On November 3, 2010, the U.S. Securities and Exchange Commission (“SEC”) unanimously approved new Rule 15c3-5 (the “Rule”),1 which will require broker-dealers to adopt and implement risk controls to govern their provision of “direct market access” (“DMA”) and “sponsored access” to their customers. The Rule, which will effectively prohibit the practice of providing customers with unfiltered, or “naked,” access to an exchange or alternative trading system (“ATS”), will take effect 60 days from the date it is published in the Federal Register. Broker-dealers who are subject to the Rule will have six months after that date to comply with its provisions.
DMA and Sponsored Access
The Rule targets DMA and sponsored access arrangements, which involve a broker-dealer entering into an agreement with a client to permit it to use the broker-dealer’s unique market participant identifier or other similar mechanism (“MPID”) to electronically access a relevant exchange or ATS (a “trading center”). In the case of DMA, the broker-dealer provides the customer with its MPID but the customer’s orders will flow through the broker-dealer’s trading systems before reaching the trading center, whereas in the case of sponsored access, the customer’s order will bypass the broker-dealer’s trading systems and flow directly to the trading center, sometimes with the assistance of a third-party technology provider. Naked access is a subcategory of sponsored access that permits the customer to enter orders into a trading center without any pre-trade filters or controls. In any event, whether the customer accesses a trading center through DMA or sponsored access arrangements, the broker-dealer remains legally responsible for all trading activity submitted under its MPID.
The development and use of automated electronic trading processes and strategies by sophisticated brokerage customers have motivated broker-dealers to offer such access arrangements. The benefits to broker-dealers of providing such customers with DMA or sponsored access include increased order volume and variety. The benefits to customers include ensuring the business confidentiality, efficiency, and lower cost of their trading strategies.
While there is existing guidance from several self-regulatory organizations (“SRO”) regarding the provision of DMA and sponsored access by broker-dealers, the SEC noted in its proposing release for the Rule that the existing guidance is primarily advisory, and not compulsory, in nature.2 The SEC stated that while there are SRO rules currently in force regarding DMA and sponsored access, those rules do not require the implementation of pre-trade controls and procedures, but rather only assign liability — and not control obligations — to the sponsoring broker-dealer, or require the access arrangements to have specified contract terms requiring commitments from the customer.3 The SEC stated in the Rule’s proposing release that while SRO efforts in this regard “have been productive steps in the right direction,”4 it proposed the Rule in order “to more effectively manage the financial, regulatory, and other risks, such as legal and operational risks, associated with market access.”
The Rule will require, with a limited exception,5 all broker-dealers that have “market access,”6 or that provide a customer or any other person with access to a trading center7 through the use of its MPID — including, as a significant change from the proposing release, all broker-dealers that operate an ATS — to “establish, document, and maintain a system of risk management controls and supervisory procedures reasonably designed to manage the financial, regulatory, and other risks of this business activity” (“Access Procedures”).8 The broker-dealer is required to preserve a copy of these Access Procedures as part of its books and records under Rule 17a-4, and these Access Procedures must include the following:
A broker-dealer must directly and exclusively control the Access Procedures, but in a change from the proposing release, the Rule permits broker-dealers, with respect to the Regulatory Controls, to “reasonably allocate, by written contract, after a thorough due diligence review,” control to a customer that is also a registered broker-dealer, provided that the delegating broker-dealer “has a reasonable basis for determining that such customer, based on its position in the transaction and relationship with an ultimate customer, has better access than the [broker-dealer] to that ultimate customer and its trading information such that it can more effectively implement the [Regulatory Controls].” Apparently, the ability to delegate responsibility for Regulatory Controls does not extend to the Financial Controls, which must remain within the exclusive control of the broker-dealer offering the market access. The Rule provides that delegating the Regulatory Controls will not relieve a broker-dealer from its ultimate responsibility for establishing, documenting, and maintaining all of the Access Procedures, including the Regulatory Controls.
The broker-dealer must also “establish, document, and maintain a system for regularly reviewing the effectiveness of … and for promptly addressing any issues [related to]” the Access Procedures. The broker-dealer must establish and preserve in accordance with Rules 17a-4(b) and 17a-4(e)(7) written procedures providing for, at a minimum, an annual review of its business activities related to providing market access (an “Annual Review”) in order to “assure the overall effectiveness of [the Access Procedures],” together with written documentation of each such review.
Finally, the Chief Executive Officer (or equivalent officer) of a broker-dealer must annually certify that (i) the broker-dealer’s Access Procedures comply with paragraphs (b) and (c) of the Rule, and (ii) that the broker-dealer has conducted the required Annual Review. The broker-dealer must preserve these annual certifications as part of its books and records in accordance with Rule 17a-4(b).
1Exchange Act Release No. 63241 (November 3, 2010).
2Exchange Act Release No. 61379 (January 19, 2010), 75 FR 4007, at 4010 (January 26, 2010).
3See id., 75 FR at 4010, note 26 (citing NYSE Rule 123B.30, NYSE Alternext Equities Rule 123B.30, NYSE Amex Rule 86, NYSE Arca Rules 7.29 and 7.30, NYSE Rule 86, CBOE Rule 6.20A, CHX Article 5, Rule 3, NSX Rule 11.9, BATS Rule 11.3(b), ISE Rule 706, NASDAQ Rule 4611(d), NASDAQ OMX BX Rule 4611(d), NASDAQ OMX PHLX Rule 1094(b)(ii)).
5A broker-dealer “that provide[s] 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 with respect to such routing services, except with regard to paragraph (c)(1)(ii) of the Rule (regarding prevention of erroneous orders),” except that the broker-dealer must comply with the requirement to establish controls and procedures to prevent erroneous orders in accordance with Rule 15c3-5 (c)(1)(ii). See supra note 1.
6“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.” 17 C.F.R. 240.15c3-5(a)(1).
7It is unclear from the proposing and adopting releases whether the phrase “trading center” includes international or foreign exchanges; therefore, it is unclear whether the Rule applies to broker-dealers that provide customers with access to such exchanges.
817 C.F.R. 240.15c3-5(b).