“With great power comes great responsibility” – Voltaire (or Spider Man’s Uncle Ben)
As the fairly controversial and seemingly very expensive SEC tick pilot comes to a close in October, it’s a good time to reflect on the very interesting exemptions to Rule 611, specifically the use of Intermarket Sweep Orders (ISOs) and their unique compliance and surveillance requirements.
Since the beginning of recorded time, the notion that the holder of power carries a higher burden of responsibility has been common. Whether in the Bible (think Luke 12:48), the French National Convention of 1793 or the very first edition of The Amazing Spider Man the notion is the same: great power brings great responsibility. The same holds true for equity traders using Intermarket Sweep Orders (ISOs). ISOs can deliver big benefits to traders but because of this, these benefits come with substantial responsibility in terms of compliance.
Why Use ISOs?
The biggest benefit to utilizing ISOs can be summed up in two words: fill rates. The use of the ISO designation can dramatically increase fill rates on orders sent to the market and this higher fill rate can both increase trading profitability as well as open up possibilities for new and different trading strategies. While most data is anecdotal and is obviously dependent on order flow, market volatility, strategy types, etc., it is clear that fill rates can rise dramatically when ISOs are used correctly. Additionally, ISOs generally provide faster executions since these orders have to be accepted and filled immediately instead of potentially being rejected outright or routed away by an exchange. Further, there is also a potential information advantage gained from being the first to a trade that informed traders can utilize to their advantage. All in all, there are substantial benefits to ISOs but these benefits come with some complex and stringent responsibilities and failure to fully meet these obligations can be very costly in terms of fines and penalties.
Getting to the Heart of ISOs: Rule 611
Passed in June 2005, Regulation National Market System (RegNMS) was intended to modernize and strengthen the US equity markets, particularly by focusing on investor protection through ‘best execution’ rules. In particular, Rule 611, also known as the Order Protection (or Trade Through) Rule, was intended to guarantee that trades occur at the best price by ensuring that no trades occurred on “Exchange A” if a better price was displayed on “Exchange B”. But, as is so often the case with overly-prescriptive regulation, unintended consequences arose. As a result, a number of exemptions were allowed to the Trade Through rule, the most commonly used being ISOs. ISOs allow for transactions that defy the order protection rule but at the cost of a fairly lengthy set of prescriptive rules and guidelines that must be heeded. If you use the power of ISOs, you need to make sure you understand the responsibilities because the consequences for non-conformance can be high. Millions in fines have been levied upon firms who do not heed both the letter and the spirit of Rule 611.
Concern from Brokers
From our experience, most Tier 1 broker dealers are unwilling to support ISO orders for their customers for one reason: liability or, sticking with our theme, ‘great responsibility’. Fear of failure to meet the strict requirements for ISOs often causes brokers to stay away.
However, where there is responsibility, there is also opportunity. As stated previously, an increase in the use of ISOs usually leads to an increase in fill rates which generally leads to greater profitability which, in turn, leads to more trading. What’s more, the fact that many brokers will not support ISO orders means that those that do have a greater chance at securing high volume clients that are attracted to this order type.
A broker that wants to allow ISO usage by their clients can do so via a conduit agreement. The application of a conduit agreement is common, particularly with respect to broker/dealers that do not have connectivity to all protected trading centers. A conduit agreement gives access to protected trading centers for the submission of ISOs and according to the SEC RegNMS FAQ:
“This conduit routing structure is appropriate as long as the originating broker-dealer and the conduit broker-dealer or trading center have clearly delineated who will perform the necessary ISO routing functions.”
Having a conduit agreement is just the first step and providing the necessary compliance and surveillance infrastructure is fairly straightforward but not without its own challenges. Fortunately, it is possible to craft solutions by using external vendors and/or internal resources to get the job done. In the end, it can be well worth it to pursue this new business opportunity.
Making the most of ISOs
Regardless of the future of the rule, there are some very interesting opportunities available to those willing to brave the exceptions to RegNMS. Order protection is important and has benefited every investor, but being able to get around this rule has clear benefits to a trader. It can seem daunting to manage the responsibilities and avoid fines and penalties that come with an ISO program but it is possible to either build or find the tools that you need to safely and effectively utilize this powerful tool. Our advice: grab the power and accept the responsibility.
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