UNDERSTANDING THE SEC MARKET ACCESS RULE

On November 3, 2010, the Securities and Exchange Commission (SEC) adopted the Market Access Rule 15c3-5 (MAR), which requires brokers and dealers to have risk controls for market access. The deadline to have risk controls in place for MAR compliance is July 14, 2011.

WHO IS COVERED? Any broker or dealer that has market access, or that provides a customer or any other person with access to an exchange or ATS through use of its MPID or otherwise, is required to comply with MAR. [See pg. 69795]

WHAT IS COVERED? All trading in all securities on an exchange or ATS, including equities, options, exchange traded funds, debt securities and security-based swaps. [See pgs. 69792, 69795, 69825]

WHAT IS REQUIRED? 8. Financial and regulatory risk management controls and supervisory procedures must be under direct and ex- Any broker or dealer providing market access is required to clusive control of the broker dealer with market access establish, document, and maintain a system of risk man- other than in limited situations related to regulatory (not agement controls and supervisory procedures reasonably financial) oversight obligations designed to: 9. Must establish a system for regularly reviewing the 1. Prevent the entry of orders that exceed appropriate effectiveness of risk management controls and pre-set credit or capital thresholds supervisory procedures and promptly assessing any 2. Prevent the entry of orders that appear to be erroneous issues 3. Prevent the entry of orders unless compliant with all 10. Chief Executive Officer of the broker dealer must certify regulatory requirements that must be complied with on annually that the risk management controls and super- a pre-order basis visory procedures comply with MAR 4. Prevent the entry of orders that the broker dealer or [See pgs. 69795 and 69796] customer is restricted from trading WHAT IS CONSIDERED “MARKET ACCESS”? 5. Restrict market access technology and systems to authorized persons “Market access” is intentionally defined broadly so as to 6. Provide appropriate surveillance personnel with immedi- include not only direct market access or sponsored access ate post-execution reports services offered to customers of broker-dealers, but also access to trading for the proprietary account of the 7. Preserve a copy of supervisory procedures and written broker-dealer and for more traditional agency activities. description of risk management controls as part of books and records [See pgs. 69796, 69798]

Page references are to the attached MAR Federal Register publication Vol. 75 No. 219 WHAT CONSTITUTES “REASONABLY DESIGNED” at all other market centers and that limit could not be CONTROLS, POLICIES AND PROCEDURES? increased to reflect any unused portion of credit limits at MAR allows flexibility for the details of the controls and other market centers (and presumably by analogy could not procedures to vary from broker-dealer to broker-dealer, be increased to reflect any unused portion of credit limits depending on the nature of the business and customer among disparate trading systems or classes of securities). base so long as they are “reasonably designed” to achieve [See pg. 69800] In addition, MAR adopting text reiterates the the goals articulated in the rule — the rule does not employ SEC’s expectation that broker-dealers should monitor on an a “one-size-fits-all” standard for determining compliance ongoing basis whether credit thresholds remain appropriate with the rule. [See pg. 69798] and should make prompt adjustments to credit thresholds, controls and procedures as warranted. [See pg. 69802]

GOALS OF THE MARKET ACCESS RULE FLEXIBILITY TO “DISCOUNT” OPEN ORDER MAR is designed to ensure that broker-dealers appropriately EXPOSURE LIMITS control the risks associated with market access, so as not The MAR adopting text acknowledges that while reasonably to jeopardize: designed risk management controls should measure com- 1. Their own financial condition pliance based on orders entered, the credit or capital ex- 2. That of other market participants posure assigned to those orders may be discounted where appropriate to account for the likelihood of actual execution 3. Integrity of trading on security markets as demonstrated by reasonable risk management models. 4. The stability of the financial system [See pg. 69792] However, any broker-dealer relying on risk management models to discount the exposure of outstanding orders CREDIT/CAPITAL THRESHOLD CHECKS ARE REQUIRED should monitor on an ongoing basis and make appropriate MAR subsection (c)(1)(i) pertains to risk management and adjustments to its method of calculating credit or capital supervisory procedures to prevent the entry of orders that exposure as warranted. Broker-dealers providing market ac- exceed appropriate pre-set credit or capital thresholds in cess may wish to establish “early warning” mechanisms to the aggregate for each customer and the broker or dealer alert them when the applicable credit or capital threshold is and, where appropriate, more finely tuned by sector, se- being approached, so that additional steps may be taken to curity, or otherwise. [See pg. 69825] MAR subsection (c)(1) assure the threshold is not breached. (See pg. 69801] (ii) separately requires prevention of erroneous orders, by rejecting orders that exceed appropriate price or size pa- rameters, on an order-by-order basis or over a short period of time, or that indicate duplicative orders.

MAR adopting text stresses the (c)(1)(i) obligations of a broker-dealer to set a reasonable aggregate credit limit for each customer. This section clarifies that if sub-limits are established for a customer at an exchange or ATS (and presumably by analogy if sub-limits are established for disparate trading systems or classes of securities), when added together they must equal the aggregate credit limit and when assessing the customer’s credit exposure at one market center, the broker-dealer must assume that the maximum credit limit has been reached by the customer

Page references are to the attached MAR Federal Register publication Vol. 75 No. 219 OBLIGATION TO PROVIDE IMMEDIATE POST EXECUTION REQUIREMENT FOR CEO CERTIFICATION REPORTS TO SURVEILLANCE PERSONNEL The MAR adopting text stipulates that the senior-most MAR subsection (c)(2)(iv) requires broker-dealers to provide manager of a broker-dealer providing market access — immediate post-trade execution reports that result from specifically it’s CEO or equivalent officer — must review market access to surveillance personnel, which will identify and certify the efficacy of the controls and procedures at the applicable customer associated with each such execu- regular intervals. The SEC states that the annual certifica- tion report. The SEC believes immediate reports of execu- tion is considered an integral component of the required risk tions will provide surveillance personnel with important management and supervisory procedures and should help information about potential regulatory violations and better to assure their effectiveness, bolster broker-dealer compli- enable them to investigate report or halt suspicious or ance programs, and promote meaningful and purposeful manipulative trading activity. In addition these reports will interaction between business and compliance personnel. provide the broker-dealer with more definitive data regard- ing its financial exposure at any given time. [See pg. 69804] It should be noted that the MAR requirement for CEO certi- fication is similar to that of Section 404 of Sarbanes-Oxley USE OF THIRD PARTY TECHNOLOGY (15 U.S.C. Section 7262(a)), which requires that the annual Sarbanes Oxley issuer report must “contain an assessment A broker-dealer providing market access can use risk … of the effectiveness of the internal control structure and management tools or technology provided by a third party procedures of the issuer for financial reporting.” that is independent of the customer, so long as it has direct and exclusive control over those tools or technology and ACTUAL TEXT OF ADOPTED MARKET ACCESS performs appropriate due diligence. The independent third RULE 15C3-5 party could be another broker-dealer, an exchange or ATS, a service bureau, or other entity that is not an affiliate, and is For the actual text of adopted Market Access Rule 15c3-5, otherwise independent of the market access customer. The see page 69825 under “PART 240—GENERAL RULES AND broker-dealer cannot rely on risk management technology REGULATIONS, SECURITIES EXCHANGE ACT OF 1934.” that is designed, built, maintained or otherwise under the control of the customer or its affiliates. The SEC stipulates in the adopting text that a reasonably designed system of risk management controls and supervisory procedures should rely on technology that is developed independent of the market access customer or its affiliates. Any broker-dealer relying on technology developed by third parties should conduct reasonable due diligence, including with respect to the independence of the developer from the market access customer or its affiliates. [See pg. 69810]

Page references are to the attached MAR Federal Register publication Vol. 75 No. 219

More Information For more information, visit www.ften.com or email [email protected].

© Copyright 2011, The NASDAQ OMX Group, Inc. All rights reserved. The above information relates generally to certain elements of the SEC Market Access Rule 15c3-5 (MAR), which has a compliance deadline of July 14, 2011. It is not intended, nor should it be used, as a replacement for independent legal and compliance analysis of the requirements of MAR. Q11-0981. 06-11 Monday, November 15, 2010

Part III

Securities and Exchange Commission 17 CFR Part 240 Risk Management Controls for Brokers or Dealers With Market Access; Final Rule

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SECURITIES AND EXCHANGE broker or dealer that, based on its dealers. New Rule 15c3–5 is designed to COMMISSION position in the transaction and ensure that broker-dealers appropriately relationship with the ultimate customer, control the risks associated with market 17 CFR Part 240 can more effectively implement them. In access, so as not to jeopardize their own [Release No. 34–63241; File No. S7–03–10] addition, a broker or dealer with market financial condition, that of other market access will be required to establish, participants, the integrity of trading on RIN 3235–AK53 document, and maintain a system for the securities markets, and the stability regularly reviewing the effectiveness of of the financial system. Risk Management Controls for Brokers the risk management controls and On January 26, 2010, Proposed Rule or Dealers With Market Access supervisory procedures and for 15c3–5 was published for public comment in the Federal Register.1 The AGENCY: Securities and Exchange promptly addressing any issues. Among Commission. other things, the broker or dealer will be Commission received 47 comment required to review, no less frequently letters on Proposed Rule 15c3–5 from ACTION: Final rule. than annually, the business activity of broker-dealers, markets, institutional SUMMARY: The Securities and Exchange the broker or dealer in connection with and individual investors, technology Commission (‘‘Commission’’ or ‘‘SEC’’) is market access to assure the overall providers, and other market 2 adopting new Rule 15c3–5 under the effectiveness of such risk management participants. Nearly all of the Securities Exchange Act of 1934 controls and supervisory procedures commenters supported the overarching (‘‘Exchange Act’’). Rule 15c3–5 will and document that review. The review goal of the proposed rulemaking—to require brokers or dealers with access to will be required to be conducted in assure that broker-dealers with market trading securities directly on an accordance with written procedures and access have effective controls and exchange or alternative trading system will be required to be documented. In procedures reasonably designed to (‘‘ATS’’), including those providing addition, the Chief Executive Officer (or manage the financial, regulatory, and sponsored or direct market access to equivalent officer) of the broker or other risks of that activity. As further customers or other persons, and broker- dealer will be required, on an annual discussed below, however, several dealer operators of an ATS that provide basis, to certify that the risk commenters recommended that the access to trading securities directly on management controls and supervisory proposal be amended or clarified in their ATS to a person other than a procedures comply with Rule 15c3–5, certain respects. As a result, the broker or dealer, to establish, document, and that the regular review described Commission is adopting Rule 15c3–5 and maintain a system of risk above has been conducted. substantially as proposed, but with management controls and supervisory DATES: Effective Date: January 14, 2011. certain narrow modifications as procedures that, among other things, are Compliance Date: July 14, 2011. discussed below. As proposed, Rule reasonably designed to systematically FOR FURTHER INFORMATION CONTACT: 15c3–5 would require brokers or dealers limit the financial exposure of the Marc F. McKayle, Special Counsel, at with access to trading directly on an broker or dealer that could arise as a (202) 551–5633; Theodore S. Venuti, exchange or ATS, including those result of market access, and ensure Special Counsel, at (202) 551–5658; and providing sponsored or direct market compliance with all regulatory Daniel Gien, Attorney, at (202) 551– access to customers or other persons, to requirements that are applicable in 5747, Division of Trading and Markets, implement risk management controls connection with market access. The Securities and Exchange Commission, and supervisory procedures reasonably required financial risk management 100 F Street, NE., Washington, DC designed to manage the financial, controls and supervisory procedures 20549–7010. regulatory, and other risks of this business activity. must be reasonably designed to prevent SUPPLEMENTARY INFORMATION: the entry of orders that exceed The development and growth of appropriate pre-set credit or capital Table of Contents automated electronic trading have allowed ever increasing volumes of thresholds, or that appear to be I. Background securities transactions across the erroneous. The regulatory risk II. Rule 15c3–5 management controls and supervisory III. Paperwork Reduction Act multitude of trading systems that procedures must also be reasonably IV. Consideration of Costs and Benefits constitute the U.S. national market designed to prevent the entry of orders V. Consideration of Burden on Competition, system. In fact, much of the order flow unless there has been compliance with and Promotion of Efficiency, in today’s marketplace is typified by Competition and Capital Formation high-speed, high-volume, automated all regulatory requirements that must be VI. Final Regulatory Flexibility Analysis satisfied on a pre-order entry basis, algorithmic trading, and orders are VII. Statutory Authority routed for execution in milliseconds or prevent the entry of orders that the Text of Rule 15c3–5 broker or dealer or customer is restricted even microseconds. Over the past year, from trading, restrict market access I. Background the Commission has taken a broad and critical look at market structure technology and systems to authorized Given the increased automation of practices in light of the rapid persons, and assure appropriate trading on securities exchanges and development in trading technology and surveillance personnel receive ATSs today, and the growing popularity strategies. The Commission has immediate post-trade execution reports. of sponsored or direct market access proposed several rulemakings, The financial and regulatory risk arrangements where broker-dealers management controls and supervisory allow customers to trade in those 1 See Securities Exchange Act Release No. 61379 procedures required by Rule 15c3–5 markets electronically using the broker- (January 19, 2010), 75 FR 4007 (January 26, 2010) must be under the direct and exclusive dealers’ market participant identifiers (File No. S7–03–10) (‘‘Proposing Release’’). control of the broker or dealer with (‘‘MPID’’), the Commission is concerned 2 Copies of comments received on the proposal market access, with limited exceptions that the various financial and regulatory are available on the Commission’s Internet Web site, located at http://www.sec.gov/comments/s7-03- specified in the Rule that permit risks that arise in connection with such 10/s70310.shtml, and in the Commission’s Public reasonable allocation of certain controls access may not be appropriately and Reference Room at its Washington, DC and procedures to another registered effectively controlled by all broker- headquarters.

