On January 19th, the Securities and Exchange Commission (the “SEC” or the “Commission”) published for comment proposed Rule 15c3-5 (the “Proposed Rule”) under the Securities Exchange Act of 1934, which would require broker-dealers with access to an exchange or alternative trading system (“ATS”) as a result of being a member or subscriber (“market access”), to implement risk management controls and supervisory procedures reasonably designed to manage the financial, regulatory, and other risks involved in such activity. The Proposed Rule, which was announced at the SEC’s open meeting a week earlier,1 is intended to place on broker-dealers, including those providing customers and other market participants with such access, sole responsibility for controlling the risks associated with such access.
The Proposed Rule reflects the SEC’s concerns that the speed and automation of today’s markets, and the increasing number of arrangements under which broker-dealers permit customers and others to trade in those markets using the broker-dealers’ market participant identifiers (“MPIDs”),2 has raised the financial and regulatory risks inherent in such activity to a level that is not appropriately and effectively controlled. To address these concerns, the SEC is proposing to require broker-dealers with access to trading directly on an exchange or ATS to establish, document, and maintain a system of risk management controls and supervisory procedures (“controls and procedures”) that are reasonably designed to limit the financial exposure that may result from having market access and providing it to others, and to ensure that those with such access, and those to whom it is provided, comply with all applicable “regulatory requirements.”3 The SEC believes that it is critical for broker-dealers – which are the only entities that may become members of exchanges, and constitute the majority of ATS subscribers – to take responsibility for controlling those to whom they provide such access. While the Proposed Rule would not apply directly to non-broker-dealers, even those that are ATS subscribers, the effects on such market participants would nevertheless be significant.
The Proposed Rule
The Proposed Rule covers all securities, including equities, options, exchange-traded funds (“ETFs”), and debt securities. It requires broker-dealers to establish and maintain controls and procedures that are reasonably designed to prevent the entry of orders that exceed pre-set credit or capital thresholds and those that appear to be erroneous; to prevent the entry of orders without compliance, on a preorder entry basis, with all applicable regulatory requirements; to prevent the entry of orders in those securities that the broker-dealer or the customer is restricted from trading; to restrict access to the technology and systems that provide market access to authorized persons; and to assure that appropriate broker-dealer surveillance personnel receive immediate post-trade execution reports.
Most significantly, the Proposed Rule would require controls to be applied on an automated, pre-trade basis, and the required controls and procedures would have to be under the “direct and exclusive control” of the broker-dealer. This would effectively prohibit “unfiltered” (“naked”) access to exchanges and ATSs. The broker-dealer would be required to establish, document, and maintain a system for regularly reviewing the effectiveness of its controls and procedures, and for promptly addressing issues.4 The broker-dealer would be required to perform and document, at least annually, a review of its activities relating to market access to ensure the overall effectiveness of the controls and procedures, and the broker-dealer’s Chief Executive Officer would be required to certify annually that the controls and procedures comply with the Proposed Rule and that the required review has been conducted (“CEO Certification”).
In the Proposing Release, the SEC explains that while innovations in trading and technology can improve the efficiency and quality of the securities markets, it is critical to ensure that regulation keeps pace in order to effectively address emerging risks. The growth and sophistication of trading has greatly increased volume across the national market system, much of it the result of high-speed, high-volume, automated algorithmic trading, where orders are routed for execution in microseconds. Sophisticated technology analyzes markets, generates orders, and effects trades with little or no involvement by broker-dealers. Instead, broker-dealers provide customers and other market participants (including other broker-dealers) with access to the markets using two methods: “direct market access,” where the orders pass through the brokerdealer’s systems before going to the exchange or ATS; and “sponsored access,” where orders flow directly to the exchange or ATS without passing through the broker-dealer’s systems. In each type of arrangement, the broker-dealer allows the customer or other market participant to use the broker-dealer’s MPID to access the exchange or ATS electronically. While in all cases, the broker-dealer is legally responsible for the trading activity, in a sponsored access arrangement the broker-dealer has only limited ability to control risk prior to the orders being executed. The Proposed Rule would effectively eliminate sponsored access.
