The Financial Industry Regulatory Authority (“FINRA”) on October 6, 2021, published a regulatory notice (“Notice”) requesting comment on a proposal requiring broker-dealers to publish quarterly order routing disclosure reports for held orders in over-the-counter (“OTC”) equity securities. The proposed reports would be similar to those required by Rule 606(a) of Regulation NMS for U.S. securities exchange listed securities (i.e., national market system (“NMS”) securities).1 Comments on the proposal must be received by December 6, 2021.
Background
Over the past decade, FINRA has made efforts to incorporate the principles of the SEC’s Regulation NMS into the regulatory framework for OTC equity securities.2 In 2010, FINRA adopted the “NMS-Principled Rules,” which govern quotation practices for OTC equity securities, including: minimum pricing increments; locking and crossing quotations; access fees; and limit order display. According to the Notice, the purpose of the NMS-Principled Rules was “to enhance market quality and to better protect investors in unlisted stocks.”
Under Rule 606 of Regulation NMS, broker-dealers are required to disclose certain information about their order routing practices and arrangements for NMS securities. Rule 606(a) requires quarterly order routing reports for “held” orders in NMS securities to be made publicly available. A “held” order is an order that a broker-dealer must attempt to execute immediately, while a “not held” order provides the broker-dealer with price and time discretion in handling the order.
Proposed Disclosures
The proposal would require each FINRA member to make publicly available a report on its routing of non-directed orders in OTC equity securities submitted on a held basis for each calendar quarter. The proposed reports would be required to be posted on a website that is free and readily accessible to the public and would be made available in a standardized format to be determined by FINRA.
Though not a part of the proposal, FINRA also requested comment as to whether other types of disclosures under Regulation NMS might be appropriate to apply to OTC equity securities (including customer-specific disclosures concerning the handling of not held orders under Rule 606(b)(3) and execution quality disclosures under Rule 605).
The proposed quarterly reports would be required to be broken down by calendar month and separated into three sections:
- Domestic OTC equity securities;
- American Depository Receipts (ADRs) and ordinary shares of foreign stock that are OTC equity securities; and
- Canadian-listed securities trading in the United States as OTC equity securities.
The reports would contain information similar to what is required for NMS stocks under Rule 606(a), but simplified to provide more targeted information relevant to the market for OTC equity securities. Under the proposal, the new quarterly reports would require disclosure of:
- The percentage of total orders that were not “directed orders”;3
- The identity of the 10 venues to which the largest number of total non-directed orders were routed for execution, the identity of any venue to which five percent or more of non-directed orders were routed for execution, and the percentage of total non-directed orders routed to each venue identified;
- For each venue identified in the report, the net aggregate amount of any payment for order flow received, payment from any profit-sharing relationship received, transaction fees paid, and transaction rebates received (both as a total dollar amount and per order); and
- A discussion of the material aspects of the member’s relationship with each venue identified in the report, including a description of any arrangement for payment for order flow and any profit-sharing relationship and a description of any terms of such arrangements (written or oral) that may influence a member’s order routing decision including (among other things):
- Incentives for equaling or exceeding an agreed-upon order flow volume threshold and/or disincentives for failing to meet an agreed-upon minimum order flow volume threshold;
- Volume-based tiered payment schedules; and
- Agreements regarding the minimum amount of order flow that the member would send to a venue.
In the Notice, FINRA notes that the proposed report would represent an “important first step” in increasing transparency in the market for OTC equity securities.
Request for Comment
FINRA requested comments on a number of specific items related to the proposal, including:
- Whether the proposed order routing disclosure reports provide useful information to the marketplace;
- What costs would be associated with the proposed disclosure reports and how much time member firms would need to make systems and other changes to implement the proposal;
- Whether orders in “grey market”4 securities should be included in the proposed routing disclosure reports;
- Whether the new reports should apply only to held orders (as proposed) or whether not held orders also should be included in the reports;
- Whether commenters agree that members not be required to break down into sub-categories held orders that were non-directed orders, based on whether the orders are market orders, marketable limit orders, non-marketable limit orders and other orders;
- Whether commenters agree with the proposed requirement to disclose aggregate payments to or from venues, both as a total dollar amount and per order (rather than per share as required for NMS stocks under Rule 606(a)); and
- Whether commenters agree with the requirement to include a discussion of the material aspects of a member’s relationship with each identified venue, including a description of any arrangement for payment for order flow and any profit-sharing relationship, as well as a description of any terms of such arrangements that may influence the member’s order routing decision.
Conclusion
The proposal is the latest action taken by regulators focusing on the OTC markets. In September 2020, the SEC adopted amendments to Exchange Act Rule 15c2-11 in an effort to enhance protections for retail investors and modernize the rule, which governs quotations for OTC securities.5 The amendments prohibit broker-dealers from publishing quotations for OTC securities when current information about the issuer of such security is not publicly available, subject to certain exceptions.
Footnotes
1) Rule 600(b)(47) of Regulation NMS defines an “NMS security” as “any security or class of securities for which transaction reports are collected, processed, and made available pursuant to an effective transaction reporting plan, or an effective national market system plan for reporting transactions in listed options.”
2) According to the Notice, FINRA rules define “OTC equity securities” as “any equity security that is not an NMS stock, other than a Restricted Equity Security.” Restricted Equity Securities are those that meet the definition of “restricted security” as contained in Securities Act Rule 144(a)(3).
3) Under the proposal, a “directed order” would be an order that the customer specifically instructs the broker-dealer to route to a particular venue for execution.
4) According to the Notice, “grey market securities” are OTC equity securities that have no published quoted prices in a quotation medium for buyers and sellers to access.
5) SEC Adopts Amendments to Enhance Retail Investor Protections and Modernize the Rule Governing Quotations for Over-the-Counter Securities, (Sept. 16, 2020).
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