Yesterday, the Securities and Exchange Commission (SEC) unanimously approved the proposal of a new rule (the “Proposed Rule”) that would prohibit broker-dealers from granting their customers “unfiltered” or “naked” access to an exchange or alternative trading system (ATS). The text of the Proposed Rule is not yet available. Accordingly, the descriptions provided in this alert are based upon the SEC’s press release.
Under an arrangement known as “direct market access” or “sponsored access,” a broker-dealer provides to its customers the market participant identifier that the broker-dealer uses to gain electronic access to exchanges and ATSs, so that those customers can gain direct access to place their own orders. When such orders pass directly into the markets without being pre-screened and properly managed by broker-dealers, it is known as “unfiltered” access or “naked” access. Unfiltered or naked access poses risks, such as the placement of erroneous orders, noncompliance with regulatory requirements and/or violations of credit or capital limits.
The Proposed Rule would require broker-dealers to establish, document and maintain risk management controls and supervisory procedures aimed at preventing erroneous orders, ensuring compliance with regulatory requirements and enforcing pre-set credit or capital limits. Specifically, the Proposed Rule would require broker-dealers to:
- create financial risk management controls reasonably designed to prevent the entry of orders that exceed appropriate pre-set credit or capital thresholds, or that appear to be erroneous;
- create regulatory risk management controls reasonably designed to ensure compliance with all regulatory requirements applicable in connection with market access;
- have financial and regulatory risk management controls applied automatically on a pre-trade basis before orders route to an exchange or ATS;
- maintain risk management controls and supervisory procedures under the direct and exclusive control of the broker-dealer with market access; and
- establish, document and maintain a system for regularly reviewing the effectiveness of its risk management controls and for promptly addressing any issues.
The SEC also approved a new Nasdaq rule (the “Nasdaq Rule”) yesterday that requires broker-dealers who offer sponsored access to Nasdaq to put in place controls to manage the risks of such an offering. The Nasdaq Rule is more limited in scope than the Proposed Rule.
The comment period on the Proposed Rule will be open for 60 days following the publication of the Proposed Rule in the Federal Register.