On January 13th, the Securities and Exchange Commission (the “SEC” or the “Commission”) held an open meeting at which the Commissioners voted unanimously to: (1) propose a new rule regarding risk management controls and supervisory procedures to manage financial, regulatory, and other risks, for brokers or dealers that provide their customers with unfiltered direct access (frequently referred to as “naked access”) to exchanges and/or alternative trading systems (“ATSs”), and (2) publish a “Concept Release” on equity market structure that would invite public comment on a wide range of issues, including the performance of the current market structure, high-frequency trading, and undisplayed (“dark”) liquidity. The open meeting was attended by members of the staff of the Division of Trading and Markets (the “Division”), which prepared each of the releases under consideration.

Publication of each of the releases is expected to occur shortly. In advance of that publication, this briefing will highlight the issues behind the proposal and the Concept Release, as well as some of the more significant questions and concerns raised by the Commissioners at the meeting. We anticipate providing follow-up briefings upon the publication of the proposed rule and the Concept Release.

Risk Management Controls for Broker-Dealers with Market Access

The Commissioners voted unanimously to propose for public comment a new rule that would effectively prohibit broker-dealers from providing customers with naked access to the securities markets. Proposed Rule 15c3-5 would require broker-dealers with direct access to trading on an exchange or ATS, including those sponsoring customer access to such exchange or ATS, to implement appropriate risk management controls and supervisory procedures to reduce or prevent the risk of erroneous transactions, ensure compliance with applicable laws, rules and regulations, and impose pre-set credit or capital thresholds on each customer. Referring to recent statistics showing that naked access accounts for nearly 38 percent of daily trading volume, Chairman Mary Schapiro analogized providing naked access to the markets to “giving your car keys to a friend who doesn’t have a license and letting him drive unaccompanied.” According to Chairman Schapiro, the proposal would require not only that the lender of the keys remain in the car, but also “see to it that the person driving observes the rules before the car is ever put into drive.”

The proposal calls for broker-dealers to:

  • Create financial risk management controls reasonably designed to prevent the entry of orders exceeding pre-set credit or capital thresholds, or that appear to be erroneous;
  • Adopt regulatory risk management controls reasonably designed to ensure compliance with all applicable regulatory requirements;  
  • Apply financial and regulatory risk management controls automatically on a pre-trade basis, before orders are routed to an exchange or ATS;
  • Maintain the required risk management controls and supervisory procedures under the direct and exclusive control of the broker-dealer providing the market access; and  
  • Establish, document, and maintain a system for regularly reviewing the effectiveness of the controls and for promptly addressing issues that arise.

Assistant Director John Roeser explained that the proposed rule would require firms to have a system of financial and regulatory risk management controls and supervisory procedures that are reasonably designed to systematically limit the financial exposure of the broker-dealer and ensure compliance with applicable regulatory requirements. In particular, there will have to be adherence to pre-set credit or capital controls.

According to Division Director Robert Cook, the SEC is particularly concerned about firms providing direct access without orders passing through the broker-dealers’ compliance and risk management controls, relying instead on an agreement by the customer to comply with applicable regulations and pre-determined risk limits, which is viewed by the Division as insufficient to prevent a major problem. He stated that various exchanges have been developing rules to address this issue, and that a proposal by the Nasdaq Stock Market has just been approved,1 but there is a need for additional protections, including uniformity, pre-trade controls in all cases, and for broker-dealers to remain responsible for the compliance and risk management controls. Thus, broker-dealers will not be permitted to outsource the control function, either to their direct access customers or to third parties. An important component of the new rule is a requirement for annual certification by each broker-dealer’s Chief Executive Officer regarding the adequacy of the firm’s risk management controls and supervisory procedures.

The proposed rule is deliberately broad. It will apply to transactions in equity securities, including options, Exchange Traded Fund (“ETF”) securities, and debt securities. Moreover, its requirements are not limited to firms that provide direct access to others. It also applies to broker-dealers’ proprietary trading activities, and even to traditional agency orders. Although the Division believes that most broker-dealers that send their own orders (including agency orders) electronically to exchanges already have compliance and risk management controls, including proprietary trading activity within the scope of the rule will reinforce to those firms (as well as to those that have not created adequate controls) the need to continually review such controls and keep them up to date. It also will subject the controls over proprietary and agency orders to the annual certification requirement. Some market participants are questioning whether this proposed rule may serve as precedent for other electronic markets not regulated by the SEC, such as futures markets.

Commissioner Kathleen Casey commented that the required controls and procedures appear to be a defensible approach to addressing the risks of direct access trading, but she expressed skepticism over whether the rule should be adopted before the SEC has an opportunity to analyze the comments that it expects to receive in connection with its market structure Concept Release (see below). According to Commissioner Casey, the SEC must develop a deeper understanding of overall market structure issues before moving to regulate, to avoid possible unintended consequences. In response to her inquiry about costs of complying with the new requirements, it was noted that current Division estimates vary, depending on factors such as whether a firm needs to create new systems or update existing ones, and whether a firm chooses to build such systems or buy them from vendors. The rule’s proposing release will seek specific information regarding this point and regarding the impact on small broker-dealers.

