The Securities and Exchange Commission (the “SEC”) recently proposed an amendment to Rule 15b9-1 under the Securities Exchange Act of 1934 (the “Exchange Act”). The proposed amendment (the “Proposed Amendment”) would require many high-frequency traders (“HFTs”)1 to become members of the Financial Industry Regulatory Authority (“FINRA”).2
Background and Discussion
Exchange Act Section 15(b)(8) requires each SEC-registered broker or dealer, other than a broker or dealer that effects securities transactions on a national securities exchange of which it is a member,3 to be a member of a registered national securities association (an “Association”). The SEC views Association membership as the primary means of regulating broker-dealer trading in the off-exchange market.4 At the present time, FINRA is the only Association in existence. Accordingly, FINRA is primarily responsible for regulating trading in the off-exchange market.5
Current Rule 15b9-1 provides an exception from the 15(b)(8) requirement of Association membership for a broker or dealer that: (i) is a member of a national securities exchange, (ii) carries no customer accounts, and (iii) has annual gross income of no more than $1,000 that is derived from securities transactions that were not effected on a national securities exchange of which the broker or dealer is a member (the “de minimisallowance”). Significantly, Rule 15b9-1 does not count any income derived from transactions for the dealer’s own account that are executed with or through another SEC-registered broker-dealer (i.e., not with a customer) toward a dealer’s $1,000 de minimisallowance (the “exclusion for proprietary trading”).
The exception was originally intended to accommodate exchange specialists and other floor members that might need to conduct limited hedging or other off-exchange activities ancillary to their floor-based business. However, the equities markets have undergone a substantial transformation since the SEC adopted Rule 15b9-1, evolving from markets with both manual and automated features and trading volumes concentrated on the primary listing exchanges, to a highly electronic, decentralized market with substantial competition among a large number and great variety of trading venues.
Under the current rules, a proprietary trading firm that is a member of a national securities exchange and carries no customer accounts may engage in unlimited off-exchange proprietary trading without triggering an obligation to be a member of an Association. Many HFTs have been relying upon Rule 15b9-1 in this way.
In 2010, the SEC issued a concept release that, among other things, solicited comment on whether all proprietary trading firms should be required to register as broker-dealers and become members of FINRA to help assure that their operations were subject to full regulatory oversight.6 After considering comments in response to the Concept Release, the SEC is proposing the Proposed Amendment. The SEC believes that HFTs are responsible for a substantial volume of orders and transactions in the off-exchange market7 and, accordingly, views HFTs’ reliance on Rule 15b9-1 as a “regulatory gap” that has in recent years permitted considerable off-exchange activity to go unregulated. The Proposed Amendment seeks to close that “gap.” Specifically, the Proposed Amendment would eliminate the de minimis allowance and the proprietary trading exception. It would replace them with a limited exemption from Association membership for national securities exchange member broker-dealers that operate on the floor of the exchange, to the extent that they effect transactions off-exchange solely for the purpose of hedging the risks of their floor-based activities. A dealer seeking to rely on the exception created for hedging must establish, maintain and enforce written policies and procedures reasonably designed to ensure and demonstrate that such hedging transactions reduce or otherwise mitigate the risks of the financial exposure the dealer incurs as a result of its floor-based activity.
Additionally, the Proposed Amendment would exempt a broker-dealer executing orders that are routed by a national securities exchange of which it is a member to prevent trade-throughs8 on such national security exchange consistent with the provisions of Regulation NMS.
The SEC believes the Proposed Amendment will enhance oversight of cross-market trading activity, which will allow FINRA to detect abusive trading practices more effectively. The practical result of the Proposed Amendment would be to require that: (i) each HFT that conducts off-exchange activity outside of the scope of Rule 15b9-1, as it is proposed to be amended, become a FINRA member and (ii) each HFT that does not trade off-exchange, but does trade indirectly on multiple exchanges, become a FINRA member or become a member of each exchange on which it effects transactions other than transactions to hedge the risks of its floor-based activities.
FINRA membership would impose upon HFTs a variety of new obligations and associated costs. The Proposed Amendment contemplates that HFTs would be required to become FINRA members no later than 360 days following publication of the final rule in the Federal Register. Comments to the Proposed Amendment should be received on or before June 1, 2015.