SEC Adopts Final Rule Regarding Risk Management Controls for Broker-Dealers with Market Access

SEC Adopts Final Rule Regarding Risk Management Controls for Broker-Dealers with Market Access

by Melissa Beck

Rule 15c3-5 is a new rule that will effectively prohibit broker-dealers with market access from providing customers with unfiltered access to an exchange or alternative trading system ("ATS").

Excerpt:

On November 3, 2010, the Securities and Exchange Commission (the "SEC") voted unanimously to adopt a new rule that will effectively prohibit broker-dealers with market access from providing customers with unfiltered access to an exchange or alternative trading system ("ATS"). Rule 15c3-5 (the "Rule") will require broker-dealers with direct market access to trading securities on an exchange or ATS to establish, document, and maintain a system of risk management controls and supervisory procedures that, among other things, are reasonably designed to (1) systematically limit the financial exposure of broker-dealers that could arise as a result of market access, and (2) ensure compliance with all regulatory requirements that are applicable in connection with market access. It encompasses trading in all securities on an exchange or ATS, including equities, options, exchange-traded funds, and debt securities, and is intended to strengthen the controls with respect to market access and reduce regulatory inconsistency and the potential for regulatory arbitrage. The Rule was adopted with only minor changes to the proposed rule that was published for comment in January 2010, and becomes effective 60 days from the date of publication in the Federal Register.

Background

Broker-dealers with direct market access to an exchange or ATS use a market participant identifier ("MPID") when effecting trades, and are legally responsible for any trades made using their MPID. Allowing third parties to trade using a broker-dealer's MPID could result in the broker-dealer paying lower transaction fees based on a volume discount. A broker-dealer also may network with another broker-dealer to gain access to an exchange where it is not a member. For customers, such as hedge funds and institutional investors, trading using a broker-dealer's MPID may facilitate more rapid trading, preserve confidentiality of trading strategies, and reduce operation and transaction costs. Broker-dealers provide customers with sponsored access to their member exchanges or ATSs either through filtered or unfiltered access arrangements.

When a broker-dealer provides filtered access to customers, the customer orders flow through the broker-dealer's system before passing into the markets. The system allows a broker-dealer to pre-screen a trade to ensure there are no manual errors, regulatory violations, or other issues prior to passing it on to the exchange or ATS. Filtered access is currently regulated by the exchanges and self-regulatory organizations; however, the regulations are not uniform, and in some instances, the rules serve merely as best practice guidelines.

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Melissa Beck is an associate in the Capital Markets Group of the New York office of Morrison & Foerster. Ms. Beck's practice is focused on the insurance industry, where she specializes in the life settlement sector. She has advised clients on the establishment of proprietary programs, the drafting of transaction documents, the development of policies and procedures, and the oversight of ongoing operations, including state licensing filings, and has performed audits on third-party providers for clients. Ms. Beck has experience in catastrophe bonds, sidecars, and CDO and CLO transactions. She has used her insurance regulatory knowledge to assist in M&A and litigation projects.