The Securities and Exchange Commission has published a proposal to amend SEC Rule 15b9-1 under the Securities Exchange Act of 1934, as amended, which exempts certain broker-dealers from membership in a registered national securities association (Association). 

Under the proposal, issued March 25, 2015, the SEC would replace the rule’s current gross income allowance with a narrower exemption from Association membership for broker-dealers that carry no customer accounts and effect transactions on a national securities exchange (Exchange).  The proposal would exempt broker-dealers that effect transactions off the Exchanges of which they are members solely for the purpose of hedging the risks of floor-based activity, and off-exchange transactions resulting from orders routed by the Exchange to prevent “trade-throughs” in accordance with the provisions of SEC Regulation NMS.

The proposal could have a significant impact on certain high-frequency and other proprietary trading firms.

Background

In 1938, Congress imposed a regulatory framework for the off-exchange market through the Maloney Act, which added Section 15A to the Exchange Act.  It provided for creation of national securities associations of broker-dealers with powers to adopt and enforce rules to regulate the off-exchange market.  Only one such Association was ever created – the National Association of Securities Dealers (NASD), which is now known as the Financial Industry Regulatory Authority, Inc. (FINRA).  Thus, references to “Association” in the rule, the proposal and this memo are, for all practical purposes, interchangeable with “FINRA.” 

Rule 15b9-1 provides an exemption from the general requirement that broker-dealers be members of an Association1 for certain broker-dealers that limit their activities to the floor of an Exchange.  The rule was intended to address the limited activities of Exchange specialists and floor brokers conducted off the Exchanges of which they are members that are ancillary to their floor-based businesses.  It exempts a broker-dealer from the Association membership requirement provided that (1) it is a member of an Exchange; (2) carries no customer accounts; and (3) has annual gross income of no more than $1,000 derived from securities transactions effected otherwise than on the Exchange of which it is a member.  This last condition is generally known as  the “de minimis allowance.”  The rule permits income derived from transactions for the broker-dealer’s own account with or through another registered broker-dealer, including transactions through an alternative trading system or “ATS,” to be excluded from the calculation of the $1,000 de minimis allowance amount (the Proprietary Trading Exclusion).

The de minimis allowance originally was designed to permit broker-dealers doing business on Exchange floors to share in commissions paid on occasional off-exchange transactions in customer accounts that they introduced to other broker-dealers, but only up to a nominal amount.  When the Proprietary Trading Exclusion was added in 1976, the circumstances under which an Exchange specialist or floor broker might trade proprietarily off such Exchange were far more limited than today; for example, when a regional Exchange specialist would hedge risk on the primary listing market.  But the important point remained that broker-dealers exempt from Association membership pursuant to the rule were broker-dealers with a business focused on the floor and only engaged in very limited activities off the Exchange.  The rule was designed to accommodate those limited, ancillary activities, and the relevant Exchange was seen as the appropriate entity to regulate all of the activities of such broker-dealer.

Of course, the equities markets have fundamentally changed since the rule and the Proprietary Trading Exclusion were adopted.  Whereas trading volumes used to be concentrated on each stock’s primary listing Exchange, today’s market is highly electronic and decentralized, and there is substantial competition among a broad range of venues.  More importantly, new types of proprietary trading firms have developed, including those engaged in what is generally referred to as high-frequency trading.  Such firms generally effect transactions across the full range of markets, on and off-exchange, and through ATSs, and generate large volumes of orders and transactions across the national market system.  Many of these firms rely on Rule 15b9-1 to avoid FINRA membership; however, the SEC believes this was not what was envisioned when the Rule was adopted. According to SEC estimates, there are currently about 125 broker-dealers exempt from Association membership, including “some of the most active cross-market proprietary trading firms, which generate a substantial volume of orders and transactions in the off-exchange market.” The release notes that orders from non-FINRA member firms represented an estimated volume-weighted average of approximately 32 percent of all orders sent directly to ATSs during 2012 but, by 2014, such firms represented a volume-weighted average of approximately 48 percent of such orders.

