Compliance March 7, 2024

Broker/Dealers Will Be Required by SEC Rule to Disclose More Information on Execution Quality

Rule amendments finalized this week will require broker/dealers to share more information on the quality of stock order executions and produce a summary report.

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The Securities and Exchange Commission finalized on Wednesday amendments to Rule 605 of Regulation NMS by a unanimous 5 to 0 vote. The revised rule will require more broker/dealers to disclose quality-of-trade-execution reports to investors and to use more data to measure the quality of execution.

Broker/dealers with at least 100 customer accounts will now be required to disclose reports on their executions of stock trades. The reports must now cover orders outside of business orders and certain types of orders with stop prices. When disclosing time-to-execute information, broker/dealers must use time increments of milliseconds or smaller and must include more information on average price spreads and price improvement.

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Lastly, covered broker/dealers are required to publish a summary report of their data on a monthly basis.

SEC Chairman Gary Gensler argued at Wednesday’s open hearing that the rule will “foster more competition” by improving transparency and comparability. Commissioner Hester Peirce said the rule would provide a “clearer picture of execution quality” and will have positive effects for institutional and retail traders. She added that the summary reports will be helpful for the financial press, which will also help inform the public.

This rule was initially proposed in December 2022, along with three other proposals that are still pending. When regarded collectively, they are known as the market structure proposals. The other proposals included a best-execution standard; mandatory auctions for retail orders; and a reduction in pricing increments to sub-penny tick sizes for certain stocks.

The finalized amendments were by far the most popular within the industry of the market structure proposals, and many recommended that it come first, because it would provide additional data which would help clarify if the other three proposals would be useful. The proposal on price increments received mostly supportive feedback, while the other two were broadly opposed by industry.

The rule becomes effective 60 days after being entered into the Federal Register, and the compliance date will be 18 months after that—probably near the end of 2026.

Compliance March 7, 2024

SEC Unlikely to Abandon Predictive Analytics Proposal, Says Outgoing Division Director

William Birdthistle, the Securities and Exchange Commission’s current director of investment management, told an IAA conference the SEC will continue to explore regulating the use of artificial intelligence in finance.

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When speaking about the Securities Exchange Commission’s controversial predictive analytics proposal Thursday, outgoing investment management division director William Birdthistle had a simple message: “Do I think this project is going to go away? No, I don’t.”

In remarks delivered at the 2024 Investment Adviser Association Compliance Conference in Washington, D.C., Birdthistle said the regulator was unlikely to abandon its efforts to regulate artificial intelligence and predictive analytics. The remarks came just one day before Birdthistle will leave the SEC to return to academia.

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The predictive analytics proposal, first proposed in July 2023, would require an adviser to “eliminate or neutralize the effect of conflicts of interest associated with the firm’s use of covered technologies in investor interactions that place the firm’s or its associated person’s interest ahead of investors’ interests.”

A covered technology refers to “a firm’s use of analytical, technological, or computational functions, algorithms, models, correlation matrices, or similar methods or processes that optimize for, predict, guide, forecast, or direct investment-related behaviors or outcomes of an investor,” according to the SEC.

Gail Bernstein, the IAA’s general counsel, noted to Birdthistle that the IAA has asked the SEC, via comment letter, to completely withdraw the rule. Other organizations and members of Congress have also called for a full withdrawal. The primary objection to the proposal is that the definition of covered technology is too broad and that conflicts of interests have normally been managed through a mitigation-and-disclosure regime—not an elimination-and-neutralization regime.

Birdthistle responded that only an SEC commissioner can formally withdraw a proposal, but if he were able to, he would withdraw it “if you can withdraw the prediction that there won’t be an AI problem in finance.” He noted, however, that “there are already problems,” and “the degree of risk is very obvious.”

Birdthistle acknowledged at a Congressional hearing in September 2023 that the definition of covered technology is also a concern for him, and he invited stakeholders to recommend changes to the definition.

During Thursday’s discussion, Birdthistle pivoted to the difficulty of informative and timely disclosure when it comes to artificial intelligence and suggested, as SEC Chairman Gary Gensler has done in public comments, that artificial intelligence is uniquely unfit for a disclosure-based regime.

“I think it’s difficult to say that disclosure solves this,” Birdthistle said. “What is being disclosed?”

He noted that artificial intelligence often produces outputs that surprise even the engineers who designed it, and there can be a lack of understanding of how the technology works, both on the part of investors and by those responsible for writing the disclosure documents.

He argued that, for many advisers, their understanding of artificial intelligence is that information goes into a black box, “magic happens,” and something comes out. The sophistication and constantly evolving nature of artificial intelligence mean it is unsuited for disclosure—a similar argument to those Gensler has also made in public.

Birdthistle also emphasized that the SEC was not going to wait for issues with AI in finance to arise before acting to regulate them. He analogized the regulation to a parent protecting a child from traffic.

“You don’t wait until the child is in the street,” he said. “You can act beforehand.”

IAA’s Bernstein concurred, saying, “I think we all agree that this will be scary,” speaking of the risks of AI in finance. She went on to argue, however, that the proposal does not accomplish the goal of mitigating financial risks that might be associated with its use.

Later in the conference, Mara Shreck, the managing director for J.P. Morgan Chase & Co.’s office of regulatory affairs, provided examples of how the proposal as written would capture many use cases that the SEC does not likely intend to include and which, in any case, would be problematic for the advisory industry.

She explained that “dumb technology” already does many of the functions covered by the rule. This could include “trading nudges” from apps that inform investors of price changes and which are automated to prompt trading. It would also likely include educational features such as retirement readiness calculators, which can calculate monthly retirement income based on inputs provided by the user.

The SEC has not provided a timeline for an update on the proposal.

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