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including this rulemaking, to address center but such orders flow through the Current self-regulatory organization specific vulnerabilities in the current broker-dealer’s trading systems prior to (‘‘SRO’’) rules and interpretations market structure.3 In addition, this past reaching the trading center. In contrast, governing electronic access to markets January, the Commission published a sponsored access generally refers to an have sought to address the risks of this concept release on equity market arrangement whereby a broker-dealer activity.12 However, the Commission structure designed to further the permits customers to enter orders into a believes that more comprehensive and Commission’s broad review of market trading center that bypass the broker- effective standards that apply structure to assess whether its rules dealer’s trading system and are routed consistently across the markets are have kept pace with, among other directly to a trading center, in some needed to effectively manage the things, changes in trading technology cases supported by a service bureau or financial, regulatory, and other risks, and practices.4 other third party technology provider.7 such as legal and operational risks, The recent proliferation of ‘‘Unfiltered’’ or ‘‘naked’’ access is associated with market access. These sophisticated, high-speed trading generally understood to be a subset of risks—whether they involve the technology has changed the way broker- sponsored access, where pre-trade filters potential breach of a credit or capital dealers trade for their own accounts and or controls are not applied to orders limit, the submission of erroneous as agents for their customers.5 In before such orders are submitted to an orders as a result of computer addition, customers—particularly exchange or ATS. In all cases, however, malfunction or human error, the failure sophisticated institutions—have whether the broker-dealer is trading for to comply with SEC or exchange trading themselves begun using technological its own account, is trading for customers rules, the failure to detect illegal tools to place orders and trade on through more traditionally conduct, or otherwise—are present markets with little or no substantive intermediated brokerage arrangements, whenever a broker-dealer trades as a intermediation by their broker-dealers. or is allowing customers direct market member of an exchange or subscriber to This, in turn, has given rise to the access or sponsored access, the broker- an ATS, whether for its own proprietary increased use and reliance on ‘‘direct dealer with market access is legally account or as agent for its customers, market access’’ or ‘‘sponsored access’’ responsible for all trading activity that including traditional agency brokerage arrangements.6 occurs under its MPID.8 and through direct market access or Under these arrangements, the broker- sponsored access arrangements. dealer allows its customer—whether an Certain market participants may find The Commission is particularly institution such as a hedge fund, mutual the wide range of access arrangements concerned about the quality of broker- fund, bank or insurance company, an beneficial. For instance, facilitating dealer risk controls in sponsored access individual, or another broker-dealer—to electronic access to markets can provide arrangements, where the customer order use the broker-dealer’s MPID or other broker-dealers, as well as exchanges and flow does not pass through the broker- mechanism or mnemonic used to ATSs, opportunities to compete for dealer’s systems prior to entry on an identify a market participant for the greater volumes and a wider variety of exchange or ATS. The Commission purposes of electronically accessing an order flow. For a broker-dealer’s understands that, in some cases, the exchange or ATS. Generally, direct customers, which could include hedge broker-dealer providing sponsored market access refers to an arrangement funds, institutional investors, individual access may not utilize any pre-trade risk whereby a broker-dealer permits investors, and other broker-dealers, such management controls (i.e. ‘‘unfiltered’’ or customers to enter orders into a trading arrangements may reduce latencies and ‘‘naked’’ access),13 and thus could be facilitate more rapid trading,9 help unaware of the trading activity 3 See, e.g., Securities Exchange Act Release Nos. preserve the confidentiality of occurring under its market identifier 60684 (September 18, 2009), 74 FR 48632 sophisticated, proprietary trading and have no mechanism to control it. (September 23, 2009) (Proposal to Eliminate Flash strategies, and reduce trading costs by Order Exception from Rule 602 of Regulation NMS) 10 lowering operational costs, transaction volume and thereby qualify for more (File No. S7–21–09); 60997 (November 13, 2009), 74 11 favorable pricing tiers. FR 61208 (November 23, 2009) (Proposal to commissions, and exchange fees. 12 See Proposing Release, 75 FR at 4010—4011 Regulate Non-Public Trading Interest) (File No. S7– and 4029—4031 for a more detailed description of 27–09); 61908 (April 14, 2010), 75 FR 21456 (April 7 See, e.g., Nasdaq Rule 4611(d)(1)(A). The previous SRO guidance and rules. The SROs have, 23, 2010) (Proposed Large Trader Reporting System) Commission notes that Rule 15c3–5 will effectively over time, issued a variety of guidance and rules (File No. S7–10–10); and 62174 (May 26, 2010), 75 prohibit any access to trading on an exchange or that, among other things, address proper risk FR 32556 (June 8, 2010) (Proposed Consolidated ATS, whether sponsored or otherwise, where pre- controls by broker-dealers providing electronic Audit Trail) (File No. S7–11–10). trade controls are not applied. access to the securities markets. In addition, this 4 8 See, e.g., NYSE IM–89–6 (January 25, 1989); and See Securities Exchange Act Release No. 61358 past January, the Commission approved a new Securities Exchange Act Release No. 40354 (August (January 14, 2010), 75 FR 3594 (January 21, 2010) Nasdaq rule that requires broker-dealers offering 24, 1998), 63 FR 46264 (August 31, 1998) (NASD (File No. S7–02–10) (‘‘Concept Release’’). direct market access or sponsored access to Nasdaq 5 NTM- 98–66). The Commission notes that brokers- The Commission notes that high frequency to establish controls regarding the associated trading has been estimated to account for more than dealers typically access exchanges and ATSs financial and regulatory risks, and to obtain a 50 percent of the U.S. equities market volume. See through the use of unique MPIDs or other variety of contractual commitments from sponsored Concept Release, 75 FR at 3606. identifiers, which are assigned by the market. access customers. See Securities Exchange Act 6 It has been reported that sponsored access 9 Highly automated trading systems deliver Release No. 61345 (January 13, 2010) (SR– trading volume accounts for 50 percent of overall extremely high-speed, or ‘‘low latency’’ order NASDAQ–2008–104) (‘‘Nasdaq Market Access average daily trading volume in the U.S. equities responses and executions in some cases measured Approval Order’’), discussed in greater detail in the market. See, e.g., Carol E. Curtis, Aite: More in times of less than 1 millisecond. Appendix to the Proposing Release. Nasdaq has Oversight Inevitable for Sponsored Access, 10 For example, broker-dealers may receive delayed the implementation of this rule until 360 Securities Industry News, December 14, 2009 market access from other broker-dealers to an days after its approval. See Securities Exchange Act (citing a report by Aite Group). In addition, exchange where they do not pay to maintain a Release Nos. 61770 (March 24, 2010), 75 FR 16224 sponsored access has been reported to account for membership. (March 31, 2010) (SR–NASDAQ–2010–039); and 15 percent of Nasdaq volume. See, e.g., Nina Mehta, 11 The Commission notes that exchanges offer 62491 (July 13, 2010), 75 FR 41918 (July 19, 2010) Sponsored Access Comes of Age, Traders Magazine, various discounts on transaction fees that are based (SR–NASDAQ–2010–086). February 11, 2009 (quoting Brian Hyndman, Senior on the volume of transactions by a member firm. 13 It has been reported that ‘‘unfiltered’’ access Vice President for Transaction Services, Nasdaq See, e.g., Nasdaq Rule 7018 and NYSE Arca, Inc. accounts for an estimated 38 percent of the average OMX Group, Inc. ‘‘[direct sponsored access to (‘‘NYSE Arca’’) Fee Schedule. Exchange members daily volume of the U.S. stock market. See, e.g., customers is] a small percentage of our overall may use access arrangements as a means to Scott Patterson, Big Slice of Market Is Going customer base, but it could be in excess of 15 aggregate order flow from multiple market ‘Naked’, Wall Street Journal, December 14, 2009 percent of our overall volume.’’). participants under one MPID to achieve higher (citing a report by Aite Group).

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The Commission also understands that market access occur with some incident provides a striking example of some broker-dealers providing regularity,16 the Commission also is just how quickly and severely today’s sponsored access may simply rely on concerned about preventing other, financial markets can move across a assurances from their customers that potentially severe, widespread incidents wide range of securities and futures appropriate risk controls are in place. that could arise as a result of inadequate products. If a price shock in one or more Appropriate controls to manage risk controls on market access. As securities were to occur as a result of financial and regulatory risk for all trading in the U.S. securities markets computer or human error, for example, forms of market access are essential to has become more automated and high- it could spread rapidly across the assure the integrity of the broker-dealer, speed trading more prevalent, the financial markets, potentially with the markets, and the financial system. potential impact of a trading error or a systemic implications. To address these The Commission believes that risk rapid series of errors, caused by a risks, the Commission believes broker- management controls and supervisory computer or human error, or a malicious dealers, as the entities through which procedures that are not applied on a act, has become more severe. In access to markets is obtained, should pre-trade basis or that, with certain addition, the inter-connectedness of the implement effective controls reasonably limited exceptions, are not under the financial markets can exacerbate market designed to prevent errors or other exclusive control of the broker-dealer, movements, whether they are in inappropriate conduct from potentially are inadequate to effectively address the response to actual market sentiment or causing a significant disruption to the risks of market access arrangements, and trading errors. markets. pose a particularly significant For instance, on May 6, 2010, the The Commission believes that Rule vulnerability in the U.S. national market financial markets experienced a brief 15c3–5 should reduce the risks faced by system. but severe drop in prices, falling more broker-dealers, as well as the markets Market participants recognize the than 5% in a matter of minutes, only to and the financial system as a whole, as risks associated with naked sponsored recover a short time later.17 This a result of various market access access, with one commenter noting, for arrangements, by requiring effective example, that the potential systemic risk 16 Proposing Release, 75 FR at 4009. For example, financial and regulatory risk 14 is now ‘‘too large to ignore.’’ Today, it was reported that, on September 30, 2008, shares management controls reasonably of Google fell as much as 93% in value due to an order placement rates can exceed 1,000 designed to limit financial exposure and orders per second with the use of high- influx of erroneous orders onto an exchange from 15 a single market participant. See Ben Rooney, Google ensure compliance with applicable speed, automated algorithms. If, for Price Corrected After Trading Snafu, regulatory requirements to be example, an algorithm such as this CNNMoney.com, September 30, 2008, http:// implemented on a market-wide basis. malfunctioned and placed repetitive money.cnn.com/2008/09/30/news/companies/ google_nasdaq/?postversion=2008093019 (‘‘Google As described below, these financial and orders with an average size of 300 regulatory risk management controls shares and an average price of $20, a Trading Incident’’). In addition, it was reported that, in September 2009, Southwest Securities should reduce risks associated with two-minute delay in the detection of the announced a $6.3 million quarterly loss resulting market access and thereby enhance problem could result in the entry of, for from deficient market access controls with respect market integrity and investor protection example, 120,000 orders valued at $720 to one of its correspondent brokers that vastly in the securities markets. For example, million. In sponsored access exceeded its credit limits. John Hintze, Risk Revealed in Post-Trade Monitoring, Securities a system-driven, pre-trade control arrangements, as well as other access Industry News, September 8, 2009 (‘‘SWS Trading designed to reject orders that are not arrangements, appropriate pre-trade risk Incident’’). Another recent example occurred on reasonably related to the quoted price of controls could prevent this outcome January 4, 2010, when it was reported that shares the security would prevent erroneously from occurring by blocking unintended of Rambus, Inc. suffered an intra-day price drop of approximately thirty-five percent due to erroneous entered orders from reaching the orders from being routed to an exchange trades causing stock and options exchanges to break securities markets, which should lead to or ATS. trades. See Whitney Kisling and Ian King, Rambus As noted in the Proposing Release, Trades Cancelled by Exchanges on Error Rule, fewer broken trades and thereby while incidents involving algorithmic or BusinessWeek, January 4, 2010, http:// enhance the integrity of trading on the other trading errors in connection with www.businessweek.com/news/2010-01-04/rambus- securities markets. trading-under-investigation-as-potential-error- Rule 15c3–5 is intended to update1-.html (stating ‘‘[a] series of Rambus Inc. 14 See letter to Elizabeth M. Murphy, Secretary, trades that were executed about $5 below today’s complement and bolster existing rules Commission, from John Jacobs, Director of average price were canceled under rules that govern and guidance issued by the exchanges Operations, Lime Brokerage LLC, March 29, 2010 stock transactions that are determined to be ‘clearly and the Financial Industry Regulatory (‘‘Lime Letter’’) at 1 (‘‘[T]he potential for systemic erroneous.’ ’’) (‘‘Rambus Trading Incident’’). More Authority (‘‘FINRA’’) with respect to risk posed by unregulated entities accessing the recently, single stock circuit breakers have been 18 public markets directly and without any triggered for trading in shares of The Washington market access. Moreover, by supervision is an issue too large to ignore, with Post Company (WPO) and Progress Energy, Inc. estimates that naked access may account for (PGN) on June 16, 2010 and on September 27, 2010, working with the exchanges and FINRA to somewhere between 10%–38% of all US equity respectively, due to severe price movements caused implement coordinated circuit breakers for market trading activity, and most likely a much by order entry errors. In addition, certain exchanges individual stocks and to clarify the process for greater participation percentage for orders placed.’’); provide a searchable history of erroneous trade breaking erroneous trades. See Securities Exchange See also letter to Elizabeth M. Murphy, Secretary, cancellations on their website, which indicate that Act Release Nos. 62283 (September 10, 2010), 75 FR Commission, from Jose Marques, Managing erroneous trades occur with some regularity. See 56608 (September 16, 2010); 62884 (September 10, Director, Global Head of Electronic Equity Trading, http://www.nasdaqtrader.com/ 2010), 75 FR 56618 (September 16, 2010); 62251 Deutsche Bank Securities Inc., March 31, 2010 Trader.aspx?id=MarketSystemStatusSearch. (June 10, 2010), 75 FR 34183 (June 16, 2010); and (‘‘Deutsche Bank Letter’’) at 2 (‘‘[W]e are cognizant 17 See Findings Regarding the Market Events of 62252 (June 10, 2010), 75 FR 34186 (June 16, 2010); of the market and systemic risks that regulators May 6, 2010, Report of the Staffs of the CFTC and see also Securities Exchange Act Release Nos. perceive in unchecked market access, and agree that SEC to the Joint Advisory Committee on Emerging 62885 (September 10, 2010), 75 FR 56641 uniform guidance from the SEC as to the Regulatory Issues at http://www.sec.gov/news/ (September 16, 2010); and 62886 (September 10, responsibilities of market access is needed.’’). studies/2010/marketevents-report.pdf. See also 2010), 75 FR 56613 (September 16, 2010). The 15 See letter to Elizabeth M. Murphy, Secretary, Preliminary Findings Regarding the Market Events Commission will continue to explore additional Commission, from John Jacobs, Director of of May 6, 2010, Report of the Staffs of the CFTC ways in which these vulnerabilities can be Operations, Lime Brokerage LLC, February 17, 2009 and SEC to the Joint Advisory Committee on addressed. (commenting on a proposed rule change filed by Emerging Regulatory Issues at http://www.sec.gov/ 18 See Proposing Release, Appendix, 75 FR at The NASDAQ Stock Market LLC to adopt a sec-cftc-prelimreport.pdf. The Commission has 4029—4031 (noting current SRO guidance with modified sponsored access rule (File No. SR– taken steps to address the market vulnerabilities regard to internal procedures and controls to NASDAQ–2008–104)). evidenced by the events of May 6th such as by manage the financial and regulatory risks associated

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establishing a single set of broker-dealer including equities, options, exchange- specific provisions of Proposed Rule obligations with respect to market traded funds, debt securities, and 15c3–5, the comments received on each access risk management controls across security-based swaps.21 Further, it will provision, and any modifications to the markets, Rule 15c3–5 will provide require that the broker or dealer with provision from the Proposing Release. uniform standards that will be market access have direct and exclusive A. Summary of Rule 15c3–5 interpreted and enforced in a consistent control of the risk management controls manner and, as a result, reduce the and supervisory procedures, while Rule 15c3–5 will require a broker or potential for regulatory arbitrage.19 permitting the reasonable and dealer that has market access, or that appropriate allocation of specific risk provides a customer or any other person II. Rule 15c3–5 management controls and supervisory with access to an exchange or ATS The Commission is adopting Rule procedures to a customer that is a through use of its MPID or otherwise, to 15c3–5—Risk Management Controls for registered broker-dealer so long as the establish, document, and maintain a Brokers or Dealers with Market broker-dealer providing market access system of risk management controls and Access—to reduce the risks faced by has a reasonable basis for determining supervisory procedures reasonably broker-dealers, as well as the markets that such customer, based on its designed to manage the financial, and the financial system as a whole, as position in the transaction and regulatory, and other risks, such as legal a result of various market access relationship with the ultimate customer, and operational risks, related to such arrangements, by requiring effective can more effectively implement them. market access. Specifically, the Rule financial and regulatory risk Finally, and importantly, Rule 15c3–5 will require that broker-dealers with management controls reasonably will require those controls to be access to trading securities on an designed to limit financial exposure and implemented on a pre-trade basis, exchange or ATS, as a result of being a ensure compliance with applicable which will necessarily eliminate the member or subscriber thereof, and regulatory requirements to be practice of broker-dealers providing broker-dealer operators of an ATS that implemented on a market-wide basis. ‘‘unfiltered’’ or ‘‘naked’’ access to any provide access to their ATS to a non- These financial and regulatory risk exchange or ATS. As a result, the broker-dealer, establish, document, and management controls should reduce Commission believes Rule 15c3–5 maintain a system of risk management risks associated with market access and should substantially mitigate a controls and supervisory procedures thereby enhance market integrity and particularly serious vulnerability of the that, among other things, are reasonably investor protection in the securities U.S. securities markets. designed to (1) systematically limit the markets. Rule 15c3–5 is intended to After careful review and financial exposure of the broker or strengthen the controls with respect to consideration of the comment letters, dealer that could arise as a result of market access and, because it will apply the Commission has determined to market access, and (2) ensure to trading on all exchanges and ATSs, adopt Rule 15c3–5 substantially as compliance with all regulatory reduce regulatory inconsistency and the proposed, but with certain narrow requirements that are applicable in potential for regulatory arbitrage. Rule modifications made in response to connection with market access.22 15c3–5 will require a broker or dealer concerns expressed by commenters as Broker-dealers that provide outbound with market access, or that provides a discussed below. Consistent with the routing services to an exchange or ATS customer or any other person with Proposing Release, Rule 15c3–5 is in order for those trading centers to access to an exchange or ATS through organized as follows: (1) Relevant meet the requirements of Rule 611 of use of its MPID or otherwise, to definitions, as set forth in Rule 15c3– Regulation NMS will not be required to establish, document, and maintain a 5(a); (2) the general requirement to comply with the Rule with respect to system of risk management controls and maintain risk management controls and such routing services, except with supervisory procedures reasonably supervisory procedures in connection regard to paragraph (c)(1)(ii) of the Rule designed to manage the financial, with market access, as set forth in Rule (regarding prevention of erroneous regulatory, and other risks, such as legal 15c3–5(b); (3) the more specific orders). and operational risks, related to market requirements to maintain certain The required financial risk access. The Rule will apply to trading in financial and regulatory risk management controls and supervisory all securities on an exchange or ATS,20 management controls and supervisory procedures must be reasonably designed procedures, as set forth in Rule 15c3– to prevent the entry of orders that with market access for members that provide 5(c); (4) the mandate that those controls exceed appropriate pre-set credit or market access to customers). and supervisory procedures, with 19 See, e.g., letters to Elizabeth M. Murphy, capital thresholds, or that appear to be Secretary, Commission, from Manisha Kimmel, certain limited exceptions, be under the erroneous. The regulatory risk Executive Director, Financial Information Forum, direct and exclusive control of the management controls and supervisory February 19, 2009 (‘‘The [Nasdaq] proposal to broker-dealer with market access, as set procedures must be reasonably designed establish a well-defined set of rules governing sponsored access is a positive step towards forth in Rule 15c3–5(d); and (5) the to prevent the entry of orders unless addressing consistency in sponsored access requirement that the broker-dealer there has been compliance with all requirements.’’); and Ted Myerson, President, regularly review the effectiveness of the regulatory requirements that must be FTEN, Inc., February 19, 2009 (‘‘[I]t is imperative risk management controls and that Congress and regulators, together with the satisfied on a pre-order entry basis, private sector, work together to encourage effective supervisory procedures, as set forth in prevent the entry of orders that the real-time, pre-trade, market-wide systemic risk Rule 15c3–5(e). This release first gives broker-dealer or customer is restricted solutions that help prevent [sponsored access] a general description of Rule 15c3–5 as from trading, restrict market access errors from occurring in the first place.’’). adopted and then, in turn, discusses the 20 Under Section 763 of the Dodd-Frank Wall Street Reform and Customer Protection Act (‘‘Dodd- 22 The Commission notes that the term Frank Act’’), the Commission has new authority 21 The Dodd-Frank Act, in Section 761, amended ‘‘regulatory requirements’’ references existing over security-based swap execution facilities. The the definition of security to include security-based regulatory requirements applicable to broker- Commission will consider possible application of swaps. As such, the Commission notes that Rule dealers in connection with market access, and is not risk management controls and supervisory 15c3–5 will apply to a broker or dealer with access intended to substantively expand upon them. The procedures to trading on security-based swap to trading security-based swaps on a national specific content of the ‘‘regulatory requirements’’ execution facilities and other venues that facilitate securities exchange that makes security-based would, of course, adjust over time as laws, rules, the trading of such products. swaps available to trade. and regulations are modified.

