The Securities and Exchange Commission ("SEC") recently adopted new Rule 15c3-5 (the "Rule")1 under the Securities Exchange Act of 1934 (the "Exchange Act") which will require broker-dealers having access to trading activities directly on an exchange or an alternative trading system ("ATS"), as a member or subscriber or as an operator of an ATS, to establish and maintain a system of risk management controls and supervisory procedures reasonably designed to : (1) systematically limit the financial exposure of the broker-dealer arising out of such market access and (2) ensure compliance with all regulatory requirements applicable in connection with such market access. The Rule will be applicable to broker-dealers providing direct market access or sponsored access to an exchange or ATS to customers or other persons and to broker-dealer operators of their own ATS granting access to persons other than broker-dealers. Since the controls required under the Rule must be applied on a pre-trade basis, the Rule effectively prohibits the practice of granting "naked" or "unfiltered" sponsored access to market participants.
BACKGROUND
The SEC has become increasingly concerned with the financial and regulatory risks arising out of the development of sophisticated technological innovations resulting in increasing use of automation in executing trades, and the growing popularity of arrangements under which broker-dealers have allowed customers to trade directly on exchanges and ATSs using the broker-dealers' market participants identifiers ("MPID"). These arrangements have taken two basic forms: (1) "direct market access," under which a broker-dealer permits customers to enter orders to a market center through the broker-dealer's own trading system and (2) "sponsored access," under which the customer enters the orders directly to a trading center without passing through the broker-dealer's trading systems. "Sponsored access" can include "naked" or "unfiltered" access which allows a customer to use the broker-dealer's MPID to enter trades directly on an exchange or through an ATS without having the broker-dealer's pre-trade controls apply to such trading. Customers given either version of such access can include hedge funds and other institutional investors and other broker-dealers. These arrangements have been found to be particularly useful to market participants engaging in high frequency trading activities, including those utilizing highly sophisticated algorithmic trading programs. Although individual exchanges have adopted rules which have imposed requirements on their members to adopt controls to mitigate the risk of these activities2 the SEC has adopted the Rule in order to impose a uniform standard and consistent interpretation across all trading markets. It also is intended to prohibit naked market access by requiring all broker-dealers having market access to implement pre-trade controls on all sponsored arrangements, as well as to their own proprietary accounts.
APPLICATION OF THE RULE
The Rule will apply to trading in all securities on an exchange or an ATS, including equities, options, exchange-traded funds, debt securities and security-based swaps.3 The broker-dealer with market access4 must have direct and exclusive control of the risk management controls, but may permit the reasonable and appropriate allocation of specific risk management controls to a customer that is a registered broker-dealer if the broker-dealer customer, based on its position in the transaction and relationship with the ultimate customer, can more effectively implement the controls. Broker-dealers that provide outbound routing services to an exchange or ATS in order for those trading centers to meet the requirements of Rule 611 of Regulation NMS will not be required to comply with the Rule, except with regard to controls as to the prevention of erroneous orders, since such routing brokers would only handle orders that have just passed through risk management controls of a broker-dealer subject to the Rule.
REQUIREMENTS OF THE RULE
All broker-dealers having market access, or providing a customer or other person with access to an exchange or ATS through use of their MPIDs or otherwise, must establish, document and maintain a system of risk management controls and supervisory procedures reasonably designed to manage the financial, regulatory and other risks, such as legal and operational risks, related to such market access. These include procedures reasonably designed to:
- Systematically limit the financial exposure of the broker-dealer arising out of such market access, and
- Ensure compliance with all regulatory requirements applicable in connection with such market access.
Systematically limit the financial exposure of the broker-dealer arising out of such market access
The required financial risk management controls must be reasonably designed to prevent the entry of orders that: (a) exceed appropriate pre-set credit limits or capital thresholds or (b) are clearly erroneous, by rejecting orders that exceed appropriate price or size parameters, on an order-by-order basis or over a short period of time, or that indicate duplicative orders.
Ensure compliance with all regulatory requirements applicable in connection with such market access
"Regulatory requirements" is defined under the Rule to include all federal securities laws, rules and regulations, and rules of self-regulatory organizations that are applicable in connection with market access.5 In general, these would include exchange trading rules relating to special order types, trading halts, odd-lot orders and SEC Regulation SHO and Regulation NMS. The Rule, therefore, will require that broker-dealers with market access establish pre-trade controls reasonably designed to:
- Prevent the entry of orders unless there has been compliance with all regulatory requirements that must be satisfied on a pre-order entry basis;
- Prevent the entry of orders for securities that the broker-dealer, customer or other person, as applicable, is restricted from trading;
- Restrict access to trading systems and technology that provide market access to persons and accounts that are pre-approved and authorized by the broker-dealer; and
- Assure that appropriate surveillance personnel receive immediate post-trade execution reports that result from market access.
Other Requirements
In addition, the broker-dealer must:
- Preserve a copy of its supervisory procedures and a written description of its risk management controls, as part of its books and records under Rule 17a-4(e)(7) under the Exchange Act;
- Review, at least annually, its business activity in connection with market access to assure the overall effectiveness of its risk management controls and supervisory procedures; and
- Have its Chief Executive Officer (or equivalent) certify annually that the firm's risk management controls and supervisory procedures comply with the Rule, and that the annual review has been conducted.
EFFECTIVE DATE
The Rule will become effective on January 14, 2011, with a compliance date of July 14, 2011.
IMPLICATIONS OF THE RULE
Broker-dealers with market access, either through an exchange or an ATS or through operation of their own ATS, will need to develop and implement pre-trade risk controls and supervisory procedures in order to comply with the Rule. The controls may involve significant systems and processes modifications to their electronic trading systems that may impede the speed at which high frequency institutional traders which employ sophisticated algorithmic trading programs, including hedge funds and other institutions and broker-dealers trading for their own proprietary accounts, execute their trades. High frequency traders which are not currently registered as broker-dealers may consider such registration, to permit them to gain market access through memberships in exchanges or subscriptions to ATSs and allow them to develop their own risk controls, but they would have to consider the economic and practical costs of doing so, and the increased regulatory scrutiny and potential loss of confidentiality that may result.
Footnotes
1 See http://sec.gov/rules/final/2010/34-63241.pdf
2 See e.g., Nasdaq Rule 4611(d).
3 Section 761 of the Dodd-Frank Wall Street Reform and Customer Protection Act amended the definition of security to include security-based swaps. The Rule will apply to a broker-dealer with access to an exchange on which security-based swaps are available to trade.
4 "Market Access" is defined as "(i) access to trading in securities on an exchange or alternative trading system as a result of being a member or subscriber of the exchange or alternative trading system, respectively; or (ii) access to trading in securities on an alternative trading system provided by a broker-dealer operator of an alternative trading system to a non-broker-dealer." See Rule 15c3-5(a)(1).
5 See Rule 15c3-5(a)(2).
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