Overview
On March 25, 2015, the Securities and Exchange Commission
("SEC" or "Commission") proposed an amendment
to Rule 15b9-1 (the "Proposal") under the Securities
Exchange Act of 1934 ("Exchange Act") that, if adopted,
would close an historical exception to the general requirement that
registered broker-dealers must become members of a registered
national securities association ("Association"),
effectively, the Financial Industry Regulatory Authority
("FINRA").1 In doing so, the SEC intends to
require SEC-registered broker-dealers that are members of one or
more securities exchanges to also become members of FINRA, subject
to FINRA rules and oversight. According to the SEC, FINRA
membership would help accomplish a key regulatory goal: enhancing
the oversight of off-exchange and cross-market trading
activity.2
Current Rule 15b9-1 Framework
Currently, Section 15(b)(8) of the Exchange Act requires a broker
dealer to register with an Association unless it effects
transactions solely on a national securities exchange
("exchange") of which it is a member.3 Rule
15b9-1 further exempts from Association membership a broker-dealer
that: (1) is a member of a national securities exchange, (2) does
not carry customer accounts, and (3) derives an annual gross income
of $1,000 or less from securities transactions that are not
effected on the national securities exchange of which it is a
member (the "de minimis allowance").4
The de minimis allowance excludes income derived from a
broker-dealer's proprietary trading transactions with or
through another broker-dealer.5 Rule 15b9-1 was
initially adopted to address the supplementary activities of
exchange specialists and other floor members engaged in limited
off-exchange trading.6
Proposed Changes
The rapidly evolving nature of the equities markets has led to the
creation of active cross-market proprietary trading firms that
trade electronically across exchange and off-exchange platforms.
According to the SEC, because Rule 15b9-1 does not explicitly limit
the exclusion from the de minimis allowance to dealer activities
ancillary to a floor-based business, many of these proprietary
trading firms have been able to engage in unlimited proprietary
trading in the off-exchange market without becoming members of
FINRA. In the Proposal, the SEC states that it seeks to realign
Rule 15b9-1's original limited purposes with the state of
current market activity and Section 15(b)(8).7 The
Proposal would amend current Rule 15b9-1 in three significant
ways:
- Elimination of the De Minimis
Allowance: The Proposal would eliminate the de
minimis allowance (including the exclusion for proprietary
trading).8 As a result, and subject to the exceptions
below for certain hedging and exchange order routing activity, a
proprietary trading broker-dealer would have to register with an
Association if it engaged in any trading activity off exchanges of
which it is a member.9
- Floor Member Hedging Exemption: The Proposal
would also create a more targeted exemption from FINRA membership
for exchange members that trade on the exchange floor (i.e.,
specialists or floor brokers) and limit their off-exchange
transactions solely to transactions for the purpose of hedging the
risks of their floor-based activities.10 Dealers relying
on this exemption would be required to adopt written policies and
procedures to ensure that their off-exchange transactions are
legitimate hedges to mitigate the risk associated with floor
activities.11 Various factors, including a
broker-dealer's business model and financial position, will
determine whether a transaction appropriately mitigates risk under
this hedging exemption.12
- Regulation NMS Routing Exemption: Finally, the
Proposal would create an exemption from Association
membership for proprietary trading exchange members whose sole off-exchange transactions result from orders routed by an exchange of which it is a member to prevent trade-throughs on that exchange.13 The orders must be routed from an exchange of which the broker-dealer is a member to another trading center.14 The Commission believes that such activity by an exchange routing broker-dealer would allow the exchange to maintain oversight of the broker-dealer's market activity.15
As described, broker-dealers who no longer qualify for the Rule
15b9-1 exemption would have to comply with Section 15(b)(8) by
limiting their trading to exchanges of which they are members or
registering with FINRA.
Potential Implications
If adopted, the Proposal would require proprietary trading firms
that are not currently members of FINRA to: (1) limit their trading
to exchanges of which they are members, (2) join FINRA, (3) join
together with other proprietary trading firms to form an
Association (an interesting but likely not practical alternative),
or (4) cease conducting business as a broker-dealer.
To the extent proprietary trading firms choose to join FINRA, they
will be subject to FINRA rules. Obtaining FINRA membership requires
an extensive application and takes about six months; we would hope
that the SEC and FINRA would consider a streamlined application
process for proprietary trading firms that seek to become members,
given that such firms are already SEC registered, are already
subject to the SEC net capital rule and do not have customers.
Proprietary trading firms that become FINRA members will also be
subject to FINRA fees and incur various implementation costs.
According to the Proposal, for instance, firms would spend
approximately $3.3 million in implementation costs, which include
FINRA application costs and costs to implement OATS
reporting.
Although the SEC expects that the benefits of the proposed rule
will outweigh its costs, it is a little unclear how the proposal
ultimately will impact the OTC market. In 2014, non-FINRA member
broker-dealers accounted for 35.31% of the 104.5 billion orders
reported in the OTC markets. On a volume-weighted basis, such firms
accounted for 48% of the 230 billion orders sent directly to an
ATS. Depending on how proprietary trading firms react to the rule
if it is adopted, liquidity may be affected. Some firms may decide
to stop their off-exchange trading in lieu of joining FINRA. Other
firms that join FINRA may opt to reduce their off-exchange activity
to curb the increased costs of trading associated with FINRA
membership. The Commission is soliciting comments on various
aspects of the changes described above. Comments are due on June 1,
2015.
Conclusion
The Proposal reflects the Commission's latest effort to address
the evolving structure of the equities markets and the increased
volume of proprietary trading, including through the use of
high-frequency trading strategies. If adopted, the Proposal would
likely result in an expansion of FINRA's jurisdiction. To the
extent that a broker-dealer may be required to become a FINRA
member, it should be prepared for the costs associated with FINRA
membership and compliance with FINRA rules. Thus, broker-dealers
currently engaged in off-exchange activity should consider the
impact of the Proposal on their activities and whether they could
rely on any of the proposed exemptions.
1 Exemption for Certain Exchange Members, Exchange
Act Release No. 74581 (Mar. 25, 2015), 80 Fed. Reg. 18035 (Apr. 2,
2015) (to be codified at 17 C.F.R. § 240.15b9-1)
("Proposal"). 15 U.S.C. § 78o(3). FINRA is
registered as a national securities association under Section
15A(a) of the Exchange Act. The National Futures Association
("NFA") is registered as a limited purpose national
securities association under Section 15A(k) of the Exchange Act,
only for the purpose of regulating the activities of NFA members
that are registered as brokers or dealers in security futures
products under Section 15(b)(11) of the Exchange Act. See Proposal
at 18039 n.34.
2 Off-exchange trading means off-exchange trading of
exchange-listed securities, and would include trading on an ATS or
directly with a broker-dealer acting as agent or principal, and is
also referred to as over-the-counter ("OTC") trading. See
Proposal at 18037 n.3.
3 15 U.S.C. § 78o(b)(8).
4 17 C.F.R. § 240.15b9-1.
5Id.
6 Proposal at 18038.
7 Proposal at 18036-18041.
8 The Proposal also would eliminate an exception from
the de minimis requirement for transactions through the
former Intermarket Trading System, which no longer exists.
9 Proposal at 18046.
10Id. at 18046-18047.
11Id.
12Id.
13Id. at 18049.
14Id.
15Id.
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