Many broker-dealers that today rely on Rule 15b9-1 are very different from those for which the rule originally was intended – specialists and other members that focus their business on the floor of the Exchange of which they are a member.  As a result, the presumption that such Exchange is in the best position to provide self-regulatory oversight of such firms may no longer be completely accurate, leaving the SEC concerned that potentially manipulative and/or other illegal behavior may go undetected.  The SEC is therefore proposing to amend Rule 15b9-1 to “better align the scope of the exemption, in light of today’s market activity” with “the original purpose” for the rule.  Under the proposal, a broker-dealer that conducts off-exchange transactions outside the limited scope of the amended rule would be required to become a FINRA member subject to FINRA oversight and rules.  

The proposed amendments

The SEC is proposing to eliminate the de minimis allowance entirely and replace it with a more focused exemption from Association membership for a broker-dealer that conducts business solely on an Exchange floor and only effects off-exchange transactions for its own account with or through another registered broker-dealer, and solely for the purpose of hedging the risks of its floor-based activities (the Hedging Exemption).  The proposal also includes an exemption for orders routed by the Exchange in compliance with trade-through rules pursuant to Rule 611 of Regulation NMS. The SEC also proposes to eliminate outdated references to the Intermarket Trading System, which was eliminated in 2007 when it was superseded by Regulation NMS.

As discussed above, the de minimis allowance was intended to permit specialists and other floor members to receive a nominal level of commissions related to occasional off-exchange transactions for accounts referred to other members without them being required to become Association members. Since floor-based businesses today represent only a small fraction of market activity, the SEC preliminarily believes that the de minimis allowance is no longer necessary or appropriate; however, it is seeking comment as to whether any floor members currently rely on the de minimis allowance to determine whether it continues to be appropriate.

The Hedging Exemption would be limited to a broker-dealer that trades on the floor of an Exchange and would allow it to effect transactions for its own account with or through another registered broker or dealer solely for the purpose of hedging the risks of its floor-based activities.  A broker-dealer relying on this exception would be required to establish, maintain and enforce written policies and procedures reasonably designed to ensure and demonstrate that such transactions reduce or otherwise mitigate the risks of the broker-dealer’s financial exposure resulting from its floor-based activity.  The relevant Exchange would be responsible for enforcing compliance with the hedging exemption, including reviewing the adequacy of those written policies and procedures and whether the off-exchange transactions comply with them.

Analysis and potential impact

The proposal appears to be directed largely at high-frequency and other proprietary trading firms.  Originally, many such firms relied on the distinction between a “trader” and a “dealer” to avoid broker-dealer registration; however, when the SEC adopted Rule 15c3-5 in 2010, restricting direct access to Exchange floors by customers of broker-dealers, the latency involved in going through the systems of a registered broker-dealer led many such firms to become Exchange members so they could continue to have direct access to the floors.  Exchange membership, of course, required registration with the SEC as a broker-dealer but Rule 15b9-1 allowed them to avoid FINRA membership.  While the activities of such firms also involved trading off-exchange through alternative trading systems, since an ATS is technically a broker-dealer, the firms were able to ignore that activity for purposes of calculating the de minimis allowance.  Under the proposal, such firms would no longer be able to ignore that trading activity and would thus be required to become FINRA members if they wish to continue being registered broker-dealers and having direct access to Exchange floors.  

The proposal would result in a significant number of firms having to become members of FINRA and therefore become subject to additional rules regarding their conduct and trading activity as well as additional fees and charges.  As far as additional review and oversight of the activities of firms that currently are Exchange members only, it bears noting that several of the Exchanges of which such firms are members have contracted for FINRA to perform their surveillance and regulatory oversight activities.  While the additional trade reporting obligations that will now apply to these new FINRA members will provide additional trading data for FINRA to review, it remains unclear how much additional oversight will actually result from the proposal.

The SEC is seeking comments on the proposal generally, as well as with respect to a number of specific questions raised in the release.  Comments will be due no later than 60 days following the release’s publication in the Federal Register, which is expected sometime during the week of March 30.  It will be interesting to see how the industry responds.