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technology and systems to authorized procedures comply with Rule 15c3–5, registered broker-dealers.29 persons, and assure appropriate and that the regular review described Accordingly, the proposed rule was surveillance personnel receive above has been conducted. Such intended to ensure that all orders immediate post-trade execution reports. certifications will be required to be submitted to an exchange would flow Each such broker-dealer will be required preserved by the broker-dealer as part of through broker-dealer systems subject to to preserve a copy of its supervisory its books and records in a manner Rule 15c3–5 prior to such orders procedures and a written description of consistent with Rule 17a–4(b) under the entering an exchange. While the its risk management controls as part of Exchange Act.26 majority of ATS subscribers are broker- its books and records in a manner dealers, the current ATS regulatory consistent with Rule 17a–4(e)(7) under B. Definitions 23 regime does not require a subscriber to the Exchange Act. As proposed, Rule 15c3–5 sets forth 30 The financial and regulatory risk be a broker-dealer. As proposed, since two defined terms: ‘‘market access’’ and management controls and supervisory a non-broker-dealer subscriber to an ‘‘regulatory requirements.’’ The term procedures required by Rule 15c3–5 ATS would not have been subject to the ‘‘market access’’ is central to Proposed must be under the direct and exclusive proposed rule, orders it submits directly Rule 15c3–5, as it determines which control of the broker-dealer with market to an ATS to which it subscribes would broker-dealers are subject to Rule and access, with certain limited exceptions not have flowed through a broker-dealer the scope of the required financial and permitting allocation to a customer that system subject to Proposed Rule 15c3– regulatory risk management controls is a registered broker-dealer of specified 5 before entering the ATS. and supervisory procedures. In the functions that, based on its position in In the Proposing Release, the the transaction and relationship with Proposing Release, the Commission ‘‘ Commission requested comment on the ultimate customer, it can more proposed to define the term market ’’ whether the broker-dealer operator of an effectively implement. In addition, a access as access to trading in securities on an exchange or ATS as a result of ATS should be required to implement broker-dealer with market access will be risk management controls and required to establish, document, and being a member or subscriber of the exchange or ATS, respectively.27 In the supervisory procedures with regard to a maintain a system for regularly non-broker-dealer subscriber’s access to reviewing the effectiveness of the risk Proposing Release, the Commission explained that ‘‘market access’’ is its ATS. Nine commenters specifically management controls and supervisory addressed non-broker-dealer access to procedures and for promptly addressing intentionally defined broadly so as to trading in securities on ATSs in any issues. Among other things, the include not only direct market access or response to this request.31 Generally, broker-dealer will be required to review, sponsored access services offered to these commenters believed that all no less frequently than annually, the customers of broker-dealers, but also business activity of the broker-dealer in access to trading for the proprietary orders entered on an exchange or ATS connection with market access to assure account of the broker-dealer and for should be subject to equivalent the overall effectiveness of its risk more traditional agency activities. In regulatory treatment, and urged the management controls and supervisory addition, the proposed definition would Commission to address this issue. For procedures. Such review will be encompass trading in all securities on example, FINRA noted that the same required to be conducted in accordance an exchange or ATS, including equities, regulatory and financial risks associated with written procedures and will be options, exchange-traded funds, debt with broker-dealer access arrangements required to be documented. The broker- securities, and security-based swaps. are present when a non-broker-dealer dealer will be required to preserve a 1. Non-Broker-Dealer ATS Subscribers copy of its written procedures, and 29 See 15 U.S.C. 78f(c)(1) (‘‘A national securities documentation of each review, as part of By its terms, the proposed rule would exchange shall deny membership to (A) any person, not have applied to non-broker-dealer other than a natural person, which is not a its books and records in a manner registered broker or dealer or (B) any natural person consistent with Rule 17a–4(e)(7) under market participants, including non- who is not, or is not associated with, a registered the Exchange Act,24 and Rule 17a–4(b) broker-dealer subscribers to ATSs.28 In broker or dealer.’’). under the Exchange Act, respectively.25 addition, as proposed, the definition of 30 See 17 CFR 242.300(b). In addition, the Chief Executive ‘‘market access’’ was limited by the 31 See letters to Elizabeth M. Murphy, Secretary, phrase ‘‘as a result of being a member or Commission, from Marcia E. Asquith, Senior Vice Officer (or equivalent officer) of the President and Corporate Secretary, FINRA, March broker-dealer will be required, on an subscriber of the exchange or ATS, 25, 2010 (‘‘FINRA Letter’’); Christopher Lee, Global annual basis, to certify that the risk respectively.’’ Accordingly, a broker- Head of Market Access, and Paul Willis, Global management controls and supervisory dealer that operates an ATS and Compliance Officer, Fortis Bank Global Clearing provides non-broker-dealer market N.V. London Branch, March 26, 2010 (‘‘Fortis Letter’’); J. Ronald Morgan, Managing Director, 23 See 17 CFR 240.17a–4(e)(7). Pursuant to Rule participants access to its ATS would not Goldman, Sachs & Co., and Timothy T. Furey, 17a–4(e)(7), every broker or dealer subject to Rule have been included within the proposed Managing Director, Goldman Sachs Execution & 17a–3 is required to maintain and preserve in an definition of market access, because Clearing, L.P., March 20, 2010 (‘‘Goldman Letter’’); easily accessible place each compliance, such access would not result from that Timothy J. Mahoney, Chief Executive Officer, supervisory, and procedures manual, including any Marybeth Shay, Senior Managing Director Sales and updates, modifications, and revisions to the broker-dealer being a subscriber to the Marketing, and Vivian A. Maese, General Counsel manual, describing the policies and practices of the ATS, but rather from its being the ATS and Corporate Secretary, BIDS Trading, March 29, broker or dealer with respect to compliance with operator. 2010 (‘‘BIDS Letter’’); P. Mats Goebels, Managing applicable laws and rules, and supervision of the Director and General Counsel, Investment activities of each natural person associated with the With regard to exchanges, the Technology Group, Inc., March 29, 2010 (‘‘ITG broker or dealer until three years after the Exchange Act requires members to be Letter’’); Peter Kovac, Chief Operating Officer and termination of the use of the manual. Financial and Operations Principal, EWT LLC, 24 Id. March 29, 2010 (‘‘EWT Letter’’); John A. McCarthy, 25 See 17 CFR 240.17a–4(b). Pursuant to Rule 26 Id. General Counsel, GETCO, April 1, 2010 (‘‘GETCO 17a–4(b), every broker or dealer subject to Rule 27 Proposed Rule 15c3–5(a)(1). Letter’’); Jeffery S. Davis, Vice President and Deputy 17a–3 is required to preserve for a period of not less 28 See Proposing Release, 75 FR at 4012 n. 35 General Counsel, The Nasdaq OMX Group (‘‘Nasdaq than three years, the first two years in an easily (stating that ‘‘Proposed Rule 15c3–5 would not Letter’’); Ann Vlcek, Managing Director and accessible place, certain records of the broker or apply to non-broker-dealers, including non-broker- Associate General Counsel, SIFMA, April 16, 2010 dealer. dealers that are subscribers of an ATS.’’). (‘‘SIFMA Letter’’).

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subscriber enters orders and accesses an present when a non-broker-dealer regulatory, and other risks of this ATS.32 subscriber directly accesses an ATS as business activity. Six commenters recommended that when a broker-dealer accesses an The Commission believes any broker- the broker-dealer operator of the ATS exchange or ATS. Accordingly, the dealer with direct access to trading on should be required to implement the Commission believes that such access an exchange or ATS, or that provides required risk management controls and should be subject to the requirements of other market participants access to supervisory procedures with regard to the proposed rule to ensure that all trading on an exchange or ATS, should order flow from non-broker-dealer orders that enter an ATS are subject to establish effective risk management subscribers.33 In general, these effective risk management controls and controls reasonably designed to prevent commenters believed that the broker- supervisory procedures reasonably breaches of credit or capital limits, dealer operator of an ATS is best designed to limit financial exposure and erroneous trades, violations of SEC or positioned to implement the risk ensure compliance with applicable exchange trading rules, and the like. management controls and supervisory regulatory requirements. Specifically, These risk management controls should procedures required under the proposed the Commission believes that the reduce risks associated with market rule for order flow entered into its ATS broker-dealer operator of an ATS should access and thereby enhance market by non-broker-dealer subscribers. For be required to implement the financial integrity and investor protection in the example, one commenter noted that, and regulatory risk management securities markets. when receiving orders from non-broker- controls and supervisory procedures 2. ‘‘Regulatory Requirements’’ dealer subscribers, the ATS’s sponsoring required by the Rule with regard to Under Proposed Rule 15c3–5(a)(2), broker-dealer is the only broker-dealer access by non-broker-dealer subscribers the term ‘‘regulatory requirements’’ was in the chain of order flow from the to its ATS. subscriber to the ATS.34 Similarly, defined to include all federal securities FINRA believed that, because ATSs As noted above, because Rule 15c3– laws, rules and regulations, and rules of themselves have regulatory obligations 5 will not apply to non-broker-dealer SROs, that are applicable in connection as registered broker-dealers and FINRA subscribers, several commenters with market access. In the Proposing members, it is appropriate to impose suggested alternative ways to subject Release, the Commission stated that it risk management obligations on ATSs to non-broker-dealer ATS subscribers to intends this definition to encompass all the extent that non-registered entities the proposed rule. The Commission of a broker-dealer’s regulatory are permitted to access its ATS.35 Two believes, however, that the broker-dealer requirements that arise in connection other commenters agreed that an ATS operator of an ATS is the best with its market access.41 ‘‘Regulatory should be required to implement risk positioned broker-dealer to implement requirements’’ is a key term that controls management controls and supervisory the risk management controls, the scope of the regulatory risk procedures with regard to order flow particularly the pre-trade controls, management controls and supervisory from non-broker-dealer subscribers, but required under the proposed rule. In procedures required by Proposed Rule they believed this obligation stems from addition, the Commission believes the 15c3–5(c)(2). While several commenters its status as a market center rather than broker-dealer operator of an ATS can addressed the scope of the term as a broker-dealer.36 effectively achieve the purposes of the ‘‘regulatory requirements’’ in the context Several commenters put forth Rule. Requiring the broker-dealer of the proposal to require risk additional ideas as to how to address operator of an ATS to implement the management controls and supervisory non-broker-dealer subscriber access to risk management controls and systems,42 a few commenters expressed an ATS. One commenter suggested that supervisory procedures required by the concern regarding the specific definition the broker-dealer that clears the trades proposed rule with respect to non- of ‘‘regulatory requirements.’’ Two that occur on an ATS for a non-broker- broker-dealer subscribers should ensure commenters requested that the dealer subscriber should be required to that all order flow entered on an ATS is Commission clarify that the definition implement the risk controls with regard subject to the Rule’s financial and does not expand or alter the current to such orders.37 Another commenter regulatory risk management controls obligations of broker-dealers with proposed that the Commission amend and supervisory procedures.40 market access or that provide other the ATS regulatory structure to require Accordingly, the term ‘‘market access’’ market participants with access to ATS subscribers to be broker-dealers.38 in Rule 15c3–5(a)(1), as adopted, is trading on an exchange or ATS.43 The Yet another commenter suggested that defined to include ‘‘access to trading in Commission emphasizes that the term the Commission directly subject the securities on an alternative trading ‘‘regulatory requirements’’ references non-broker-dealer subscribers to the system provided by a broker-dealer existing regulatory requirements proposed rule.39 The Commission operator of an alternative trading system applicable to broker-dealers in received no comments suggesting that to a non-broker-dealer.’’ A broker-dealer connection with market access, and is non-broker-dealer subscriber access to operator of an ATS, therefore, would not intended to substantively expand an ATS should be outside the scope of have ‘‘market access’’ if it provides non- upon them (a concern noted by some the proposed rule. broker-dealer subscribers access to its commenters). As discussed below in The Commission agrees that similar ATS. Such a broker-dealer ATS operator Section II.E, these regulatory regulatory and financial risks are would be subject to Rule 15c3–5 and requirements would include, for would be required, among other things, example, pre-trade requirements such as 32 See FINRA Letter at 3–4. to establish, document, and maintain a exchange trading rules relating to 33 See FINRA Letter at 3–4; Fortis Letter at 5; Goldman Letter at 1 n. 3; BIDS Letter at 4; ITG system of risk management controls and 41 See Proposing Release, 75 FR at 4012. Letter at 9; SIFMA Letter at 7. supervisory procedures reasonably 42 These comments are addressed in Section II.E. 34 See ITG Letter at 9. designed to manage the financial, below. 35 See FINRA Letter at 3–4. 43 SIFMA Letter at 6; letter to Elizabeth M. 36 See Fortis Letter at 5; BIDS Letter at 4. 40 As discussed in greater detail, infra, a broker- Murphy, Secretary, Commission, from Joseph M. 37 See EWT Letter at 2. dealer subscriber of an ATS will be able to utilize Velli, Chairman and Chief Executive Officer, 38 See GETCO Letter at 7. the risk management tools and software provided ConvergEx Group, April 9, 2010 (‘‘ConvergEx 39 See Nasdaq Letter at 2. by the ATS to fulfill the requirements of the Rule. Letter’’) at 6.

