Institutions have a right to understand the potential impact that third-party agreements have on their orders. That is how we interpret the SECs proposed rules on the Disclosure of Order Handling Information. The SECs Proposal focuses on the potential conflicts of interest in routing and execution that may arise from the economic relationships broker-dealers (brokers) have with execution venues. In our view, the focus is too narrow.
In our comment letter to the SEC, we suggest that the SEC apply the same principals of disclosure and transparency at the beginning of the order handling process – when an order is routed to a broker. Doing this enables buy-side investors to evaluate the order routing strategies employed by their broker-dealer and the quality of resulting executions.
One area that could benefit from more transparency is the agreement a broker has with OMS/EMS vendors to share commissions. Brokers are assessed various connectivity fees – including in some cases per-share transaction fees – by the buy sides OMS/EMS vendor. The buy-side customer is a third-party in the commercial arrangement between the broker and their OMS/EMS vendor. Although fee arrangements are based on their order flow, most investment firms lack adequate transparency into the commercial arrangements that could have an effect on how their broker handles their orders.
The Proposed Rule Encourages Competition
The SECs Proposal encourages competition between trading venues by noting brokers can choose from a variety of venues when they route and execute retail and institutional customer orders. The call for more disclosure around order handling practices shows its concern that commercial policies used by trading venues to attract order flow could influence a brokers order routing decisions and degrade customer execution quality.
The SECs Proposal also encourages competition among brokers for customer order flow by creating a standard framework of disclosure, information and execution quality metrics to help the buy side, across brokers, identify where potential conflicts of interest may exist (e.g. economic incentives), how their brokers are managing conflicts (e.g. where they route), and the affects that their choices may have on execution quality (e.g. orders, leakage, executions).
SECs Focus is on Broker to Venue
In its Proposal, the SEC focuses on the last mile – the goal being to provide institutions with more details about a brokers order routing decisions from the time the order is received by the broker through the execution of the order. In our opinion, this focus is too narrow.
The TABB Group noted in their April 2016 report on European Equity Trading, that brokers globally are evaluating buy side relationships based on current net profitability rather revenue or expectations of future revenues. All costs matter. This is why potential conflicts in order handling may begin when the buy side sends the order to the broker, not just when it is received. With more and more commercial relationships assessing fees based on the buy sides order and activity, the buy side needs more information and disclosure to identify if these relationships create potential conflicts for the commissions they pay.
Improving Disclosure
Bloomberg operates the Asset and Investment Manager (AIM), an institutional order management system for the buy side and the Sell Side Equity Order Management System (SSEOMS) for broker-dealers. Bloomberg also operates an Execution Management System (EMSX) platform and FIX Network connectivity business.
There are generally two connectivity fee models that enable the buys side to send orders from their OMS/EMS to their broker. Fees may be assessed either as a flat per-month connectivity fee or a variable transaction-based fee (i.e., a broker-dealer will pay the OMS a fee per share for orders routed through the OMS to the broker).
In conversations with the buy and sell side, we found anecdotally that the terms of these contractual agreements are typically difficult to determine because the agreements appeared to be governed by nondisclosure provisions preventing either the OMS/EMS and/or the sell-side broker from publicly disclosing the economic terms of their agreement. As a result, the true costs incurred by the broker for any trade, any impact on the broker-customer relationship, or any potential conflicts of interest resulting from these costs, are hidden from the institution.
This anecdotal evidence was confirmed through a survey we conducted last month involving 24 of Bloombergs institutional investor customers representing about $2.1 trillion of assets under management. We discovered that, although 70% of investors knew of the existence of the compensation arrangements between their OMS/EMS vendor and their brokers, only 37% believe they have adequate transparency with regard to the fees.
Additionally, 37% of investors surveyed believe fee arrangements have an impact on their relationship with their broker, and 42% were unsure whether there was an impact.
This is a problem the SEC can address with its current proposal by expanding its scope.
Transparency Builds Trust
The SECs Proposal is predicated on the notion that customers require information regarding their brokers incentives (and costs), order routing decisions, and execution quality in order to understand their brokers potential conflicts of interest and effectiveness in executing the customers orders. The transaction-based arrangements between the OMS/EMS provider and the broker are a form of commission sharing. Institutions have a right to understand, and be provided with transparency into, how their commissions are being allocated and whether certain fee arrangements could potentially influence their brokers order handling decisions.
We look forward to seeing the SECs views on this in the adopting release.
This article first appeared on Bloomberg Trading Solutions
