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SEC Adopts New Rule Preventing Unfiltered Market Access

FOR IMMEDIATE RELEASE
2010-210

Washington, D.C., Nov. 3, 2010 — The Securities and Exchange Commission today voted unanimously to adopt a new rule to require brokers and dealers to have risk controls in place before providing their customers with access to the market.

The new rule focuses on a practice in which broker-dealers hand their customer a special pass to access the markets called a market participant identifier. The customer then gains direct access to the applicable exchange or alternative trading system (ATS), also known as “sponsored access.”

The rule approved today prohibits broker-dealers from providing customers with “unfiltered” or “naked” access to an exchange or ATS. It also requires brokers with market access — including those who sponsor customers’ access to an exchange or ATS — to put in place risk management controls and supervisory procedures to help prevent erroneous orders, ensure compliance with regulatory requirements, and enforce pre-set credit or capital thresholds.

“I have previously likened unfiltered access to giving your car keys to a friend who doesn't have a license and letting him drive unaccompanied,” said SEC Chairman Mary L. Schapiro. “This rule requires that broker-dealers not only remain in the car, but also maintain control of it so we can all be assured the rules of the road will be observed before the car is ever put into drive.”

Through sponsored access — especially “unfiltered” or “naked” sponsored access arrangements — there is the potential that financial, regulatory and other risks associated with the placement of orders are not being appropriately managed. Of particular concern is the quality of broker-dealer risk controls in “unfiltered” access arrangements. In some cases, the broker may be relying on assurances from its customer that the customer has appropriate risk controls in place.

The new rule is part of a larger effort by the SEC to help ensure that the markets are fair, transparent and efficient. Among other rules recently proposed by the Commission:

Effectively prohibit all markets from displaying marketable flash orders.
Generally require that information about an investor’s interest in buying or selling a stock be made publicly available, instead of just to a select group operating within a dark pool.
Help identify and provide information on certain large traders.
Promote fair and efficient access to listed options markets.
Require the establishment of a consolidated audit trail system that would enable regulators to track information related to trading orders received and executed across the securities markets.

The new rule will be effective 60 days from the date of its publication in the Federal Register. Once effective, broker-dealers subject to the rule will have six months to comply with the requirements.

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FACT SHEET

Background

Market Access by Broker-Dealers:

Broker-dealers are required to comply with the rules of the exchanges to which they have access. Using their ‘special pass,’ known as the market participant identifier (MPID), they can electronically access an exchange or ATS and place an order for a customer.

Broker-dealers are specially regulated with respect to their access on an exchange or ATS because they are subject to the federal securities laws as well as the rules of the self-regulatory organizations that regulate their operation.

Customers Placing Orders Themselves:

Today, most orders are routed for execution in milliseconds through high-speed, high-volume, automated algorithmic trading. High-frequency trading alone has been estimated to account for more than 50 percent of the U.S. equities market volume. As a result, some sophisticated customers — particularly institutions and high-frequency traders — have begun using technological tools to place orders and execute high-speed trades themselves. They do so by essentially bypassing their broker-dealer, who provides the customer with the MPID.

When the customer is provided with access to an exchange or ATS using the broker-dealer’s MPID, the arrangement is known as “direct market access” or “sponsored access.”

In some of these arrangements, the customer is able to place an order that flows directly into the markets without first passing through the broker-dealer’s systems and without being pre-screened by the broker-dealer in any manner. This type of sponsored access arrangement is known as “unfiltered” access or “naked” access.

Regardless of the type of market access, the broker-dealer who provides the access is legally responsible for all trading activity that occurs under the MPID.

The Potential Concerns Associated with Market Access

The application of sophisticated, high-speed trading technology — combined with the ability of customers to place orders and trade on markets with little or no substantive intermediation by their brokers — has given rise to increased concerns about the quality of broker-dealer risk controls in market access arrangements.

Of particular concern is the quality of broker-dealer risk controls in “unfiltered” access arrangements. In some cases, the broker may be relying on assurances from its customer that the customer has appropriate risk controls in place.

Through sponsored access, especially “unfiltered” or “naked” sponsored access arrangements, there is the potential that financial, regulatory and other risks associated with the placement of orders are not being appropriately managed.

In particular, there is an increased likelihood that customers will:

Enter erroneous orders as a result of computer malfunction or human error.
Fail to comply with various regulatory requirements.
Breach a credit or capital limit.

The potential impact of a trading error or a rapid series of errors, caused by a computer or human error, or a malicious act, has become more severe. In addition, the inter-connectedness of the financial markets can exacerbate market movements, whether they are in response to actual market sentiment or trading errors.

Requirements Under the Rule

The rule adopted by the Commission requires either …

Broker-dealers who are members of an exchange or subscribe to an ATS …

or
Broker-dealer operators of an ATS that provide access to trading securities directly on their ATS to a person other than a broker or dealer …

… to implement certain risk management controls and supervisory procedures to manage the various risks. These controls and supervisory procedures would effectively eliminate “unfiltered” or “naked” sponsored access.

Under the rule, a broker-dealer has to establish, document and maintain a system of risk management controls and supervisory procedures reasonably designed to manage the financial, regulatory and other risks related to its market access, including access on behalf of sponsored customers.

In association with this requirement, broker-dealers have to:

Create financial risk management controls reasonably designed to prevent the entry of orders that exceed appropriate pre-set credit or capital thresholds, or that appear to be erroneous.
Create regulatory risk management controls reasonably designed to ensure compliance with all regulatory requirements applicable in connection with market access.
Have certain financial and regulatory risk management controls applied automatically on a pre-trade basis before orders route to an exchange or ATS
Maintain risk management controls and supervisory procedures under the direct and exclusive control of the broker-dealer with market access. There would however be limited exceptions, as specified in the rule, to permit a broker or dealer to reasonably allocate certain controls and procedures to another registered broker or dealer that, based on its position in the transaction and its relationship with the ultimate customer, can more effectively implement them.
Establish, document and maintain a system for regularly reviewing the effectiveness of its risk management controls and for promptly addressing any issues.

Other Market Structure Actions

The new rule is part of a larger effort by the SEC to help ensure that the markets are fair, transparent and efficient.

Among other things, the Commission already has proposed rules that would:

Effectively prohibit all markets from displaying marketable flash orders.
Generally require that information about an investor’s interest in buying or selling a stock be made publicly available, instead of just to a select group operating with a dark pool.
Help identify and provide information on certain large traders.
Promote fair and efficient access to listed options markets.
Require the establishment of a consolidated audit trail system that would enable regulators to track information related to trading orders received and executed across the securities markets.

Additionally, the Commission has approved pilot rules that require the exchanges and FINRA to pause trading in certain individual stocks and ETFs if the price moves 10 percent or more in a five-minute period.

Finally, the Commission has sought public comment on a concept release covering a wide range of topics concerning the equity markets to help facilitate the SEC’s ongoing review of market structure issues.

What’s Next?

Rule 15c3-5 will be effective 60 days from the date of publication of the rule in the Federal Register. Once effective, broker-dealers subject to the rule will have six months to comply with the requirements of Rule 15c3-5.

http://www.sec.gov/news/press/2010/2010-210.htm