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special order types, trading halts, odd- articulated in the proposed rule.46 while acknowledging the risks posed by lot orders, and SEC rules under Accordingly, Rule 15c3–5 does not unfiltered sponsored access Regulation SHO and Regulation NMS, employ a ‘‘one-size-fits-all’’ standard for arrangements, questioned the need for as well as post-trade obligations to determining compliance with the rule.47 the rule to cover other market access monitor for manipulation and other For example, a broker-dealer that only arrangements.52 In contrast, one illegal activity. The specific content of handles order flow from retail clients commenter stated that Rule 15c3–5 the ‘‘regulatory requirements’’ would, of may very well develop different risk should apply equally to customer and course, adjust over time as laws, rules management controls and supervisory proprietary trading activity, and ‘‘should and regulations are modified. procedures than a broker-dealer that not just be applicable to those members mostly services order flow from offering third party access.’’ 53 Another C. Requirement to Maintain Risk sophisticated high frequency traders.48 commenter similarly noted that uniform Management Controls and Supervisory principles with respect to market access Procedures 2. Application to Traditional Agency Brokerage and Proprietary Trading are warranted, and that any final rule on Proposed Rule 15c3–5(b) sets forth the market access should not advantage a general requirement that any broker- As noted above, the Commission broker-dealer’s proprietary business dealer with access to trading on an expressed the view in the Proposing over its customer business.54 Yet exchange or ATS must establish risk Release that the financial and regulatory another commenter noted that management controls and supervisory risk management controls and subjecting proprietary trading of broker- procedures reasonably designed to supervisory procedures described in the dealers to Rule 15c3–5 would create manage the associated risks. proposed rule should apply broadly to ‘‘common expectations for all firms to Specifically, Proposed Rule 15c3–5(b) all forms of market access by broker- police themselves in order to limit provides that a broker-dealer with dealers that are exchange members or potential market impacting events.’’ 55 market access, or that provides a ATS subscribers, including sponsored The Commission continues to believe customer or any other person with access, direct market access, and more that the risks associated with market access to an exchange or ATS through traditional agency brokerage access—whether they involve the use of its MPID or otherwise, shall arrangements with customers, as well as 49 potential breach of a credit or capital establish, document, and maintain a proprietary trading. Accordingly, the limit, the submission of erroneous ‘‘ ’’ system of risk management controls and proposed term market access includes orders as a result of computer supervisory procedures reasonably all such activities. malfunction or human error, the failure Certain commenters suggested that designed to manage the financial, to comply with SEC or exchange trading the scope of the proposed rule is too far- regulatory, and other risks, such as legal rules, the failure to detect illegal and operational risks, of this business reaching in that it encompasses broker- dealer activities that do not raise risks conduct, or otherwise—are present activity. Proposed Rule 15c3–5(b) as significant as those that occur in whenever a broker-dealer trades as a requires the controls and procedures to ‘‘unfiltered’’ sponsored access member of an exchange or subscriber to be documented in writing, and requires arrangements.50 One commenter an ATS, whether for its own proprietary the broker-dealer to preserve a copy of believed that the proposed rule would account or as agent for its customers, its supervisory procedures and a written lead to duplicative, unnecessary, and including traditional agency brokerage description of its risk management costly regulation.51 Another commenter, and through direct market access or controls as part of its books and records sponsored access arrangements. The in a manner consistent with Rule 17a– 46 In agreeing with the approach of the proposed Commission believes that to effectively 44 4(e)(7) under the Exchange Act. rule, one commenter noted that ‘‘[a]n effective risk address these risks, Rule 15c3–5 must management system should be tailored to the 1. ‘‘Reasonably Designed’’ Controls and apply broadly to all access to trading on business of the broker-dealer, taking into account a an exchange or ATS. Procedures comprehensive view of the firm’s activities, including the individual circumstances of various In addition, the Commission, Proposed Rule 15c3–5(b) requires that customers and clients, and a quantitative analysis consistent with our understanding of the risk management controls and of the trading goals and strategies employed across current broker-dealer best practices, supervisory procedures of a broker- all asset classes for each entity placing orders.’’ See continues to believe that, in many cases, dealer subject to the rule be ‘‘reasonably EWT Letter at 4. 47 ABA Letter at 5 (requesting that the particularly with respect to proprietary designed’’ to manage the risks associated Commission clearly state that the proposed trading and more traditional agency with market access. Commenters ‘‘reasonably designed’’ standard is not meant to be brokerage activities, that Rule 15c3–5 generally supported the proposed a one-size-fits-all test that would unreasonably burden smaller broker-dealers). See also letter to should be substantially satisfied by ‘‘reasonably designed’’ standard in the Elizabeth M. Murphy, Secretary, Commission, from existing risk management controls and rule.45 In the Proposing Release, the Edward Wedbush, President, and Jeff Bell, supervisory procedures already Commission noted that the proposed Executive Vice President, Wedbush Securities Inc., March 31, 2010 (‘‘Wedbush Letter’’) at 1 (stating that rule allows flexibility for the details of 52 ‘‘the requirements of the Proposed Rule should not CBOE Letter at 2. the controls and procedures to vary be applied on a one size fits all basis.’’). 53 Fortis Letter at 4. from broker-dealer to broker-dealer, 48 The Commission agrees with a commenter that 54 Letter to Elizabeth M. Murphy, Secretary, depending on the nature of the business noted that ‘‘[r]isk controls must be tailored to the Commission, from Stuart J. Kaswell, Executive Vice and customer base, so long as they are particular nature of the market access, the President and Managing Director, General Counsel, arrangements between the market participants and Managed Funds Association (‘‘MFA’’), March 29, reasonably designed to achieve the goals the market venue, and the client’s trading strategy.’’ 2010 (‘‘MFA Letter’’) at 2. MFA recognized that Goldman Letter at 2. different types of filters and control settings for 44 See 17 CFR 240.17a–4(e)(7). 49 Proposed Rule 15c3–5 would not apply to non- proprietary orders and customer orders may be 45 See, e.g., EWT Letter at 4; SIFMA Letter at 2; broker-dealers, including non-broker-dealers that warranted due to the different types of risks letters to Elizabeth M. Murphy, Secretary, are subscribers of an ATS. presented by such orders. Id. See also Wedbush Commission, from Jeffrey W. Rubin, Chair, 50 See, e.g., ABA Letter at 2–3; CBOE Letter at 1; Letter at 4 (‘‘Certain pre-trade risk filters should be Committee on Federal Regulation of Securities, letter to Elizabeth M. Murphy, Secretary, applied to all orders whether sponsored or not, American Bar Association, April 5, 2010 (‘‘ABA Commission, from Kimberly Unger, Executive thereby eliminating the performance or speed Letter’’) at 5; Edward J. Joyce, President and Chief Director, The Securities Traders Association of New differential, and effectively encouraging firms to Operating Officer, Chicago Board Options York, Inc., March 29, 2010 (‘‘STANY Letter’’) at 2. utilize these controls.’’). Exchange, Incorporated (‘‘CBOE Letter’’) at 3. 51 STANY Letter at 2. 55 GETCO Letter at 2.

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implemented by broker-dealers.56 For treatment of all orders entered on that provisions of Rule 611 of Regulation these broker-dealers, Rule 15c3–5 market center,60 and would more NMS 65 for NMS stocks, and the trade- should have a minimal impact on equitably allocate risk management through provisions of Options Linkage current business practices and, obligations among those that benefit Plan 66 for listed options, by routing therefore, should not impose significant from trading.61 In this regard, orders to better-priced quotes at away additional costs on those broker-dealers commenters noted that certain markets. Some exchanges and ATSs use that currently employ a prudent exchanges currently provide users with affiliated broker-dealers to perform this approach to risk management.57 Rule an array of pre-trade risk controls, and function, and others contract with an 15c3–5 will assure that broker-dealer urged the Commission to allow broker- unaffiliated broker-dealer to do so.67 In controls and procedures are dealers to rely on these exchange general, the outbound order routing appropriately strengthened, as controls to comply with the Rule.62 The service provided to exchanges by necessary, so that consistent standards Commission believes that market center- broker-dealers is regulated as a facility are applied for all types of market provided pre-trade risk controls can be of the exchange, and therefore is subject access. By requiring all forms of market useful risk management tools. The to direct Commission oversight.68 access by broker-dealers to meet certain Commission continues to believe, Commenters noted that, under the baseline standards for financial and however, that broker-dealers with proposal, orders submitted to an regulatory risk management controls, market access should be responsible in exchange would first have to flow Rule 15c3–5 should reduce risks to the first instance for establishing and through broker-dealer systems that are broker-dealers, the markets, and the maintaining appropriate risk subject to the financial and regulatory financial system, and thereby enhance management controls under the Rule. risk controls required by proposed Rule market integrity and investor protection. The Commission notes, as discussed in 15c3–5, and suggested that requiring Section F. below, that broker-dealers routing brokers to perform the same risk 3. Risk Management Controls Provided may be able to use market center- checks immediately thereafter would be by Exchanges and ATSs provided pre-trade risk controls as part duplicative.69 These commenters Several commenters addressed the of an overall plan to comply with the suggested that subjecting routing role of market centers—exchanges and Rule. In addition, the Commission notes brokers to proposed Rule 15c3–5 would ATSs—in connection with the that market centers may independently impose unnecessary costs and establishment of risk management implement pre-trade risk management inefficiencies without any controls.58 Some commenters suggested controls to supplement those applied by corresponding benefits. In addition, that market centers, rather than broker- broker-dealers. some commenters argued that routing dealers with market access, should be 4. Routing Brokers brokers would not necessarily have the responsible for implementing certain requisite knowledge to effectively pre-trade risk management controls. In the Proposing Release, the implement the required pre-trade risk These commenters generally argued that Commission requested comment on checks.70 the market center is best positioned to whether any particular market access implement pre-trade risk management arrangement warranted different 65 See 17 CFR 242.611. Pursuant to Rule 611 of controls such as those designed to treatment under the proposed rule. In Regulation NMS, exchanges and ATSs are required prevent erroneous orders and assure response, eight commenters expressed to, among other things, establish, maintain, and compliance with SRO rules relating to concern with the application of the enforce written policies and procedures that are 59 reasonably designed to prevent trade-throughs on trading halts and special order types. proposed rule to broker-dealers that such exchange or ATS of protected quotations in Some commenters argued that applying provide outbound order routing services NMS stocks. Exchanges and ATSs generally comply pre-trade risk controls at the market to exchanges.63 In addition, two of these with this requirement, in part, by employing an center level would provide for uniform commenters noted the same concerns affiliated or unaffiliated broker-dealer to route orders received by the exchange or ATS to other with respect to broker-dealers that trading centers displaying protected quotations. 56 See Proposing Release, Appendix, 75 FR at provide outbound order routing services 66 The Options Linkage Plan is a Commission- 4029–4031 (noting current SRO guidance with to ATSs.64 As proposed, Rule 15c3–5 approved national market system plan. Securities regard to internal procedures and controls to Exchange Act Release No. 60405 (July 30, 2009), 74 manage the financial and regulatory risks associated would have applied to routing brokers because they have ‘‘market access,’’ as FR 39362 (August 6, 2009) (Order Approving the with market access for members that provide National Market System Plan Relating to Options market access to customers). defined in Rule 15c3–5(a)(1). Order Protection and Locked/Crossed Markets 57 Id. Exchanges and ATSs use outbound Submitted by the Chicago Board Options Exchange, 58 See Wedbush Letter at 4; Fortis Letter at 2; order routing services provided by Incorporated, International Securities Exchange, SIFMA Letter at 6; CBOE Letter at 4; Goldman broker-dealers to, among other things, LLC, The NASDAQ Stock Market LLC, NASDAQ Letter at 7; GETCO Letter at 6; ITG Letter at 3–4; OMX BX, Inc., NASDAQ OMX PHLX, Inc., NYSE Lime Letter at 6; Deutsche Bank Letter at 5–6; letters comply with the trade-through Amex LLC, and NYSE Arca, Inc.) (‘‘Options Linkage to Elizabeth M. Murphy, Secretary, Commission, Plan’’). from Richard D. Berliand, Managing Director and 60 See, e.g., Deutsche Bank Letter at 2; Lime Letter 67 See, e.g., Direct Edge Letter at 2; Nasdaq Letter Head of Prime Services and Market Structure at 6; Wedbush Letter at 4; Pershing Letter at 3. at 4; NYSE Letter at 4. Group, and John J. Hogan, Managing Director and 61 See, e.g., Newedge Letter at 2. 68 Chief Risk Officer, Investment Bank, J.P. Morgan See, e.g., The NASDAQ Stock Exchange LLC 62 Securities Inc., April 26, 2010 (‘‘JP Morgan Letter’’) See, e.g., Wedbush Letter at 4. See also NYSE Rule 4758(b); BATS Exchange, Inc. Rule 2.11(a); at 2–3; Jesse Lawrence, Director and Managing Letter at 3; BATS Letter at 2; BIDS Letter at 2. and New York Stock Exchange, Inc. Rule 13. Counsel, Pershing LLC, March 24, 2010 (‘‘Pershing 63 See Nasdaq Letter at 4; CBOE Letter at 3; EWT Several commenters noted that exchange routing Letter’’) at 3–4; Nicole Harner Williams, Vice Letter at 4; ConvergEx Letter at 5; GETCO Letter at brokers operate as facilities of exchanges. See President and Associate General Counsel, Penson 5; letters to Elizabeth M. Murphy, Secretary, Nasdaq Letter at 4; NYSE Letter at 4; Direct Edge Worldwide, Inc., March 29, 2010 (‘‘Penson Letter’’) Commission, from Eric W. Hess, General Counsel, Letter at 1. Nasdaq stated that ‘‘exchange-operated at 3; Gary DeWaal, Senior Managing Director and Direct Edge Holdings, LLC, March 26, 2010 (‘‘Direct broker-dealers are already heavily regulated as Group General Counsel, Newedge USA, LLC, March Edge Letter’’) at 1–3; Eric J. Swanson, Senior Vice exchange facilities, including rule strictly limiting 29, 2010 (‘‘Newedge Letter’’) at 2, 4; John M. President and General Counsel, BATS Exchange, them to a single client, the exchange itself.’’ Damgard, President, Futures Industry Association, Inc., March 21, 2010 (‘‘BATS Letter’’) at 3–4; Janet 69 See Nasdaq Letter at 4; NYSE Letter at 5; BATS May 6, 2010, (‘‘FIA Letter’’) at 2. M. Kissane, Senior Vice President—Legal and Letter at 4; Direct Edge Letter at 2–3; CBOE Letter 59 See, e.g., Pershing Letter at 3; Penson Letter at Corporate Secretary, Office of the General Counsel, at 3; GETCO Letter at 5. 3; Deutsche Bank Letter at 5; Goldman Letter at 7; NYSE Euronext, March 29, 2010 (‘‘NYSE Letter’’) at 70 See Direct Edge Letter at 2; ConvergEx Letter ITG Letter at 3; Lime Letter at 6; JP Morgan Letter 4–5. at 5; GETCO Letter at 5; BATS Letter at 4; EWT at 2. 64 See, e.g., GETCO Letter at 5; CBOE Letter at 3. Letter at 4.