Commissioner Elisse Walter expressed support for the proposal, pointing out that allowing customers to trade without pre-trade controls could lead to significant erroneous transactions with the potential to seriously destabilize the market. She argued that standardizing requirements across markets, and bringing uniformity to control requirements, would bring order to the process and level the playing field for markets and market participants. Commissioner Luis Aguilar expressed support, stating that the SEC must ensure that the quest for speed of execution does not lead to additional risk, and avoid the temptation to sacrifice control for speed. Commissioner Troy Paredes said that he is keenly interested in seeing comments on the potential impact of the proposed rule on trading activity, as well as its overall impact on markets. He also is concerned about the costs that would result from the proposed rule. With respect to systemic risk, Commissioner Paredes inquired about the likelihood of a systemwide event being caused by improperly controlled sponsored access transactions. Associate Director David Shillman noted that, while it has not happened yet, the evolution of the markets has led to algorithms generating thousands of orders per second, making it easy to envision someone, deliberately, negligently, or through a problem with an algorithmic trading system, entering thousands of erroneous orders that quickly add up to millions of shares and a significant market impact, even if trades were subsequently broken.

Concept Release on Equity Market Structure

As has been expected for several months, the Commissioners also voted to approve publication of a Concept Release, inviting public comment on a wide range of issues related to equity market structure. According to Chairman Schapiro, trading has grown in volume and the speed of trading has moved from seconds, to milliseconds, to microseconds. The recent SEC rule proposals relating to flash orders and dark pools,2 and the direct access proposal discussed above, are attempts to address the novel issues raised by this evolution of trading. However, the SEC feels compelled to continue evaluating the impact of these and other changes on the ways in which transactions are executed.

The Concept Release will focus on a number of matters, including:

  • What the best metrics are for assessing market quality for long-term investors and whether those metrics have improved or worsened. 
  • Fairness of the current market structure, including whether the current, highly automated, high-speed market structure, is fundamentally fair for investors.  
  • The types of strategies used by high-frequency proprietary trading firms, and whether those strategies benefit or harm other investors.  
  • Whether the overall use of harmful strategies by proprietary firms is sufficiently widespread to warrant a regulatory initiative.  
  • Whether co-location services3 give proprietary trading firms an unfair advantage and, if so, whether the proprietary firms that use these services should be subject to any specific trading obligations. 
  • Whether the trading volume of dark pools and other undisplayed trading centers is at such a sufficiently significant level that it detracts from the quality of public price discovery.  
  • Whether routing more individual investor orders to public markets would promote quote competition in the public markets, lead to narrower spreads, and ultimately improve order execution quality for individual investors beyond current levels.  
  • Whether there are a significant number of individual investor orders executed in dark pools and, if so, the quality of execution for such orders.

Director Cook noted that today’s markets are large and complex, with exchanges, ATSs, and broker-dealers generating volume that often reaches 10 billion shares and 40 million trades in a single day. Through the Concept Release, the Division hopes to get the views of market participants on the impact of this growth. The Division is not looking to take a definitive position on the issues raised at this time; rather, it is trying to acquire as much information as possible. The Division wants to know whether trading systems are sufficiently linked to satisfy Congress’ mandate for a national market system, how different types of investors fare under the current market structure, and how that structure works for issuers.

Commissioner Casey noted that there would be a 90-day comment period and that she was pleased that the SEC would be able to obtain strong analysis and data, and comments from all types of investors. She reiterated her earlier comment, made in connection with the direct access proposal, that enacting new regulations before analyzing the detailed information sought by the Concept Release could have unintended consequences. According to Commissioner Walter, the U.S. markets are the envy of the world because they are open, transparent, and fair. By seeking this information, the Commission hopes to ensure that those markets remain that way, especially for long-term investors. She also called for similar examination of other markets, mentioning the debt market as one with a decentralized structure that may contribute to its higher transaction costs, poor transparency, and lesser liquidity. Commissioner Aguilar stated that the SEC’s goal is to learn everything that it can through the responses to the Concept Release, and thus urged all interested parties to share their views. Commissioner Paredes pointed out the need for data, which disciplines decision making, and stated that rigorous studies will be especially helpful. He pointed out the quality of the U.S. markets, noting that they performed well during the recent economic crisis (even though some investors suffered losses), and concluded that the SEC’s analysis must include an analysis of the “bottom line,” i.e., how do the U.S. equity markets perform? He also noted that technical developments can add to the quality of the markets’ performance, even if they may appear to lead to fragmentation.

The releases have not yet been published. Once they are, we will review the details and provide additional information and analysis.