On January 13th, the Securities and Exchange Commission (the “SEC” or the “Commission”) approved a proposal by the Nasdaq Stock Market LLC (“Nasdaq”) to modify its rule governing electronic access to Nasdaq’s order execution systems. As modified, Nasdaq Rule 4611 (the “Modified Rule”) will govern the manner in which a Nasdaq member provides another entity with access to Nasdaq order execution systems using the member’s market participant identifier (“MPID”).1

The Modified Rule is intended to ensure that the member firm assumes full responsibility for the customer’s trading activity and has in place effective financial and regulatory controls to protect market participants from systemic risk and preserve market integrity. It reflects Nasdaq’s concern that unfettered access by customers of member firms to trading systems presents serious risks to the market and its participants. This concern is shared by the SEC, as reflected in its vote, on the same day that it approved the Modified Rule, to propose a new rule regarding risk management controls and supervisory procedures for brokers or dealers that provide customers with unfiltered access to exchanges and/or alternative trading systems (“ATSs”).2

The Modified Rule seeks to improve the regulatory framework surrounding access to the Nasdaq market by requiring members to implement focused controls and procedures, and impose specific contractual provisions, to address its requirements. It will require broker-dealers to re-evaluate their relationships and agreements with those for whom they provide such access. It also will require each broker-dealer to review and revise its financial and regulatory controls to make certain that those controls are sufficient to satisfy FINRA’s (and indeed the SEC’s) goal of ensuring that the firm assumes full responsibility for its customers’ trading activity and has effective financial and regulatory controls in place to protect market participants from systemic risk and preserve the integrity of the marketplace.

The Modified Rule

The Modified Rule requires each Nasdaq member that enters into an arrangement to provide another person or entity, such as a customer, another member, or a non-member broker-dealer, with access to Nasdaq, or to allow the person to route its orders to Nasdaq using the Nasdaq member’s MPID, to do so through a “Sponsored Access System” or a “Member System,” as each is defined in the Rule.3 Members that provide such access are responsible for all trading conducted pursuant to that arrangement as if the trading was conducted by the member itself for the customer. The member must have policies and procedures for supervising and monitoring the trading activity pursuant to the arrangement to ensure that it complies with all applicable laws, rules and regulations, irrespective of the manner in which the orders reach Nasdaq.

Under the Modified Rule, there are two types of access – “Sponsored Access” and “Direct Market Access.” Sponsored Access involves a Nasdaq member (a “Sponsoring Member”) providing access to Nasdaq to another person, firm, or customer (each a “Sponsored Participant”) without the orders passing through a Member System prior to reaching Nasdaq. Direct Market Access involves a Sponsoring Member providing access to Nasdaq to a Sponsored Participant, with the orders passing through a Member System prior to reaching Nasdaq. The Modified Rule applies to Sponsoring Members regardless of whether its Sponsored Participants are broker-dealers, non-broker-dealers, or non-member broker-dealers.

The proposal requires Sponsoring Members providing Direct Market Access to comply with certain financial and regulatory controls. Those providing Sponsored Access must comply with certain contractual provisions as well as the financial and regulatory controls.

Contractual Provisions

A Sponsoring Member that provides Sponsored Access must execute and maintain agreements with each Sponsored Participant containing the following undertakings:

  • All of the Sponsored Participant’s trading activity must comply with all applicable laws, rules and regulations (the “Regulatory Requirements”).
  • The Sponsored Participant must, promptly upon request, provide the Sponsoring Member with access to such books and records and financial information as is necessary to allow the Sponsoring Member to comply with its regulatory obligations relating to the Sponsored Participant’s activity, and cooperate with the Sponsoring Member in maintaining compliance with the Regulatory Requirements.
  • The Sponsored Participant must maintain its trading activity within credit, product or other financial limits specified by the Sponsoring Member.
  • The Sponsored Participant must maintain all technology permitting Sponsored Access to Nasdaq in a physically secure manner and may not permit unauthorized individuals to use the system or obtain access to Nasdaq. The Sponsored Participant must familiarize authorized individuals with the Regulatory Requirements and provide appropriate training prior to permitting use of the system or access to Nasdaq.
  • The Sponsored Participant must agree that the Sponsoring Member or Nasdaq may terminate Sponsored Access immediately if either determines that continuing such access poses serious risk to the Sponsoring Member or to market integrity.