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The Commission is adopting Rule the exchange or ATS under Rule 611 of arrangements.72 Some commenters, 15c3–5 to include an exception for Regulation NMS, or a national market however, suggested that the broker-dealers that provide outbound system plan for listed options. Routing Commission clarify how a broker-dealer routing services to an exchange or ATS services of an exchange or ATS routing could reasonably set credit and capital for the sole purpose of accessing other broker that are not limited to thresholds under the proposed rule.73 In trading centers with protected compliance with Rule 611 of Regulation particular, one commenter thought quotations on behalf the exchange or NMS may include a more complex order broker-dealers should have the ATS in order to comply with Rule 611 routing process involving new decision- flexibility to set credit limits for of Regulation NMS, or a national market making by the routing broker that customers on a market-by-market system plan for listed options. Under warrant imposition of the full range of basis.74 The Commission believes that a Rule 15c3–5, orders sent to an exchange market access risk controls. broker-dealer that sets a reasonable or ATS for execution on that exchange Accordingly, the Commission believes aggregate credit limit for each customer or ATS are required to be subject to that in these circumstances the could satisfy Rule 15c3–5(c)(1)(i) if the broker-dealer risk management controls exchange or ATS routing broker should broker-dealer imposes that credit limit immediately before submission to the be fully subject to Rule 15c3–5. The by setting sub-limits applied at each 71 exchange or ATS. When providing exception would not apply, for example, exchange or ATS to which the broker- outbound routing services to an to a broker-dealer when it provides dealer provides access that, when added exchange or ATS for the sole purpose of other routing services for the exchange together, equal the aggregate credit accessing other trading centers with or ATS, such as directed routing for limit. This approach, however, would protected quotations on behalf the exchange or ATS customers. In necessarily require that, when assessing exchange or ATS in order to comply addition, the Commission emphasizes the customer’s credit exposure at one with Rule 611 of Regulation NMS, or a that this exception only applies to the market center, the broker-dealer assume national market system plan for listed requirements of Rule 15c3–5. that the maximum credit limit has been options, routing brokers necessarily Accordingly, this exception would not reached by the customer at all other would only handle orders that have just relieve a routing broker that is a member exchanges and ATSs to which it passed through broker-dealer risk of an exchange of its obligation to provides access. For example, if a management controls subject to comply with the rules of that exchange. reasonable aggregate credit limit for a Proposed Rule 15c3–5. Accordingly, the customer is $1,000,000 and the broker- Commission believes that excepting D. Financial Risk Management Controls dealer provides it access to five routing brokers employed by exchanges and Supervisory Procedures exchanges or ATSs, the broker-dealer and ATSs to comply with Rule 611of may set individual market center credit Regulation NMS, or a national market Proposed Rule 15c3–5(c) would have limits of $200,000 to be applied at the system plan for listed options, from the required a broker-dealer’s risk market center level, but that limit could requirements of Rule 15c3–5 should management controls and supervisory not be increased to reflect any unused serve to encourage efficient routing procedures to include certain elements. portion of the credit limits at other services for the purpose of Regulation Proposed Rule 15c3–5(c)(1) was market centers. NMS compliance without increasing the intended to address financial risks, and risks associated with market access. The would have required that the risk 2. More Finely-Tuned Credit Limits Commission notes, however, that management controls and supervisory routing brokers will not be exempt from procedures be reasonably designed to A few commenters argued that the requirement to set finely-tuned credit or the requirement in Rule 15c3–5(c)(1)(ii) systematically limit the financial capital thresholds, where appropriate, is to prevent the entry of erroneous orders, exposure of the broker-dealer that could unclear, and the Commission should by rejecting orders that exceed arise as a result of market access. provide more detail or eliminate the appropriate price or size parameters, on Among other things, the controls and requirement.75 One commenter believed an order-by-order basis or over a short procedures must be reasonably designed the requirement was vague, and period of time, or that indicate to: (1) Prevent the entry of orders that expressed concern that a broker-dealer duplicative orders. The Commission exceed appropriate pre-set credit or could be found to have violated the believes that requiring routing brokers capital thresholds in the aggregate for proposed rule if it did not finely-tune its to have controls reasonably designed to each customer and the broker-dealer, prevent the entry of erroneous or and where appropriate more finely- duplicative orders should help ensure 72 See, e.g., Wedbush Letter at 4 (‘‘Pre-trade filters tuned by sector, security, or otherwise, benefit the entire industry by helping to prevent that order handling by an exchange or by rejecting orders if such orders exceed computerized trading malfunctions * * *.’’); Lime ATS routing broker would not increase the applicable credit or capital Letter at 5 (‘‘Real-time pre-trade, order-placement risk. thresholds; and (2) prevent the entry of controls are certainly a critical component to The Commission notes that the erroneous orders, by rejecting orders mitigate many of the risks associated with market exception applies only to the extent a access.’’), SIFMA Letter at 2 (‘‘SIFMA supports the that exceed appropriate price or size general principle underlying the Proposal that pre- routing broker is providing services to parameters, on an order-by-order basis trade and post-trade controls and procedures are an exchange or ATS for the purpose of or over a short period of time, or that appropriate in sponsored access arrangements.’’), JP fulfilling the compliance obligations of Morgan Letter at 2 (‘‘We agree with the Commission indicate duplicative orders. that pre-trade controls need to be applied to all orders sent under a broker-dealer’s MPID to an 71 The Commission notes that, as adopted, Rule 1. Individual Trading Center Credit exchange or ATS.’’). 15c3–5 requires a broker-dealer operator of an ATS Limits 73 to implement the financial and regulatory risk See, e.g., BIDS Letter at 3; SIFMA Letter at 8; ConvergEx Letter at 5. management controls required by the rule with Commenters generally agreed that regard to non-broker-dealer subscriber’s access to its 74 BIDS Letter at 3 (suggesting that ‘‘it would be ATS. As discussed above, with this change, Rule systematic, pre-set credit or capital a reasonable procedure for a broker-dealer to set 15c3–5 requires all orders that enter an ATS (i.e. thresholds applied on a pre-trade basis thresholds with reference to the aggregate trading orders entered by broker-dealer subscribers and are reasonable and appropriate financial potential of such customer that is known to the firm on a per market basis’’). non-broker-dealer subscribers) to flow through risk management controls that should be broker-dealer risk management controls subject to 75 See, e.g., ITG Letter at 8; Deutsche Bank Letter the proposed rule. in place for market access at 3.

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credit or capital thresholds.76 Another algorithmic approach to determining the additional steps may be taken to assure commenter thought the requirement is credit and capital threshold would be the threshold is not breached. unclear, and questioned the need for it 82 preferable. One commenter suggested 4. Duplicative Orders in light of an aggregate credit or capital that the Commission should require threshold.77 In contrast, one commenter ‘‘real-time trade flow controls which A few commenters expressed concern agreed with the proposed rule that ‘‘an incorporate an algorithmic approach to regarding the requirement in Proposed aggregate exposure threshold should be resting orders, executions and Rule 15c3–5(c)(1)(ii) that a broker-dealer required for each account and, where cancellation rates in order to have controls and procedures appropriate, for specific industry sectors accomplish desired improvements in reasonably designed to prevent the entry and/or securities.’’ 78 Rule 15c3– systemic risk management without of orders that indicate duplicative 5(c)(1)(i), the provision addressing more adversely impacting liquidity in the orders. One commenter noted that this finely-tuned credit or capital thresholds, marketplace.’’ 83 aspect of the proposal could create where appropriate, is intended to operational difficulties in determining provide a broker-dealer flexibility in In the Proposing Release, the how to set the risk management ‘‘ setting its credit and capital threshold Commission stated that because parameters, and requested that the consistent with the broker-dealer’s financial exposure through rapid order Commission either eliminate this business model and the goals of the entry can be incurred very quickly in requirement from the rule or clarify that Rule. A broker-dealer should assess its today’s fast electronic markets, controls a broker-dealer could apply reasonable business and its customers to determine should measure compliance with standards to detect duplicative orders if it is appropriate to establish more appropriate credit or capital thresholds based on the activity of its customers.85 tailored credit or capital limits by on the basis of orders entered rather Another commenter noted the sector, security, or otherwise. This than executions obtained.’’ 84 The difficulties in setting parameters to underscores the reasonable policies and Commission continues to believe that detect duplicative orders and suggested procedures approach of the Rule and the broker-dealers should monitor the Commission allow for flexibility in Commission’s recognition that a ‘‘one- compliance with applicable credit or setting parameters so as not to size-fits-all’’ model for risk management capital thresholds based on orders disadvantage clients by rejecting orders controls and supervisory procedures in entered, including the potential that are not in fact duplicative.86 The connection with market access is not financial exposure resulting from open Commission emphasizes that the appropriate.79 orders not yet executed. The controls and procedures must be Commission recognizes, however, that ‘‘reasonably designed’’ to prevent the 3. Reasonable Models for Credit or some active trading strategies entry of erroneous orders, including Capital Exposure of Outstanding Orders predictably result in executions for only duplicative orders, which allows broker- Several commenters suggested more a small percentage of orders entered, dealers some flexibility in crafting them, flexibility with respect to the proposed and that requiring broker-dealers to so long as they are reasonably designed pre-order entry financial risk assume that every order entered will be to achieve the stated goal. Among other management controls in paragraph executed will, in some cases, things, the Commission believes broker- (c)(1)(i) of the Rule. One commenter significantly overestimate actual credit dealers should take into account the suggested that the controls be applied or capital exposures. Accordingly, the type of customer as well as the on a rolling intra-day or post-close basis, Commission believes that, while the customer’s trading patterns and order with compliance being calculated based reasonably designed risk management entry history in determining how to set on executed orders rather than orders controls contemplated by Rule 15c3–5 such parameters.87 routed but not yet executed.80 In other should measure compliance based on words, a broker-dealer’s controls would orders entered, the credit or capital 5. Rule 15c3–5(c)(1) block the routing of additional orders exposure assigned to those orders may The Commission is adopting Rule and cancel any open orders only after be discounted, where appropriate, to 15c3–5(c)(1) as proposed. The the execution of orders exceeding the account for the likelihood of actual Commission believes that, in today’s applicable credit or capital limit had execution as demonstrated by fast electronic markets, effective occurred. Other commenters suggested reasonable risk management models. controls with respect to financial risk additional variations on the proposed Any broker-dealer relying on risk incurred on exchanges and ATSs must approach to compliance with credit and management models to discount the be automated and applied on a pre-trade capital thresholds so as to reduce the exposure of outstanding orders should basis. These pre-trade controls should potential impact on liquidity.81 For monitor the accuracy of its models on protect broker-dealers providing market example, commenters suggested that an an ongoing basis and make appropriate access, as well as their customers and adjustments to its method of calculating other market participants, by blocking 76 Deutsche Bank Letter at 3. credit or capital exposures as warranted. orders that do not comply with 77 ITG Letter at 8. Broker-dealers providing market access applicable risk management controls 78 Goldman Letter at 6. also may wish to establish ‘‘early from being routed to a securities market. 79 See ABA Letter at 5 (requesting that the Commission clearly state that the proposed warning’’ mechanisms to alert them As noted above, there is flexibility for ‘‘reasonably designed’’ standard is not meant to be when the applicable credit or capital the specific parameters of the controls a one-size-fits-all test that would unreasonably threshold is being approached, so that and procedures to vary from broker- burden smaller broker-dealers). dealer to broker-dealer, depending on 80 Goldman Letter at 6. 82 81 Deutsche Bank Letter at 3 (suggesting that the STANY Letter at 5–6; FTEN Letter at 4. 85 Commission replace the pre-trade credit threshold 83 FTEN Letter at 4. See also STANY Letter at 5 NYSE Letter at 2. with a threshold based on the total dollar value of (stating that ‘‘an analysis of the likelihood of an 86 SIFMA Letter at 9. open orders placed by a customer); STANY Letter infraction occurring within the overall setting of the 87 For example, a reasonably designed risk control at 5–6; letter to Elizabeth M. Murphy, Secretary, orders, executions and cancellation rates * * * to prevent the entry of duplicative orders for a high Commission, from Ted Myerson, Chief Executive would result in desired improvements in systemic frequency trader may very well be different—in Officer, Doug Kittelsen, Chief Technology Officer, risk controls without adversely impacting liquidity particular, more tolerant—than controls designed to and M. Gary LaFever, General Counsel, FTEN, Inc., in the marketplace.’’). perform the same function for individual investors March 29, 2010 (‘‘FTEN Letter’’) at 4. 84 Proposing Release, 75 FR at 4013. at a retail brokerage firm.

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the nature of the business and customer that rejection must occur if such orders promptly make adjustments to them as base, so long as they are reasonably would exceed the applicable credit or warranted. designed to achieve the goals articulated capital thresholds, the broker-dealer The Commission emphasizes that the in the Rule. In many cases, particularly must assess compliance with the financial risk management controls and with respect to proprietary trading and applicable threshold on the basis of supervisory procedures described in more traditional agency brokerage exposure from orders entered on an Rule 15c3–5(c) should not be viewed as activities, the Rule may be substantially exchange or ATS, rather than relying on a comprehensive list of those that satisfied by existing financial risk a post-execution, after-the-fact should be utilized by broker-dealers. management controls and supervisory determination. Because financial Instead, the Rule simply sets a uniform procedures already implemented by exposure through rapid order entry can baseline standard for the types of broker-dealers. However, the be incurred very quickly in today’s fast financial risk management controls and Commission believes that the Rule electronic markets, controls should supervisory procedures that a broker- should help to assure that a consistent measure compliance with appropriate dealer with market access should standard applies to all broker-dealers credit or capital thresholds on the basis providing any type of market access implement. A broker-dealer may, for a of orders entered rather than executions variety of reasons, implement financial and, importantly, will address the obtained. As noted above, however, in serious gap that exists with those risk management controls and appropriate cases reasonable risk supervisory procedures above and broker-dealers that today offer management models may be used to ‘‘unfiltered’’ sponsored access. beyond those specifically described in discount the credit or capital exposure the Rule, depending on the nature of its Under Rule 15c3–5(c)(1)(i), the generated by outstanding but broker-dealer’s controls and procedures business, customer base, and other unexecuted orders. must be reasonably designed to prevent specific circumstances. the entry of orders that exceed Under Rule 15c3–5(c)(1)(ii), the broker-dealer’s controls and procedures E. Regulatory Risk Management appropriate pre-set credit or capital Controls and Supervisory Procedures thresholds in the aggregate for each must be reasonably designed to prevent customer and the broker-dealer, and the entry of erroneous orders, by As noted above, Proposed Rule 15c3– where appropriate more finely-tuned by rejecting orders that exceed appropriate 5(c) requires a broker-dealer’s risk sector, security, or otherwise, by price or size parameters, on an order-by- management controls and supervisory rejecting orders if such orders exceed order basis or over a short period of procedures to include certain elements. the applicable credit or capital time, or that indicate duplicative orders. Proposed Rule 15c3–5(c)(2) deals with thresholds. Under this provision, a Given the prevalence today of high- regulatory compliance risk, and requires broker-dealer will be required to set speed automated trading algorithms and that the risk management controls and appropriate credit thresholds for each other technology, and the fact that supervisory procedures be reasonably customer for which it provides market malfunctions periodically occur with designed to ensure compliance with all access, including broker-dealer those systems, the Commission believes regulatory requirements that are customers,88 and appropriate capital that broker-dealer risk management applicable in connection with market thresholds for proprietary trading by the controls should be reasonably designed access, including being reasonably broker-dealer itself. The Commission to detect malfunctions and prevent designed to: (1) Prevent the entry of expects broker-dealers will make such orders from erroneously being entered orders unless there has been compliance determinations based on appropriate as a result, and that identifying and with all regulatory requirements that due diligence as to the customer’s blocking erroneously entered orders on must be satisfied on a pre-order entry business, financial condition, trading an order-by-order basis or over a short basis; (2) prevent the entry of orders for patterns, and other matters, and period of time would accomplish this. securities that the broker-dealer, document that decision. In addition, the These controls also should be customer, or other person, as applicable, Commission expects the broker-dealer reasonably designed to prevent orders is restricted from trading; (3) restrict will monitor on an ongoing basis from being entered erroneously as a access to trading systems and whether the credit thresholds remain result of manual errors (e.g., erroneously technology that provide market access appropriate, and promptly make entering a buy order of 2,000 shares at to persons and accounts pre-approved adjustments to them, and its controls $2.00 as a buy order of 2 shares at and authorized by the broker-dealer; and procedures, as warranted. $2,000.00). For example, a systematic, (4) assure that appropriate surveillance In addition, because the controls and pre-trade control reasonably designed to personnel receive immediate post-trade procedures must be reasonably designed reject orders that are not reasonably execution reports that result from to prevent the entry of orders that related to the quoted price of the market access. exceed the applicable credit or capital security would help prevent Several commenters were concerned thresholds by rejecting them, the broker- erroneously-entered orders from with the scope of the Rule, particularly dealer’s controls must be applied on an reaching the market.89 As with the to the extent it requires controls and automated, pre-trade basis, before orders financial risk management controls and are routed to the exchange or ATS. procedures reasonably designed to supervisory procedures relating to credit ensure compliance with all regulatory Furthermore, because the risk or capital thresholds, the broker-dealer management controls and supervisory requirements applicable in connection also would be required to monitor on a 90 procedures should be designed such with market access. These regular basis whether its controls and commenters requested that the procedures are effective in preventing 88 Commission clarify that the proposed The broker-dealer providing market access may the entry of erroneous orders, and also wish to supplement the overall credit limit it rule would not impose new regulatory places on the activity of its broker-dealer customers obligations on broker-dealers that with assurances from those broker-dealer customers 89 In this regard, the Commission notes that some provide access to trading on an that they have implemented controls reasonably markets provide price collars for market orders to designed to assure that trading by their individual help ensure that executions are reasonably related customers remains within appropriate pre-set credit to the quoted price. See e.g. NYSE Arca Rule 7.31(a) 90 ConvergEx Letter at 6; SIFMA Letter at 6; ITG thresholds. and Nasdaq Rule 4751. Letter at 4.

