how broker/dealers route orders and (2) empower investors to choose execution practices that best fit their needs and the current market conditions.
We, however, have serious concerns regarding the rule proposal 11Ac1-5, Disclosure of Order Routing. We fear that it will do little to advance the interests of retail and institutional investors while imposing significant costs on the broker/dealer community. The benefits of the rule proposal simply do not justify the costs. As evidenced by the length of the proposed rule, the problems the rule intends to correct are extremely complex. In fact, it is this very complexity that advantages many broker/dealers in terms of how they route customer orders and that disadvantages investors. It is the complexity of the current market structure that we believe the SEC should focus on and correct.
Unfortunately, this complexity cannot be remedied solely with additional disclosures. This is evidenced by the ineffectiveness of the disclosure requirements in place today. Today, broker/dealers must notify their customers if their orders are not routed for best execution. Typically, this disclosure is made on the trade confirmation and is commonly ignored by investors. The proposed rule intends to expand on the current disclosure requirements by mandating that broker/dealers also report a significant statistical data on each trade. It is highly unrealistic to expect investors to understand this data as doing so assumes that investors (1) understand the complexity inherent to the system and (2) have the statistical know-how to interpret the numbers. The rule implies that retail consumers wishing to participate in the market should immerse themselves in the numerical details or risk being disadvantaged.
As stated in our letter dated April 27, 2000, addressing the SEC's Market Fragmentation Concept Release, we again strongly recommend that an independent task force, adequately representing all stakeholders in the financial markets, be empanelled to make recommendations on regulatory action only after obtaining a keen understanding of how the market operates today. This would entail (1) quantifying the impact of technology and recent regulation on the current market structure and (2) determining an ideal market structure with a methodology of achieving it. Only once this understanding is achieved can the SEC propose the necessary changes that will remedy the current complexity embedded in our current market system while fully considering all the interests at stake.
Proposed Rule 11Ac1-5
Like the SEC, we too believe that educated investors improve their returns over time which, consequently, enhances the competitiveness of participants and market efficiency overall. We have historically supported the rule's underlying premise of full disclosure. We, however, do not favor Rule 11Ac1-5 as we do not believe its will further the interests of investors. The market fragmentation and the ensuing interests this fragmentation serves cannot be corrected solely with additional disclosures. We strongly believe that the SEC should focus on how the current market structure allows customer orders to be routed for execution. Requiring broker/dealers to disclose trade statistics will only provide an apparent temporary fix to a much larger problem. Assuming that the data released allowed investors to adequately assess the quality of their trades (which we do not believe it does), investors would be hard pressed to accurately use this data to their advantage.
With this said and assuming additional disclosures would be a viable remedy, the proposed disclosures do not provide the information necessary to evaluate the quality of the trade. Basically, the rule ignores the concept of best execution. In addition, the proposed rules does not address the impact of (1) the compliance costs, (2) the legal and financial implications of data errors and omissions, (3) the exemption of institutional trades, and (4) how investors will interpret the information. We believe investors will be confused with the large amounts data proposed and that the data is incomplete because it ignores (1) the motivation behind the trade and (2) the market conditions at the time the transaction took place.
Contrary to the SEC claim that this rule will have a small financial and systems burdens on the broker/dealer community, we believe that the proposal will be costly for both large and small broker/dealer firms. It is important to note that our objection to the rule is not based on its implied costs to the broker/dealer community, but rather on the limited benefits such costs will buy investors. We believe broker/dealers will incur costs doing the following:
Although it is true that broker/dealers track trade execution data for each transaction, they (1) do not have it in the proposed format and (2) cannot insure the accuracy of each data observation. Currently, this information is mostly used for internal purposes and generally has not been stress tested for accuracy.
The rule proposal does not address the consequences of errors and omissions, nor does it specify any corrective action should these exist. Data errors and omissions may expose broker/dealers to liability and financial risks should incorrect data be released to and relied upon by the public.
The rule ignores the considerable up-front systems costs that smaller broker/dealers will incur to comply. These broker/dealers will have to upgrade their computer systems to gather and warehouse the required data. Their current systems will, most likely, be unable to handle the large volumes of data and the statistical measures proposed.
The rule imposes an ongoing compliance cost for large and small broker/dealers alike. They will have to adopt a compliance program to validate the accuracy of the data being disclosed, to create a record-keeping system, and to warehouse past data. This compliance program will require firms to develop a validation process and to retain a competent staff responsible for this process.
As stated above, we believe the proposed rule will do little to better investor interests and possibly impose significant financial and systems costs on broker/dealers. In our opinion, the benefits of the rule simply do not justify the potential costs. We would find these costs acceptable if the rule provided meaningful information to investors. Because the data does not provide the necessary information to determine best execution, we fear the data could, in fact, mislead investors. The statistical data provides no indication as to (1) the needs of the investor at the time of each trade and (2) the characteristics of the market at the time the transaction took place. Categorizing and averaging the data as proposed will also result in an inappropriate benchmark for best execution.