A Sponsoring Member that provides Sponsored Access also must execute and maintain agreements with each “Third Party Provider” that provides a Sponsored Access System to Sponsored Participants. Such agreements must specify which of the Modified Rule’s financial and regulatory controls are satisfied by the system, and must contain the following undertakings:

  • The Third Party Provider will provide the Sponsoring Member, promptly upon request, with access to any books and records, and financial information, necessary to allow the Sponsoring Member to comply with its regulatory obligations with respect to the Sponsored Participant’s activity, and otherwise cooperate with the Sponsoring Member in maintaining compliance with the Regulatory Requirements.  
  • Third Party Providers must maintain all technology permitting Sponsored Access to Nasdaq in a physically secure manner and may not permit unauthorized individuals to use the system or obtain access to Nasdaq.  
  • Third Party Providers must agree that Nasdaq or its agent may audit the Sponsored Access System and that the Sponsoring Member or Nasdaq may immediately terminate Sponsored Access if the Sponsored Participant or Third Party Provider fails to comply with its commitments.

Financial Controls

Under the Modified Rule, Sponsoring Members must establish adequate procedures and controls to effectively monitor and control compliance with Regulatory Requirements, and systemically limit the Sponsoring Member’s financial exposure. This applies to both Sponsored Access and Direct Market Access relationships. At minimum, the system must be reasonably designed to:

  • Prevent each Sponsored Participant from entering orders that, in the aggregate, exceed pre-set credit thresholds.
  • Prevent Sponsored Participants from trading products that the Sponsoring Member is restricted from trading, or that a Sponsored Participant is restricted from trading for reasons specific to that Sponsored Participant.
  • Prevent Sponsored Participants from submitting erroneous orders by providing for rejection of orders that exceed certain price or size parameters, on an order-by-order basis or over a short period of time, or that indicate the presence of duplicative orders.

Regulatory Controls

The Modified Rule requires Sponsoring Members to establish adequate procedures and controls reasonably designed to permit them to effectively monitor and control compliance with the Regulatory Requirements. This also applies to both Sponsored Access and Direct Market Access relationships. Each Sponsoring Member must have systemic controls reasonably designed to ensure compliance by Sponsored Participants with the Regulatory Requirements, and must ensure that appropriate supervisory personnel receive and review timely reports of all trading activity by Sponsored Participants sufficient to permit the Sponsoring Member to comply with the Regulatory Requirements and to monitor for illegal activity. At a minimum, appropriate supervisory personnel should receive immediate post-trade execution reports relating to each Sponsored Participant, and all required audit trail information and information necessary to create and maintain required trading records by the end of the trading day.

Discussion

In approving the Modified Rule, the SEC expressed its belief that the Modified Rule will clarify and strengthen the obligations of Sponsoring Members to control risks when providing customers with Direct Market Access or Sponsored Access to Nasdaq execution facilities. By requiring Sponsoring Members to establish effective procedures and controls to systemically limit their financial exposure and comply with applicable regulatory requirements, as well as by requiring Sponsoring Members providing Sponsored Access to comply with certain contractual provisions, the Commission believes that the Modified Rule will help reduce the risks that arise from a Sponsoring Member providing Sponsored Participants with access to Nasdaq.

Interestingly, the SEC’s proposed direct access rule would effectively end Sponsored Access. That proposal 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 risk management controls and supervisory procedures that effectively require all orders to pass through the broker-dealers’ compliance and risk management controls. Nevertheless, until that rule is adopted, Sponsored Access to the Nasdaq market will be governed by this rule.

Although the SEC has approved the Modified Rule, it is inviting interested persons to submit written data, views, and arguments concerning the Modified Rule. Comments should be submitted within 21 days from publication of the adopting release in the Federal Register, which is expected during the week of February 19th.