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exchange or ATS.91 The Commission reasonably designed to prevent the entry has the information immediately notes that, as stated in the Proposing of orders for securities that the broker- available to effectively control both its Release, it intends these controls and dealer, customer, or other person, as financial and regulatory risks. This procedures to encompass existing applicable, is restricted from trading. provision does not require, however, regulatory requirements applicable to Regulatory requirements that must be that post-trade surveillances for broker-dealers in connection with satisfied on a pre-trade basis are those manipulation, fraud, and other matters market access, and does not intend to requirements that can effectively be occur immediately. These surveillances substantively expand upon them.92 The complied with only before an order is should occur in a timely fashion as Commission also notes that the defined entered on an exchange or ATS. Those warranted by the facts and term ‘‘regulatory requirements’’ is where pre-trade compliance is required circumstances. limited to those ‘‘that are applicable in on an order-by-order basis include the A few commenters were concerned connection with market access.’’ marking and locate requirements of with the confidentiality of trading Accordingly, the regulatory risk Regulation SHO, the conditions that information received by a broker-dealer management controls and supervisory must be satisfied under Regulation NMS as a result of the Rule’s requirements.98 procedures required under Rule 15c3– before an order can be marked an The Commission notes that the Rule 5(c)(2) must address those regulatory ‘‘intermarket sweep order,’’ various requires only that appropriate requirements that flow from a broker- exchange rules applicable to particular surveillance personnel of the broker- dealer having or providing access to order types, and compliance with dealer providing market access receive trading securities on an exchange or trading halts. Some commenters also the immediate post-trade execution ATS.93 noted that certain regulatory obligations reports. In this regard, the Commission In addition, commenters requested are complied with on a post-trade basis, expects that broker-dealers will that the Commission specify which such as surveillance for fraud and establish appropriate safeguards to regulatory requirements must be manipulation.95 Whether compliance is assure that customer trading satisfied on a pre-trade basis.94 Certain pre-trade or post-trade, however, information is kept confidential and provisions of Proposed Rule 15c3– Proposed Rule 15c3–5(c)(2) would not available only to appropriate personnel 5(c)(2) require the broker-dealer to impose new substantive regulatory for regulatory compliance purposes. The ‘‘prevent the entry of orders’’ under requirements on the broker-dealer, but Commission notes that Section 15(f) of certain circumstances, which would rather establish a clear requirement that the Exchange Act requires broker- necessarily require the broker-dealer to the broker-dealer have appropriate dealers registered with the Commission implement its controls on a pre-trade mechanisms in place that are reasonably to establish, maintain, and enforce basis. Specifically, Proposed Rule 15c3– designed to effectively comply with its written policies and procedures 5(c)(2)(i) requires the broker-dealer’s existing regulatory obligations in an reasonably designed, taking into controls be reasonably designed to automated high-speed trading consideration the nature of such broker- prevent the entry of orders unless there environment. dealer’s business, to prevent the misuse has been compliance with all regulatory In addition, several commenters asked in violation of the Exchange Act, or the requirements that must be satisfied on a the Commission to clarify that Rule rules or regulations thereunder, of pre-order entry basis. In addition, 15c3–5 does not require broker-dealers material, nonpublic information by the Proposed Rule 15c3–5(c)(2)(ii) would to substantially change their existing broker-dealer or any person associated require the broker-dealer’s controls to be monitoring or surveillance practices in with it.99 A broker-dealer that does not order to comply with the Rule.96 While maintain appropriate confidentiality of 91 ConvergEx Letter at 6 (stating that the the Commission is not in a position to customer order and trading information Commission should ‘‘make clear that any controls be reasonably designed to ensure that the Market provide broad assurances in this regard, could potentially be at risk of violating Access Broker complies with its regulatory it believes that in many cases the Rule the federal securities laws and obligations and not that such controls are required should reinforce existing regulatory risk regulations, including Section 15(f) of to make the Market Access Broker assume management controls already the Exchange Act.100 responsibility for preventing violative activity by a The Commission is adopting Rule Sponsored Broker.’’); SIFMA Letter at 6 (stating that implemented by broker-dealers. Broker- the Commission should clarify ‘‘that broker-dealers dealers providing market access should 15c3–5(c)(2) as proposed. As stated in providing market access would not be liable for review their regulatory risk management the Proposing Release, the Commission regulatory requirements that are only tangentially controls in light of the Rule, and make intends these controls and procedures to related to accessing the market, such as margin encompass existing regulatory requirements, or violative behavior that depends on adjustments, as appropriate. the intent of the sponsored customer.’’). In this regard, some commenters requirements applicable to broker- 92 The specific content of the ‘‘regulatory requested that the Commission clarify requirements’’ will, of course, adjust over time as how the proposed rule’s requirement to 98 MFA Letter at 2–3; BIDS Letter at 3–4; STANY laws, rules and regulations are modified. assure that appropriate surveillance Letter at 7; letter to Elizabeth M. Murphy, Secretary, 93 Regulatory requirements not connected with a personnel receive immediate post-trade Commission, from Ari Burstein, Senior Counsel, broker-dealer’s having or providing access to Investment Company Institute, March 29, 2010 (‘‘ICI trading securities on an exchange or ATS, as a execution reports that result from Letter’’) at 2–3. result of being a member or subscriber thereof, are market access would affect a broker- 99 15 U.S.C. 78o(f). not included within the scope of the Rule. Although dealer’s surveillance procedures.97 The 100 Id. See, e.g., Securities Exchange Act Release a broad range of regulatory requirements may, to Commission notes that the requirement No. 59555, Admin. Proceeding No. 3–13407 (March varying degrees, be connected to market access, the 11, 2009) (finding that Merrill Lynch, Pierce, Commission would not expect broker-dealers, in in Rule 15c3–5 that the broker-dealer Fenner & Smith Incorporated (‘‘Merrill Lynch’’) response to the Rule, to formally reassess their providing market access receive violated Section 15(f) of the Exchange Act by failing compliance procedures with respect to rules such immediate post-trade execution reports to maintain and enforce written policies and as those relating to trading in the over-the-counter is designed to assure the broker-dealer procedures reasonably designed, taking into market (other than on an ATS) or those relating to consideration the nature of its business, to prevent the delivery of customer account statements. The misuse, in violation of the federal securities laws, Commission emphasizes that, as indicated above, 95 ConvergEx Letter at 6; SIFMA Letter 6; ITG of material, nonpublic information by Merrill Lynch the Rule is intended neither to expand nor diminish Letter at 4. or any person associated with it, which allowed the underlying substantive regulatory requirements 96 Goldman Letter at 6; Deutsche Bank Letter at certain day traders to trade ahead of customer otherwise applicable to broker-dealers. 4; SIFMA Letter at 7. orders to the detriment of Merrill Lynch’s 94 ITG Letter at 4; SIFMA Letter 6. 97 Deutsche Bank Letter at 4. institutional customer).

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dealers in connection with market designed to prevent the broker-dealer or surveillance personnel receive access, and not to substantively expand customer or other person from entering immediate post-trade execution reports upon them.101 As with the financial risk orders for securities it is restricted from that result from market access. Among management controls and supervisory trading. For example, if the broker- other things, the Commission expects procedures, this provision will allow dealer is restricted from trading options that broker-dealers will be able to flexibility for the details of the because it is not qualified to trade identify the applicable customer regulatory risk management controls options, its regulatory risk management associated with each such execution and procedures to vary from broker- controls must be reasonably designed to report. The Commission believes that dealer to broker-dealer, depending on automatically prevent it from entering immediate reports of executions will the nature of the business and customer orders in options, either for its own provide surveillance personnel with base, so long as they are reasonably account or as agent for a customer. In important information about potential designed to achieve the goals articulated addition, if a broker-dealer is obligated regulatory violations, and better enable in the Rule. In many cases, particularly to restrict a customer from trading in a them to investigate, report, or halt with respect to proprietary trading and particular security, then the broker- suspicious or manipulative trading more traditional agency brokerage dealer’s controls and procedures must activity. In addition, these immediate activities, the Rule should reinforce be reasonably designed to prevent execution reports should provide the existing regulatory risk management orders in such security from being broker-dealer with more definitive data controls already implemented by submitted to an exchange or ATS for the regarding the financial exposure faced broker-dealers. However, the account of that customer. by it at a given point in time. This Commission believes that the Rule will Under Rule 15c3–5(c)(2)(iii), the should provide a valuable supplement assure a consistent standard applies to broker-dealer’s controls and procedures to the systematic pre-trade risk controls all broker-dealers providing any type of also must be reasonably designed to and other supervisory procedures market access and, importantly, will restrict access to trading systems and required by the Rule. As noted above, address the serious gap that exists with technology that provide market access this provision does not require that those broker-dealers that today offer to persons and accounts pre-approved post-trade surveillances for ‘‘unfiltered’’ sponsored access. and authorized by the broker-dealer. manipulation, fraud, and other matters Under Rule 15c3–5(c)(2)(i), the The Commission believes that occur immediately. These surveillances broker-dealer’s controls and procedures reasonably designed, effective security should occur in a timely fashion as must be reasonably designed to prevent procedures such as these are necessary warranted by the facts and the entry of orders unless there has been for controlling the risks associated with circumstances. compliance with all regulatory market access. The Commission expects requirements that must be satisfied on a that elements of these controls and F. Direct and Exclusive Broker-Dealer pre-order entry basis. Rule 15c3– procedures would include: (1) An Control Over Financial and Regulatory 5(c)(2)(ii) also will require the broker- effective process for vetting and Risk Management Controls and dealer’s controls and procedures to approving persons at the broker-dealer Supervisory Procedures prevent the entry of orders for securities or customer, as applicable, who will be Proposed Rule 15c3–5(d) would that the broker-dealer, customer, or permitted to use the trading systems or require the financial and regulatory risk other person, as applicable, is restricted other technology; (2) maintaining such management controls and supervisory from trading. trading systems or technology in a procedures described above to be under The Commission notes that, by physically secure manner; and (3) the direct and exclusive control of the requiring the regulatory risk restricting access to such trading broker-dealer that is subject to management controls and procedures to systems or technology through effective paragraph (b) of the proposed rule. be reasonably designed to prevent the mechanisms that validate identity. Several commenters requested that the entry of orders that fail to comply with Among other things, effective security Commission clarify what constitutes regulatory requirements that apply on a procedures help assure that only ‘‘direct and exclusive’’ control under pre-order entry basis, the Rule would authorized, appropriately-trained Rule 15c3–5(d). This provision is have the effect of requiring the broker- personnel have access to a broker- designed to eliminate the practice, dealer’s controls be applied on an dealer’s trading systems, thereby which the Commission understands automated, pre-trade basis, before orders minimizing the risk that order entry exists today under current SRO rules, route to the exchange or ATS. These errors or other inappropriate or whereby the broker-dealer providing pre-trade, system-driven controls would malicious trading activity might occur. market access relies on its customer, a therefore be reasonably designed to Finally, Rule 15c3–5(c)(2)(iv) will third party service provider, or others, prevent orders from being sent to the require the broker-dealer’s controls and to establish and maintain the applicable securities markets, if such orders fail to procedures to assure that appropriate risk controls. Under the proposal, meet certain conditions. The pre-trade appropriate broker-dealer personnel controls must, for example, be sale order from another registered broker or dealer should be able to directly monitor the reasonably designed to assure that is required to comply with Exchange Act Rule operation of the financial and regulatory 203(b)(1). For example, where an introducing risk management controls in real-time. compliance with exchange trading rules broker-dealer submits a short sale order for relating to special order types, trading execution, either on a principal or agency basis, to Broker-dealers would have the halts, odd-lot orders, SEC rules under another broker-dealer, the introducing broker-dealer flexibility to seek out risk management Regulation SHO and Regulation has the responsibility of complying with the locate technology and software developed by 102 requirement. The broker-dealer that received the third parties, but such technology and NMS. They also must be reasonably order from the introducing broker-dealer would not be required to perform the locate requirement. software would have to be independent 101 The specific content of the ‘‘regulatory However, a broker or dealer would be required to of the market access customer or its requirements’’ will, of course, adjust over time as perform a locate where it contractually undertook affiliates. The broker-dealer would have laws, rules and regulations are modified. to do so or the short sale order came from a person to perform appropriate due diligence to 102 The Commission notes that Exchange Act Rule that is not a registered broker-dealer. See Securities 203(b)(2)(i) provides an exception from the uniform Exchange Act Release No. 50103 (July 28, 2004), 69 assure that the reasonably designed locate requirement of Exchange Act Rule 203(b)(1) FR 48008, 48015 (August 6, 2004) (File No. S7–23– controls and procedures are effective for a registered broker or dealer that receives a short 03). and otherwise consistent with the

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provisions of the Rule. The broker- control of the risk management controls arrangements to consist of multiple dealer also could allow a third-party and supervisory procedures. broker-dealers.107 For instance, one that is independent of its market access commenter noted that today multiple 1. Allocation of Certain Regulatory customers to supplement its own broker-dealers can be involved in Compliance Obligations to Broker- monitoring of the operation of its Dealer Customers market access arrangements, such as controls. In addition, the broker-dealer where: could permit third parties independent Proposed Rule 15c3–5(d) would ■ An introducing broker-dealer of its market access customers to require broker-dealers with or providing routes customer orders to an exchange perform routine maintenance or market access to have direct and through the market access broker-dealer implement technology upgrades on its exclusive control of the specified risk and clears through a separate clearing risk management controls, if the broker- management controls and supervisory broker; dealer conducts appropriate due procedures. In the Proposing Release, ■ A clearing broker provides order diligence regarding any changes to such the Commission stated that ‘‘by entry systems to introducing firms for controls and their implementation. In requiring the financial and regulatory use by the introducing firm’s customers; all circumstances, the broker-dealer risk management controls and ■ An executing broker uses a market with market access would remain fully supervisory procedures be under the access broker-dealer to access an ATS responsible for the effectiveness of the direct and exclusive control of the and clears the trade through a separate risk management controls. broker or dealer, any changes would be prime broker; and The Commission believes that, subject made only by appropriate broker-dealer ■ A broker-dealer uses another to the limited exception described personnel * * *. Accordingly, the broker-dealer for access to exchanges of broker-dealer could not delegate the below, appropriate broker-dealer which it is not a member.108 oversight of its controls to a third party, personnel must have the direct and These commenters urged the exclusive obligation to assure the or allow any third party to adjust them.’’ 104 The Commission specifically Commission to permit the broker-dealer effectiveness of, and the direct and with market access to allocate some or exclusive ability to make appropriate requested comment on whether a market access arrangement where a all of the required risk management adjustments to, the reasonably designed controls and supervisory procedures to financial and regulatory risk broker-dealer provided another broker- dealer with market access should be other broker-dealers that are part of the management controls. This would allow 109 treated differently under the rule and market access arrangement. only the broker-dealer providing market In addition, several commenters noted access to make, for example, intra-day whether an allocation of responsibilities for implementing the risk management that the concept of broker-dealer adjustments to risk management allocation of regulatory functions is controls to appropriately manage a controls and supervisory procedures between such broker-dealers should be embedded within the current regulatory customer’s credit limit. The framework.110 The examples most often Commission expects that, by requiring permitted. Several commenters responded to the cited by the commenters were NYSE the financial and regulatory risk 111 Commission’s request for comments on Rule 382 and NASD Rule 3230, and management controls and supervisory 112 this particular matter, and most Regulation SHO. Some commenters procedures to be under the direct and supported some form of allocation of the believed that NYSE Rule 382 and NASD exclusive control of the broker or dealer, required risk management controls and Rule 3230 currently provide an efficient any changes would be made only by supervisory procedures among broker- mechanism for the allocation of appropriate broker-dealer personnel. dealers where multiple broker-dealers functions to the party best situated to Accordingly, the broker-dealer with are involved in a market access ensure compliance with a particular market access could not delegate the 113 arrangement.105 Other commenters did regulatory requirement. In light of oversight of, or power to adjust, its not address the issue of allocation controls to a third party. specifically, but emphasized that the 107 See e.g., SIFMA Letter at 3; ConvergEx Letter The broker-dealer with market access, broker-dealer with market access should at 3; CBOE Letter at 2; EWT Letter at 3; Marchant Letter at 1. as the member of the exchange or be ultimately and fully responsible for subscriber of the ATS, is responsible for 108 See SIFMA Letter at 3. activity that results from the use of its 109 all trading that occurs under its MPID or See e.g., FINRA Letter at 4; ConvergEx Letter MPID, even if its market access at 4–8; CBOE Letter at 3; EWT Letter at 3–4. other market identifier.103 If the broker- customer is another broker-dealer.106 110 Pershing Letter at 2–3; Penson Letter at 2; dealer does not effectively control the A few commenters specifically noted STANY Letter at 3; Wedbush Letter at 2; Deutsche risks associated with that activity, it that it is commonplace in today’s Bank Letter at 2–3; EWT Letter at 3; SIFMA Letter at 4. jeopardizes not only its own financial marketplace for market access viability, but also the stability of the 111 NYSE Rule 382 and NASD Rule 3230, relating to Carrying Agreements, permit the introducing markets and, potentially, the financial 104 Proposing Release, 75 FR at 4015. broker or dealer and the clearing broker or dealer, system. The Commission believes this 105 See Fortis Letter at 5; EWT Letter at 1; pursuant to a written agreement, to specifically responsibility is too great to allow the Deutsche Bank Letter at 2; Wedbush Letter at 2; allocate functions and responsibilities between the requisite risk management controls to be GETCO Letter at 4–5; STANY Letter at 3; ABA parties. These rules require that such agreements Letter at 3–4; ConvergEx Letter at 4–8; SIFMA specifically account for the following functions: (1) controlled by a third party, and in Letter; JP Morgan Letter at 4; Pershing Letter at 1– Opening, approving and monitoring of accounts, (2) particular a market access customer 3; Penson Letter at 1–2; Lime Letter at 3–4; letters extension of credit, (3) maintenance of books and which, in effect, would be policing to Elizabeth M. Murphy, Secretary, Commission, records, (4) receipt and delivery of funds and itself. Because the broker-dealer from Sandor G. Lehoczky, Managing Director, Jane securities, (5) safeguarding of funds and securities, Street Holding, LLC, March 29, 2010 (‘‘Jane Street (6) confirmations and statements and (7) acceptance providing market access assumes the Letter’’) at 1; David A. Marshall, Senior Vice of orders and execution of transactions. immediate financial risks of all orders, President, Financial Markets Group, Federal 112 The Commission notes that Regulation SHO as well as regulatory compliance Reserve Bank of Chicago, March 25, 2010 (‘‘FRB provides an exception from the uniform locate obligations, the Commission believes Chicago Letter’’) at 4; letter to Mary L. Schapiro, requirement for a registered broker or dealer that Chairman, Commission, from Kenny Marchant, receives a short sale order from another registered that it should have direct and exclusive Randy Neugebauer, and Pete Sessions, Members of broker or dealer that is required to comply with Congress, August 11, 2010 at 1 (‘‘Marchant Letter’’). Exchange Act Rule 203(b)(1). See supra note 102. 103 See supra note 8. 106 FINRA Letter at 2; NYSE Letter at 2. 113 Pershing Letter at 3; Lime Letter at 4.

