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Market Infrastructure

Modern Retail Needs Modern Rules

Shouldn’t retail reporting align with how large retail really is?

We recently talked about all the different ways there are to define a retail investor. In reality, there isn’t actually a definition of a retail investor, especially in Reg NMS (which does a lot to protect retail trading).

A number of the definitions apply different protections to “large” or “active” traders, but how they do that isn’t entirely consistent. Instead, the industry tends to fall back on three somewhat relevant rules:

  • NMS Rule 605: applies to covered orders of less than 10,000 shares.
  • NMS Rule 606: applies to customer orders of less than $200,000 (although it was recently enhanced to include institutional orders based on them being “not covered” orders).
  • FINRA retail attestation: allows retail brokers to attest that “substantially all” orders being sent originated from a natural person.

When we take a deeper dive into Rule 605, we discover it doesn’t reflect how retail orders trade as well as you might think.

Why Rule 605?

Rule 605 is important because it measures execution quality, in the aggregate, for retail investors who trust their brokers to fill their orders. That’s because 605 only includes “covered” orders. Covered orders have no “discretion,” or judgment, from the broker.

That is typically how retail investors send orders to brokers.

Although, it’s how routers often send orders to exchanges, too, with all their different order types, and that makes assessing 605 metrics on most other venues a much less useful task.

That, in turn, is also why the retail attestation is important. It differentiates between covered orders from a sophisticated algorithm and a natural person.

Rule 605 reports then group each order based on whether it should have crossed the spread and traded or not.

  • Orders that cross the spread should trade instantly, including market orders, which should trade regardless of price, and marketable orders, which should trade up until their limit price is reached.
  • Other “non-marketable” limit orders, including orders with price limits inside the quote (between the bid and offer), at the quote or near the quote (i.e., up to 10 cents away from the bid for a buy).

For all orders, 605 also reports the number of shares executed and canceled, as well as the average time to execute orders and realized spread calculated after the trade.

Results are then grouped by order size, based on shares. From the lowest starting at a 100-share order, up to the largest trade at 9,999 shares, as we show in Chart 1. Soon that won’t even include all round lots.

Chart 1: How Rule 605 groups orders for execution quality results in very different order values included in the same bucket as stock prices rise

Trade value

E/Q for marketable orders

Each order that should cross the spread and trade immediately also benefits from a competitive exchange NBBO. That’s because it is also scored based on their execution price and the NBBO at the same time.

  • Effective spread: measures the actual distance the execution price was from the midpoint of the NBBO at the time of order receipt. This is often compared to the distance to the actual far touch, and a ratio is created, commonly called an “E/Q” (effective over quoted) score.
  • Price improvement: means an execution better than the far-touch. It is measured in cents-per-share and also counted. By comparing the price improved order count to the number of all marketable orders, a “percentage price improved” is often calculated.
  • Disimproved shares: Rule 605 also requires a count and measure of disimproved shares. In theory, these are shares that traded through the far-touch. However, in today's markets, it’s common for large orders to completely remove the far touch and need to trade remaining shares at higher prices (for a buyer) to complete an order.
  • Realized spread: compares the execution price to the NBBO midpoint five minutes after the execution. This is similar to the “markouts” that institutions use but on a much longer timeframe.

Chart 2: How 605 measures execution quality

Terms for a buyer

How does retail get price improved?

Reg NMS Rule 612 requires all orders to be sent in whole ticks (which are currently decimals for most stocks). However, it does not require all trades to be in decimals.

That allows executions to occur at non-decimal prices, typically when customers entrust an execution to a facilitation broker who executes against their own risk book. As we have discussed before, retail orders frequently trade off-exchange for price improvement.

As we noted on our basic overview of the Securities Information Processor (SIP). However, how Rule 605 uses exchange quotes to improve retail executions shows why retail benefits significantly from their explicit contribution to the SIP, even though individuals do all almost their trading off exchange, and (mostly) pay no explicit commissions.

However, a common complaint with this quirk in the rulebook is that it means institutional investors can’t typically trade directly with retail investors because they’re not able to use sub-decimal limits in their trading algorithms. Although some exemptions have been created for institutions to participate in exchange retail programs using sub-decimal orders, those will not display and will only interact if retail orders routed to an exchange.

Does Rule 605 need to be modernized to fit retail?

Arguably, one thing Rule 605 has failed to keep up with is the increasing stock prices seen in the U.S. market. For example, using price improved orders, we recently estimated the typical retail trade sizes (Chart 3). More than 92% of the orders are for less than $20,000, with the average order being about $8,000.

Putting that in context and drawing data from the buckets used to calculate E/Q in Chart 1 above:

  • A trade of 9,999 shares in AMZN represents more than $30 million.
  • The smallest AMZN trade included in Rule 605, a round lot, is equal to a trade of more than $300,000.

Clearly, there is a disconnect, especially when retail is now trading in fractional shares and odd lots.

Chart 3: The actual distribution of price improved orders on the Trade Reporting Facility (TRF)

Sub-decimal trade count by trade size

In addition, by grouping all orders by share count, rather than trade difficulty or cost, 605 may mathematically incentivize cross-subsidies within E/Q buckets, where large traders benefit at the expense of others. Ironically, that’s the opposite of the main benefit of segmenting retail trades out.

Shouldn’t retail reporting align with how large retail really is?

It’s interesting how retail has evolved into its own separate stock market: trading off exchange for price improvement, relying on competitive spreads from exchanges, and using 605 reports to ensure their brokers’ executions are good.

But is Rule 605, in its share-based form, still the right way to define and protect a retail execution?

As share prices rise, wholesalers are forced to price-improve order sizes that seem far from typical retail trades. Citadel Securities recently called for a modernization of 605 to more accurately take size into account. Perhaps we could consider other rules, like the $100,000 large trader definition, or the $200,000 block-size rule, to determine who really deserves that price improvement most. That might even align Rule 605 better with Rule 606.

It might also result in true retail getting an even better deal.

Phil Mackintosh


Phil Mackintosh is Chief Economist and a Senior Vice President at Nasdaq. His team is responsible for a variety of projects and initiatives in the U.S. and Europe to improve market structure, encourage capital formation and enhance trading efficiency. 

Read Phil's Bio