Last week, the Securities and Exchange Commission proposed to amend SEC Rule 15b9-1 under the Securities Exchange Act of 1934, which exempts certain broker-dealers from membership in a registered national securities association (of which there is only one - FINRA). The SEC would replace the rule’s current gross income allowance with a narrower exemption from FINRA 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. Rule 15b9-1 provides an exemption from the general requirement that broker-dealers be FINRA members provided that they limit their activities to the floor of an Exchange. The rule was intended to address the limited off-exchange activities of Exchange specialists and floor brokers that are ancillary to their floor-based businesses. It exempts a broker-dealer from FINRA membership requirements 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 US$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 US$1,000 de minimis allowance amount (the Proprietary Trading Exclusion).
Of course, the equities markets have fundamentally changed since the rule and the Proprietary Trading Exclusion were adopted. Trading volumes used to be concentrated on each stock’s primary listing Exchange, but 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. 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 FINRA 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 SEC is proposing to eliminate the de minimis allowance entirely and replace it with a more focused exemption from FINRA 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 applicable trade-through rules. The SEC also proposes to eliminate outdated references to the Intermarket Trading System, which was eliminated in 2007.
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 FINRA 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. The Hedging Exemption would be limited to a broker-dealer that trades on the Exchange floor 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. The relevant Exchange would be responsible for enforcing compliance with the hedging exemption.
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 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. 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. It will be interesting to see how the industry responds.