Market access arrangements enable broker-dealers, exchanges, and ATSs to compete for increased volume and a wider variety of order flow. Customers can use such arrangements, especially sponsored access arrangements, to reduce the latency inherent in routing orders through a broker-dealer’s system before it goes to an exchange or ATS for execution. This is especially important for those engaged in high-frequency trading and similar strategies, since the elimination of microseconds of latency can be critical to successfully effectuating the strategy.5 Certain exchanges and self-regulatory organizations have adopted rules intended to address the risks of access;6 however, the SEC believes that comprehensive, uniform, cross-market standards are needed to effectively manage the risks associated with market access. These risks, which include possible breaches of credit or capital limits, deliberate or inadvertent submission of erroneous orders, failure to comply with applicable rules or regulations, and failure to detect illegal conduct, exist whenever a broker-dealer trades as an exchange member or ATS subscriber, whether trading for its own account or for others, through traditional brokerage activities or through market access arrangements. Where there are no pretrade controls, or the broker-dealer relies solely on assurances from others that appropriate controls are in place, the brokerdealer could be unaware of potentially damaging activity until it is too late. The proposed definition is therefore intentionally broad. The SEC believes that any broker-dealer with direct access to trading on an exchange or ATS should have effective risk management controls.
According to the Proposing Release, the SEC’s biggest concern is preventing a severe, widespread incident arising from inadequate controls on market access. The Proposed Rule would thus require controls and procedures that are reasonably designed to prevent the entry of orders that: (1) exceed pre-set credit or capital thresholds; (2) appear to be erroneous; (3) fail to comply with applicable regulatory requirements; (4) prevent the entry of orders that the broker-dealer or customer is restricted from trading; (5) restrict market access technology and systems to authorized persons;7and (7) assure that appropriate surveillance personnel receive immediate post-trade execution reports. The Proposed Rule allows each broker-dealer flexibility with regard to the details of their controls and procedures, depending on each one’s business and customer base, provided that they are reasonably designed to achieve the SEC’s goals. The SEC notes that the requirements already may be substantially satisfied by existing controls and procedures for proprietary trading and traditional brokerage activities. For sponsored access and certain other activities, the Proposed Rule should assure that controls and procedures are appropriately strengthened.
Request for Comments
The SEC is seeking comment on all aspects of the Proposed Rule, including:
- Whether the Proposed Rule would appropriately and adequately mitigate the risks of market access, whether different arrangements warrant different controls and procedures, whether there are other risks that the SEC should address, and circumstances in which a broker-dealer should not be responsible for trading conducted by others under its MPID.
- Whether the Proposed Rule would affect volume, market quality, speed and/or efficiency of trading; whether it would affect different types of securities differently; and whether the Proposed Rule should apply equally to all securities.
- Whether the Proposed Rule should apply equally to brokerdealers with market access, irrespective of whether they are proprietary traders, traditional brokers, or providers of direct market or sponsored access; whether market access should be treated differently depending on the type of market participants to which it is provided; and whether market access provided to another broker-dealer should be treated differently, including allowing the broker-dealers to allocate responsibility for controls and procedures.
- Whether broker-dealers should have separate MPIDs for each customer or other person for which they provide sponsored access.
- The costs and benefits associated with naked access; whether the SEC should consider alternatives to prohibiting “naked” access; and the impact that prohibiting naked access would have on broker-dealers providing access, customers, and the markets generally.
- Whether pre-trade controls provide the best method for mitigating risks associated with market access, whether the method for managing risk should be particular to the specific risk, and whether there are alternatives for managing such risks.
- Whether market participants would be required to change their business models or practices if the Proposed Rule were adopted, and whether the Proposed Rule would impact competition and innovation.
- Which market participants are the most common or active users of sponsored access generally, and naked access in particular; and the number of small broker-dealers that have or use sponsored access arrangements.
- Whether the required review of controls and procedures, or CEO Certification, should occur more or less than once per year.
Comments should be submitted on or before March 29, 2010. The Proposing Release “strongly encourages” commenters to respond within the designated comment period, stating that the SEC intends to act quickly in reviewing the comments and assessing further action.