We believe that it is probable that, as speculated in the proposal, a new industry will emerge to collect and interpret the information disclosed for investors if the proposed rule (or a like version) is adopted. Third parties, like sell-side analysts, for a fee will evaluate performance trends imbedded in the data. As more analysts do the same, the subjective opinion of one may eventually become the market consensus. However, third parties will not be able to accurately assess the quality of a broker/dealer's trading record as they are not privy to (1) the investor's needs motivating the trade and (2) market conditions at the time of each trade. In addition, there is a possibility that these third parties will not accept unverified raw trade data. Rather, it is likely that they will require that an independent auditor verify the information, further increasing the costs of the proposal.
The limited trading information inferred from the disclosed data is further constrained by exempting institutional trades (which constitute the majority of all trades) from the rule. Specifically, the rule exempts (1) transactions traded on proprietary or small markets centers (such as crossing networks), (2) after-market trades, (3) SmallCap transactions, and (4) options. Excluding institutional trades incorporates significant bias into the data pool as one eliminates the valuable trading information that sophisticated investors provide.
Should the propose rule be amended to truly reflect information relevant to determining best execution and the rule continues to exempt institutional trades, we recommend that the effects of the exclusions be clearly noted. More specifically, we believe that the percentage of disclosed transactions to total actual trades should be disclosed to underscore the limited percentage of total shares traded represented in the data. In addition, investors should be informed of the types of transactions excluded and how the exclusion will affect reported results. We believe blanket exclusions create an unleveled playing field across market participants.
We believe investors will be overwhelmed with statistical data and measures that they do not understand and that add little value to assessing the best execution of their trades. We recognize the SEC's attempt to make the disclosed information more manageable by classifying the data into multiple categories. However, having categories or averages further distorts the integrity and, thus quality, of the data. Judging the quality of a trade cannot be done on an aggregate basis, but rather can only be done on a transaction-by-transaction basis after considering (1) the customer's motivation behind the trade and (2) the current market conditions at the time of the trade.
Proposed Rule 11AC1-6
We support the proposed Execution Practices rule that will require a broker to disclose quarterly (1) the venues where it routed orders, (2) its objectives supporting its choice of venues, and (3) the financial benefits to its clients. Overall, we believe that disclosing execution practices will enhance the transparency of our markets and possibly improve the execution quality for consumers. The proposed disclosures will provide investors with a better understanding of the broker/dealer's services and expertise. With this information, investors will be able to better direct their trades to broker/dealers in a way that best meets their needs considering the current market conditions.
We have concerns, however, with the large order exclusion and with the SEC's consideration to require broker/dealers to disclose monetary compensation for directed order flow. Block orders, though usually handled via a specialist, should not be excluded from the disclosure. These orders comprise a significant percentage of trades and how they are routed and executed has an impact on the broker/dealer forwarding the trade and on the investor who initiates the transaction. Rather, we suggest that broker/dealers disclose block trades separately. Reporting this information separately avoids biasing the data disclosed while providing investors important market information. Disclosing specific monetary arrangements, even if in the aggregate, may reveal important proprietary information that would detail confidential competitive information that may be critical to the broker/dealer's business operations.
We also support the SEC's proposal that requires broker/dealers to respond to reasonable customer requests for information concerning a specific trade. Broker/dealers should disclose, when requested, where the trade was executed and show a relevant range of prices for same trades around the time of the customer's initial transaction. A broker/dealer could reasonably satisfy a price range request, for example, by showing the ten transactions preceding and following the customers trade. Quantifying the upper and lower end of the range with time (i.e., ten minutes as the rule proposes) is inappropriate given that the number of trades that could potentially fall within this range will vary significantly depending on the market depth of the security in question.
In closing, we caution the Commission against the hasty implementation of the disclosure requirements proposed in Rule 11Ac1-5. We strongly believe that such information will yield little or no benefit to investors because it fails to take into account the concept of best execution. Yet, the proposal does impose significant monetary, systems, and staff burdens on the broker/dealer community. Investors will ultimately absorb these costs in the form of greater trading costs. The added costs will also disadvantage domestic market makers vis-à-vis their off-shore and electronic counterparts not subject to the same reporting requirements.
The USAC appreciates the opportunity to comment on these issues. Should you have questions or need additional information, please do not hesitate to contact Maria J. A. Clark by phone at 804.951.5314; by fax at 804.951.5320; or by e-mail at email@example.com.
Deborah A. Lamb
Deborah A. Lamb
Advocacy Advisory Committee
Maria J. A. Clark
Maria J. A. Clark
Cc: AIMR Distribution List
USAC Distribution List
AIMR Best Execution Task Force
Michael S. Caccese, Senior Vice President, General Counsel & Secretary, AIMR
Patricia Doran Walters, CFA, Vice President, Advocacy, AIMR
Jessica E. Mann, CFA, Vice President, Standard Setting, AIMR
Philippa B. Hughes, Associate, Advocacy, AIMR
1 The Association for Investment Management and Research is a global, non-profit organization of over 41,000 investment professionals from over 90 countries. Through its headquarters in the U.S. and 97 Member Societies and Member Chapters worldwide, AIMR provides global leadership in investment education, professional standards, and advocacy programs.