SEC Bans Broker-Dealers from Providing Customers Unfiltered or Naked Access to Exchanges and Alternative Trading Systems

January 13, 2010

The SEC proposed a new rule that would effectively prohibit broker-dealers from providing customers with "unfiltered" or "naked" access to an exchange or alternative trading system (ATS).  If adopted, the rule would require brokers with market access, including those who sponsor customers' access to an exchange, to put in place risk management controls and supervisory procedures. The SEC stated that among other things, the procedures would help prevent erroneous orders, ensure compliance with regulatory requirements, and enforce pre-set credit or capital thresholds.

According to the SEC, broker-dealers use a "special pass" known as their market participant identifier (MPID) to electronically access an exchange or ATS and place an order for a customer.  While broker-dealers are subject to the federal securities laws as well as the rules of the self-regulatory organizations that regulate their operation, those laws and rules do not apply to a non-broker-dealer customer who a broker-dealer provides with their MPID in order to individually gain access to an exchange or ATS. Under this arrangement known as "direct market access" or "sponsored access," the customer can sometimes 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 direct market access arrangement is known as "unfiltered" access and "naked" access.  The SEC estimated that naked access accounts for 38 percent of the daily volume for equities traded in the U.S. markets.

Through sponsored access, especially "unfiltered" or "naked" sponsored access arrangements, the SEC warned that 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, or breach a credit or capital limit.

The SEC's proposed rule would require broker-dealers 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.

Broker-dealers would be required 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 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.

· Establish, document and maintain a system for regularly reviewing the effectiveness of its risk management controls and for promptly addressing any issues.

The SEC also approved a new Nasdaq rule that requires broker-dealers offering sponsored access to Nasdaq to establish certain controls over the financial and regulatory risks of that activity. The proposed SEC rule would extend beyond the new Nasdaq rule in several respects. For example, the SEC's proposal would require the broker-dealer to automatically apply its controls on a pre-trade basis, and to retain exclusive control over those controls without delegation of this critical function to the customer or another third party. The SEC's proposal also would require broker-dealers to establish a supervisory system, including an annual CEO certification, to assure the ongoing effectiveness of its controls In addition, the SEC's proposed risk management controls would apply market-wide, whenever a broker-dealer directly accesses any exchange or ATS.

Click to access the proposal.


Exchange-Traded Funds (ETFs), Mutual Funds, Regulatory