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these rules, some commenters suggested dealers. One commenter suggested that broker-dealer with market access should that the proposed Rule’s requirement the allocation of risk management have procedures to ensure compliance that the broker-dealer with market controls and supervisory procedures with the Rule.125 Another commenter access have direct and exclusive control would be appropriate because a broker- suggested the introducing broker take of the risk management controls and dealer using the MPID of another responsibility for monitoring and supervisory procedures, without broker-dealer with market access would managing the credit and capital providing for the reasonable allocation be a regulated entity whose trading thresholds of its customer.126 of the same, would be inconsistent or in activity would be identifiable and Three commenters, all SROs, tension with currently accepted broker- referable to the applicable SRO.119 indicated that broker-dealers with dealer practices and current SRO and Other commenters believed that, while market access are already required to SEC rules.114 the allocation of risk management have supervisory policies related to Several commenters emphasized that controls and supervisory procedures orders generated as a result of market the relative positions of the broker- between broker-dealers should be access.127 FINRA asserted that it had dealers in a market access arrangement permitted, the ultimate responsibility ‘‘consistently taken the view that, under would impact the efficacy of the risk for compliance with the market access FINRA rules, a firm providing market management control or supervisory rule and any applicable regulatory access to a third party, including procedure used to reasonably ensure a requirements should remain with the another broker-dealer, or otherwise particular regulatory requirement. For broker-dealer with market access.120 allowing a third party to use the firm’s instance, some commenters stressed that Some commenters opined that where [MPID] is responsible for the trading an introducing broker would be best a broker-dealer provides access to conducted pursuant to that relationship. situated to implement the pre-trade another broker-dealer, the broker-dealer Thus, for example, under NASD Rules controls required by the Rule because with market access should be able to 3010 and 3012, as well as Incorporated the introducing broker, by virtue of its reasonably rely upon the NYSE Rule 342, a member must control, direct relationship with the ultimate representations of the introducing monitor and supervise all orders for customer, would have the critical broker that appropriate risk which it is the broker of record, customer information necessary for management controls and supervisory including orders entered by customers compliance.115 Based on a similar procedures are in place.121 One through market access arrangements rationale, some commenters stated that commenter specifically noted that a with the member. Members providing the introducing broker would be better broker-dealer with access should not be market access to customers must also situated to identify scienter-based able to ignore ‘‘obvious red flags,’’ but have controls and supervisory violations such as marking-the-close, should be able to otherwise reasonably procedures in place that are reasonably wash sales, or other forms of rely on an introducing broker to comply designed to ensure compliance with 128 manipulation.116 with its obligations to ‘‘supervise its applicable regulatory requirements.’’ These commenters generally endorsed business and conduct of its FINRA also stated its belief that both an allocation model similar to NYSE customers.’’ 122 the broker-dealer with market access Rule 382 and NASD Rule 3230 that Some commenters suggested that the and the broker-dealer being provided would permit the broker-dealers reasonable reliance of the broker-dealer market access should retain the engaging in the market access with market access should be based in respective, independent obligations that part on its own policies and procedures would exist if they accessed the market arrangement to contractually allocate 129 specific risk management controls and that would ascertain the effectiveness of directly. FINRA explained that the supervisory procedures based on which the risk management controls and independent regulatory obligations of a firm was better situated to perform the supervisory procedures.123 For instance, broker-dealer that is provided market access should not alter the fact that the particular control or procedure.117 one commenter stated the broker-dealer broker-dealer with market access is However, other commenters suggested with market access should have responsible for trading conducted using that the Commission take a more procedures to support its reasonable its MPID.130 prescriptive approach and specify the reliance, including representations and NYSE expressed a view similar to particular functions that potentially warranties from the broker-dealer that FINRA that a broker-dealer with market could be allocated between broker- has been allocated the risk management access should be subject to the Rule dealers in a market access controls and supervisory procedures.124 with respect to all of its market access arrangement.118 Another commenter agreed that the customers, including other broker- Some commenters offered additional dealers.131 NYSE also noted that the arguments in support of the allocation 119 See Penson Letter at 2. 120 concerns identified by the Commission of risk management controls and SIFMA Letter at 4; Fortis Letter at 5. Fortis believed that ‘‘it is a broadly accepted principle of in connection with market access supervisory procedures among broker- regulation that whilst performance of an obligation arrangements are just as relevant for may be delegated, responsibility for that obligation broker-dealer customers as for other 114 See, e.g., Pershing Letter at 2–3; Wedbush cannot. Therefore it should be possible to delegate 132 Letter at 2; ConvergEx Letter at 10–11. to a third party, including a client broker/dealer, all types of market participants. In 115 BATS Letter at 3; ConvergEx Letter at 5; EWT operational aspects of compliance with the addition, NYSE explained that because Letter at 3; CBOE Letter at 3. proposed rules but not the ultimate responsibility each exchange is responsible for 116 See e.g., ConvergEx at 7. for compliance with the proposed rules. In practice this should mean that the party to whom the rules 117 SIFMA Letter at 4; EWT Letter at 3; Pershing 125 See Fortis Letter at 5. See also Lime Letter at Letter at 1–3; Lime Letter at 4; Fortis Letter at 5; apply directly must have procedures and monitoring in place on an ongoing basis to ensure 4. Wedbush Letter at 2, Deutsche Bank Letter at 2; 126 GETCO Letter 4–5. GETCO Letter 4–5; STANY Letter at 3. See also ITG that the proposed rules are followed.’’ See also Lime 127 FINRA Letter at 2; BATS Letter at 2–3; Nasdaq Letter at 6. Letter at 2–3; FINRA Letter at 2. 121 Letter at 2. 118 JP Morgan Letter at 2–4; FRB Chicago Letter See SIFMA Letter at 4; Pershing Letter at 2; 128 FINRA Letter at 2. at 4; letter to Elizabeth M. Murphy, Secretary, Penson Letter at 2. 129 Commission, from Douglas J. Engmann, President, 122 Pershing Letter at 3. FINRA Letter at 2. and C. Mark Bold, Senior Advisor, Engmann 123 See Lime Letter at 3; Fortis Letter at 5; SIFMA 130 FINRA Letter at 2. Options, Inc., March 16, 2010 (‘‘Engmann Letter’’) at Letter at 4. 131 NYSE Letter at 2. 2. 124 See SIFMA Letter at 4. 132 NYSE Letter at 2.

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monitoring orders submitted by its and clearing of a trade would be 15c3–5—for preventing the ultimate member firms, and exchanges must be unnecessary and duplicative.140 customer from trading securities such able to hold a specific party responsible After careful consideration of the customer is restricted from trading. for compliance with applicable comments submitted with respect to the Control also could be allocated with exchange rules on each order, it would possible allocation of certain respect to surveillance for manipulation be impractical for the exchange to have compliance responsibilities to broker- or fraud in the ultimate customer’s to determine the regulatory status of the dealer customers, the Commission has account—such as wash sales, marking underlying market participant to discern determined to permit, subject to certain the close, and insider trading—since the whether the exchange is required to conditions, broker-dealers providing broker-dealer providing market access follow up with the broker-dealer with market access to reasonably allocate may only see aggregate trading by the market access or the underlying broker- control over certain regulatory risk broker-dealer customer in an omnibus dealer customer.133 NYSE stated that management controls and supervisory or other account, and not trading at the this inefficiency would be amplified if procedures to customers that are individual customer account level. If a an exchange had to determine whether registered broker-dealers who, based on broker-dealer providing market access or not the broker-dealer customer was their position and relationship with an were to reasonably allocate control over itself a member of the exchange.134 ultimate customer, can more effectively these functions to a customer that is a One commenter, however, took the implement them. registered broker-dealer, however, the Specifically, the Commission is position that a broker-dealer with Commission expects the broker-dealer modifying Proposed Rule 15c3–5(d) to market access should have no providing market access to immediately permit a broker-dealer providing market obligations to supervise another broker- provide its customer that is a registered access to reasonably allocate, by written dealer with which it has a contractual broker-dealer with the post-trade contract, control over specific regulatory relationship under NYSE 342(a) and executions reports it receives from risk management controls and NASD 3010(b).135 This is because the exchanges and ATSs pursuant to supervisory procedures to a customer broker-dealer with market access would paragraph (c)(2)(iv) of Rule 15c3–5, so that is a registered broker-dealer, so long not know the customers of the that the broker-dealer customer can as the broker-dealer providing market introducing broker, and therefore would effectively surveil for fraud and access has a reasonable basis for not be able to devise supervisory manipulation in the accounts of the determining that such customer, based ultimate customers. Finally, in systems reasonably designed to ensure on its position in the transaction and compliance with the applicable accordance with the requirements of 136 relationship with an ultimate customer, Regulation SHO, the broker-dealer regulatory requirements. The has better access to that ultimate commenter did, however, believe that providing market access may rely on a customer and its trading information registered broker-dealer customer’s the broker-dealer with market access such that it can more effectively compliance with the locate requirement should conduct reviews that are implement the specified controls and of Rule 203(b)(1) of Regulation SHO, reasonably designed to ensure procedures.141 The Commission unless the broker-dealer providing compliance with the SRO marketplace believes a broker-dealer providing market access contractually undertook rules.137 market access could allocate to a responsibility for compliance with the Finally, several commenters customer that is a registered broker- locate requirement.143 expressed concern that the Rule would dealer, consistent with this standard, The foregoing is not an exhaustive list require every broker-dealer in the chain control over those regulatory risk of the regulatory risk management of a market access arrangement to management controls and supervisory controls and supervisory procedures for implement pre-trade controls and procedures encompassed by paragraph which control may be reasonably thereby introduce redundancies and (c)(2) of Rule 15c3–5 that require allocated to a customer that is a inefficiencies into the order routing specific knowledge of the ultimate registered broker-dealer, but in all cases process.138 Some of these commenters customer and its trading activity that the the broker-dealer providing market were also concerned that if the Rule broker-dealer providing market access access must be prepared to demonstrate required multiple broker-dealers to would not have. These could include a reasonable basis for determining that implement pre-trade checks it could obligations under suitability and other the broker-dealer customer, based on its make these arrangements impractical ‘‘know your customer’’ rules,142 since position in the transaction and and the benefits of volume aggregation the broker-dealer with the direct relationship with an ultimate customer, to achieve tiered pricing, cooperative customer relationship may have better has better access than the broker-dealer leveraging of broker-dealer technology, access than the broker-dealer with with market access to that ultimate and non-member access to markets market access to that ultimate customer and its trading information could be reduced or eliminated.139 On customer’s information to more such that it can more effectively the other hand, some commenters effectively assess the ultimate implement the specific function over argued the rule properly should only be customer’s financial resources and which control is allocated.144 This is applicable to the broker-dealer with investment objectives. For similar consistent with one of fundamental market access, because application to all reasons, the broker-dealer providing principles underlying Rule 15c3–5, that broker-dealers involved in the execution market access could allocate to its the controls over the financial and customer that is a registered broker- regulatory risks associated with market 133 NYSE Letter at 2. dealer control over the mechanisms— access should be overseen directly by 134 NYSE Letter at 2. required by paragraph (c)(2)(ii) of Rule the broker-dealers providing that access, 135 ConvergEx Letter at 7. given their responsibility for trading 136 ConvergEx Letter at 7. 140 See FINRA Letter at 2. 137 ConvergEx Letter at 5. 141 The Commission notes that such broker-dealer 143 See 17 CFR 242.203(b)(1). 138 See BATS Letter at 3–4; EWT Letter at 4; that can more effectively implement the specified 144 The Commission notes that, generally, a Deutsche Bank Letter at 2; ABA Letter at 3–4; controls or procedures likely would also be able to member of an SRO would be able to more Marchant Letter at 1. more efficiently do so. effectively implement a regulatory obligation to 139 See e.g., Wedbush Letter at 2–3; Penson Letter 142 See, e.g., FINRA Rule 2010; NASD Rules 2310 comply with rules specific to a particular SRO than at 3; Lime Letter at 4–5. and IM–2310–3; and NYSE Rule 405. a broker-dealer that is not a member of such SRO.

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that occurs under their MPIDs and the (3) In accordance with Rule 15c3–5(e), not have a responsibility to supervise fact that in general they are better establish, document, and maintain a the activity of customers of an positioned to more effectively system to regularly review the introducing broker, in part, because it implement those controls. To maximize performance of the registered broker- would not have a direct relationship the effectiveness of the reasonably dealer customer under such contract, with the ultimate customer and would designed risk management controls in and the effectiveness of the allocated be unable to discern salient facts such connection with market access, controls and procedures, and promptly as the customer’s financial condition, however, paragraph (d)(1) of Rule 15c3– address any performance weaknesses, risk tolerance, trading strategies, 5 accommodates allocation of control including termination of the allocation objectives or account holdings.146 While over a regulatory risk management arrangement if warranted. the Commission agrees, as discussed control or supervisory procedure in In the Proposing Release, the above, that a customer that is a those circumstances where—and only Commission expressed concern that the registered broker-dealer may reasonably where—another registered broker-dealer broker-dealer providing sponsored be allocated control of certain regulatory is better positioned to implement it than access may not utilize any pre-trade risk risk management controls and the broker-dealer providing market management controls (i.e., ‘‘unfiltered’’ supervisory procedures that, based on access. or ‘‘naked’’ access), and thus could be its position in the transaction and Paragraph (d)(1) of Rule 15c3–5 also unaware of the trading activity relationship with the ultimate customer, requires that any reasonable allocation occurring under its market identifier it can more effectively implement, the of control contemplated thereby be in a and have no mechanism to control it.145 Commission believes the broker-dealer written contract and specify the In addition, the Commission noted that providing market access should retain regulatory risk management controls some broker-dealers providing ultimate responsibility for trading and supervisory procedures over which sponsored access may simply rely on activity that occurs by virtue of its control is being allocated. Paragraph assurances from their customers that MPID. 147 (d)(2) of Rule 15c3–5 makes clear that appropriate risk controls are in place Finally, the Commission notes that any such allocation of control does not and the Commission concluded that risk various commenters expressed concern relieve the broker-dealer providing management controls and supervisory that the Rule would require every market access from any obligation under procedures that are not applied on a broker-dealer in the chain of a market the Rule, including the overall pre-trade basis or that are not under the access arrangement to implement pre- responsibility to establish, document exclusive control of the broker-dealer trade controls which would introduce and maintain a system of risk are inadequate to effectively address the redundancies and inefficiencies into the management controls and supervisory risks of market access arrangements, and order routing process.148 The procedures reasonably designed to pose a particularly significant Commission emphasizes that the Rule is manage the financial, regulatory, and vulnerability in the U.S. national market applicable to the broker-dealer with other risks of market access. Thus, the system. market access, not every broker-dealer While the Commission believes it is broker-dealer providing market access in a market access arrangement. Under appropriate to permit the reasonable remains ultimately responsible for the the Rule, the broker-dealer with market allocation of certain regulatory risk performance of any regulatory risk access is required to reasonably ensure management controls and supervisory management control or supervisory that appropriate risk management procedures, as described above, to a procedure for which control is allocated controls and supervisory procedures are to a customer that is a registered broker- customer that is a registered broker- utilized in relation to its market access, dealer under Rule 15c3–5(d). dealer, the Commission continues to be including appropriate pre-trade Consistent with this approach, the concerned about circumstances where Commission expects a broker-dealer that broker-dealers providing market access controls. However, the Rule does not provides market access and desires to simply rely on assurances from their require multiple layers of pre-trade reasonably allocate control over customers that appropriate risk controls controls for any order and is not specified functions to a customer that is are in place. In the Commission’s view intended or designed to introduce any a registered broker-dealer as described these concerns are present even if the unnecessary or unwarranted above, to: customer of the broker-dealer with redundancies and inefficiencies into the (1) Conduct a thorough due diligence market access is a broker-dealer. order routing process for market access review to establish a reasonable basis for Accordingly, the Commission arrangements. determining that the registered broker- emphasizes that in any permitted 2. Risk Management Systems Developed dealer customer to which control has allocation arrangement, the broker- by Others been allocated has the capability and, dealer providing market access may not based on its position in the transaction merely rely on another broker-dealer’s In the Proposing Release, the and relationship with an ultimate attestation that it has implemented Commission specifically addressed the ‘‘ customer, has better access than the appropriate controls or procedures, or application of the Rule’s direct and ’’ broker-dealer with market access to that has agreed to be responsible for the exclusive control provisions to the use ultimate customer and its trading same. Instead, as noted above, the of risk management technology information such that it can more broker-dealer providing market access developed by third parties. In relevant effectively implement the reasonably should independently review, on an part, the Commission stated that: designed risk management controls and ongoing basis, the effectiveness of the Under the proposal, appropriate broker- supervisory procedures that are reasonably designed controls or dealer personnel should be able to directly specifically allocated to it; procedures allocated to a customer that monitor the operation of the financial and (2) Enter into a written contract with is a registered broker-dealer and regulatory risk management controls in real- such registered broker-dealer customer promptly address any weaknesses. 146 that clearly articulates the scope of the One commenter took the position that See ConvergEx Letter at 7. 147 See FINRA Letter at 2; BATS Letter at 2–3; arrangement and the specific a broker-dealer with market access does Nasdaq Letter at 2. See also, FINRA Rule 3310. responsibilities of each party, consistent 148 See BATS Letter at 3–4; EWT Letter at 4; with the foregoing discussion; and 145 See Proposing Release, 75 FR at 4008. Deutsche Bank Letter at 2; ABA Letter at 3–4.

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time. Broker-dealers would have the that would be acceptable and stated in the proposing Release, or flexibility to seek out risk management unacceptable under the Rule.154 required.163 technology developed by third parties, but Two commenters believed that a the Commission expects that the third parties Two commenters agreed with the premise that a broker-dealer providing broker-dealer providing market access would be independent of customers provided should be able to utilize risk with market access. The broker-dealer would market access should be permitted to management systems provided by also be expected to perform appropriate due use third party risk management customers or entities affiliated with diligence to help assure controls are effective systems, provided that that broker- customers.164 One commenter opined and otherwise consistent with the provisions dealer is able to monitor trading activity that technology developed by customers of the proposed rule. The Commission in real-time and maintain control of the understands that such technology allows the or entities affiliated with customers can system.155 One of these commenters broker or dealer to exclusively manage such be just as effective as technology controls. The broker-dealer also could allow asserted that this should include third developed by independent third parties a third party that is independent of party risk management systems or broker-dealers.165 The commenter 156 customers to supplement its own monitoring provided by exchanges. Another also thought the Rule should allow the of the operation of its controls. In addition, commenter noted that risk management flexibility to use customer technology to the broker-dealer could permit third parties software and controls provided by a to perform routine maintenance or help to mitigate the potential that a market center are common and provide broker-dealer’s proprietary trading desk implement technology upgrades on its risk an efficient and effective means for management controls, so long as the broker- could gain a competitive advantage over dealer conducts appropriate due diligence broker-dealers to monitor and control its customer trading desk as a result of 157 regarding any changes to such controls and their risk exposure. Another a negative impact on execution speed their implementation. Of course, in all commenter stated that to the extent that and latencies.166 circumstances, the broker-dealer would the Rule permits the use of exchange- Another commenter stated that the remain fully responsible for the effectiveness provided risk management tools, the broker-dealer providing market access of the risk management controls.149 Commission should indicate whether a should be responsible for determining Several commenters addressed the broker-dealer providing market access baseline limits for its customer but Commission’s position with respect to could rely on exchange representations opined that ‘‘there are other entirely risk management systems developed by regarding the efficacy of such tools appropriate adjustments that occur (and third parties, as articulated in the without requiring further investigation should continue to occur) outside of the Proposing Release. One commenter, for or monitoring of those systems by the broker-dealer’s exclusive control.’’ 167 example, was unclear as to whether a broker-dealer.158 That commenter The commenter noted that it is not broker-dealer providing market access believed independent verification unusual for sophisticated customers to could outsource the development of a should not be necessary unless the have front-end systems that permit such risk management system to a third party broker-dealer becomes aware of customers to independently tighten technology service provider.150 The problems with the system.159 their aggregate credit, size or position commenter suggested that the One commenter opined that a broker- limits, or impose additional or Commission clarify that outsourcing to enhanced trading restrictions on a dealer providing market access should 168 a technology service provider is not be permitted to utilize a risk particular trader or group of traders. permissible by removing the word management system provided by a Thus, the commenter concluded that, if ‘‘ ‘‘exclusive’’ from paragraph (d) of the customer or an affiliate of a customer.160 the baseline limits are established and proposed Rule.151 Another commenter However, the commenter also requested enforced by the [broker-dealer providing asked that the Commission clarify that the Commission clarify whether a market access], customers should be whether third party software could be broker-dealer providing market access permitted to tighten risk management controls as they see fit.’’ 169 under the control of a third party could rely on the representations from One commenter advised the vendor, provided that the broker-dealer a third-party provider of risk providing market access is able to Commission to permit a broker-dealer management systems regarding its providing market access to purchase a control the parameters and thresholds affiliations.161 Another commenter applied by the software.152 Commenters risk management system from its asked that the Commission clarify customer, and then use that risk also requested that the Commission whether a third party that is an affiliate, clarify whether a broker-dealer management system to monitor the but not a controlled affiliate, of a customer’s trading activity.170 The providing market access could use risk customer to which a broker-dealer management controls provided by commenter opined that, in such provides market access, would be instances, the broker-dealer providing exchanges and ATSs to fulfill its considered ‘‘independent’’ of the obligations under the Rule, provided market access should be able to customer. That commenter did not demonstrate that it has disabled the that the broker-dealer providing market believe that such non-controlled access could control the parameters of customer’s control of the system, and affiliates should be excluded from that the acquired system is able to the risk management controls.153 One 162 providing risk management software. perform effectively, consistent with the commenter suggested it would be The commenter also requested that the 171 ‘‘ Rule’s standards. helpful in understanding the contours Commission clarify whether Finally, one commenter suggested of the ‘direct and exclusive’ control ‘‘independence’’ would be ‘‘expected,’’ as that requiring a broker-dealer providing requirement’’ if the Commission provided a non-exclusive list of 154 SIFMA Letter at 5–6. 163 SIFMA Letter at 5. examples of third party arrangements 155 Goldman Letter at 7; MFA Letter at 2. 164 MFA Letter at 2; ConvergEx Letter at 11. 156 Goldman Letter at 7. 165 MFA Letter at 2. 149 Proposing Release, 75 FR at 4015. 157 BIDS Letter at 2. 166 MFA Letter at 2. 150 ConvergEx Letter at 11. 158 Deutsche Bank Letter at 6. 167 ConvergEx Letter at 11. 151 ConvergEx Letter at 11. 159 Deutsche Bank Letter at 6. 168 ConvergEx Letter at 11. 152 SIFMA Letter at 5. 160 Goldman Letter at 7. 169 ConvergEx Letter at 11. 153 SIFMA Letter at 5; BIDS Letter at 3; Deutsche 161 Goldman Letter at 7. 170 Lime Letter at 7. Bank Letter at 6; CBOE Letter at 4. 162 SIFMA Letter at 5. 171 Lime Letter at 7.

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market access to use a risk management with the provision of effective risk that a broker-dealer develop the risk system independent from the customer management technology to the broker- management technology itself. Instead, ‘‘could destroy the business model’’ for dealer. the direct and exclusive control certain market access arrangements The Commission acknowledges that provisions require the broker-dealer involving brokers or options traders, certain market access customers may providing market access to have the given the trading delays those systems have sophisticated and effective ability to directly monitor and the might require.172 technology to manage the risks related exclusive ability to adjust, as After careful consideration of the to their particular trading strategies. appropriate, the operation of the comments submitted on the Rule’s However, the Commission believes that financial and regulatory risk ‘‘direct and exclusive control’’ direct responsibility for having an management controls in real-time. As provisions in relation to third party effective system of reasonably designed stated in the Proposing Release,176 the providers of risk management risk management controls belongs with direct and exclusive control provision is technology, the Commission is adopting the broker-dealer providing market designed to eliminate the practice Rule 15c3–5(d) as proposed. As an access, as the regulated entity through whereby the broker-dealer providing initial matter, the Commission confirms which access to the markets is obtained market access may rely on its customer, the position taken in the Proposing and the party responsible for trading a third party service provider, or others, Release that a broker-dealer providing occurring under its MPID. The Rule market access can use risk management would not preclude the customer from to establish and maintain the applicable tools or technology provided by a third having risk management controls that risk controls. The Commission believes party that is independent of the exceed those under the direct and the potential risks presented by market customer, so long as it has direct and exclusive control of the broker-dealer— access are too great to permit a broker- exclusive control over those tools or however, as required above, the broker- dealer to delegate the control of these technology and performs appropriate dealer cannot rely on risk management critical risk management systems to the due diligence. Specifically, the broker- technology that is designed, built, customer or another third party. dealer could ‘‘outsource’’ to an maintained or otherwise under the The Commission reaffirms the independent third party the design and control of the customer or its affiliates. position taken in the Proposing Release building of the risk management tools or In addition, the Commission believes a that the broker-dealer providing market technology for the broker-dealer, and reasonably designed system of risk access, consistent with the reasonably the performance of routine management controls and supervisory designed risk management system maintenance, so long as the broker- procedures should rely on technology required by the Rule, could permit a dealer performs appropriate due that is developed independent of the third party that is independent of diligence as to their effectiveness. In market access customer or its affiliates. customers to supplement its own addition, the risk management tools or Requiring such independence should monitoring of the operation of its risk technology could be located at the reduce the risk that the effectiveness of management controls.177 The broker- facilities of the independent third party, these critical controls could be dealer providing market access also so long as the broker-dealer can directly undermined by allowing market access could allow a third party that is monitor their operation and has the customers to develop the tools to, in independent of customers to perform effect, police themselves. One exclusive ability to adjust the controls. routine maintenance or the commenter asked whether a broker- Further, the independent third party implementation of technology upgrades dealer providing market access could could, in response to specific direction on its risk management controls; but the rely on a customer representation of from the broker-dealer on a case-by-case broker or dealer with market access basis, make an adjustment to the independence from the technology provider.175 The Commission believes should conduct appropriate due controls as agent for the broker- diligence regarding any changes to such 173 that simple reliance on a customer dealer. controls and their implementation to The independent third party could be representation of independence is assure their continued effectiveness. another broker-dealer, an exchange or insufficient; instead, any broker-dealer One commenter asked whether a broker- ATS, a service bureau, or other entity providing market access that intends to dealer providing market access could that is not an affiliate,174 and is rely on risk management technology rely on an exchange representation otherwise independent, of the market developed by third parties should regarding the efficacy of exchange- access customer. When evaluating conduct an appropriate level of due provided risk management technology whether a technology provider is diligence, including with respect to the and software, and argued that independent of the customer, the independence of the developer from the independent verification should be Commission will look at the substance market access customer or its affiliates. unnecessary unless the broker-dealer rather than the form of the relationship. The Commission recognizes that becomes aware of a problem.178 For example, the Commission would market access arrangements have As not consider a third party independent developed in many different ways, and noted above, the Commission believes from a customer just because it is there has been a similarly varied that a broker-dealer relying on risk technically not an affiliate, if it has a response to the development and use of management technology developed by material business or other relationship risk management technology. third parties should perform appropriate with the customer which could interfere Accordingly, the Commission due diligence to help assure the controls emphasizes that it is not requiring a are reasonably designed, effective, and 172 Fortis Letter at 12. ‘‘one-size-fits-all’’ approach to risk otherwise consistent with the Rule. 173 The Commission notes that any adjustment to management. The direct and exclusive Mere reliance on representations of the the controls by a third party as agent for the broker- control provisions allow for a variety of third party technology developer—even dealer should be made pursuant to specific reasonable risk management if an exchange or other regulated direction, on a case-by-case basis, from the broker- approaches, consistent with the Rule, dealer rather than pursuant to standing instructions. 174 An affiliate includes any person that, directly and, as discussed above, will not require 176 Proposing Release, 75 FR at 4014. or indirectly, controls, is under common control 177 Proposing Release, 75 FR at 4015. with, or is controlled by, the customer. 175 Goldman Letter at 7. 178 See Deutsche Bank Letter at 6.

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entity—is insufficient to meet this due commenters indicated that the review supervisory procedures contemplated diligence standard. and certification requirements would be by Rule 15c3–5, and should help assure burdensome and costly, and would their effectiveness. As noted in the G. Regular Review of Risk Management divert supervisory resources from other Proposing Release, the Commission also Controls and Supervisory Procedures projects.180 One commenter expressed believes that the CEO certification Proposed Rule 15c3–5(e) would concern that various requirements for requirement should serve to bolster require a broker-dealer with or separate CEO certifications for different broker-dealer compliance programs, and providing market access to establish, rules could be unwieldy and promote meaningful and purposeful document, and maintain a system for burdensome.181 Others commenters interaction between business and regularly reviewing the effectiveness of recommended that the certification compliance personnel.186 its reasonably designed risk requirement be imposed on another The Commission is adopting Rule management controls and supervisory officer (such as the Chief Risk Officer, 15c3–5(e) as proposed. In the Proposing procedures and for promptly addressing Chief Compliance Officer, or an Release, the Commission noted that any issues. Proposed Rule 15c3–5(e)(1) equivalent officer) or an outside firm.182 Proposed Rule 15c3–5 is ‘‘intended to would require, among other things, the A few commenters requested complement and bolster existing rules broker-dealer to review, no less clarification as to whether the proposed and guidance issued by the exchanges frequently than annually, the business CEO certification requirement would and by FINRA with respect to market activity of the broker-dealer in create a completely new obligation or access.’’ 187 The Commission would connection with market access to assure whether it could be viewed as expect, in many cases, the annual CEO the overall effectiveness of its risk encompassed by existing certification certification required under Rule 15c3– management controls and supervisory processes, such as the FINRA Rule 3130 5(e)(2) to be completed in conjunction procedures, and to conduct that review certification process.183 In addition, with a firm’s annual review and in accordance with written procedures several commenters recommended that certification of its supervisory systems and document each such review. That broker-dealers should be able to satisfy pursuant to FINRA Rule 3130. However, provision also would require the broker- the CEO certification requirement the CEO certification contemplated by dealer to preserve a copy of its written through the existing FINRA Rule 3130 the Rule is a separate and distinct procedures, and documentation of each certification or other existing certification from the FINRA 3130 such review, as part of its books and certification processes.184 certification or any other similar records in a manner consistent with As proposed, Rule 15c3–5(e) is certification process.188 That said, the Rule 17a–4(e)(7) under the Exchange intended to assure that a broker-dealer Commission believes a FINRA member Act, and Rule 17a–4(b) under the with or providing market access could combine in the same document Exchange Act, respectively. implements supervisory review the CEO certification required by Rule Finally, Proposed Rule 15c3–5(e)(2) mechanisms to support the effectiveness 15c3–5(e)(2) with the FINRA 3130 or would require the Chief Executive of its risk management controls and other required certifications, so long as Officer (or equivalent officer) of the supervisory procedures on an ongoing the substance of each of the required broker-dealer, on an annual basis, to basis. In the Proposing Release, the certifications is contained in that certify that its risk management controls Commission expressed the view that, document. because of the potential risks associated and supervisory procedures comply III. Paperwork Reduction Act with the Rule and that the broker-dealer with market access, and the dynamic conducted the regular review. These nature of both the securities markets The Rule contains ‘‘collection of CEO certifications also are required to and the businesses of individual broker- information’’ requirements within the be preserved by the broker-dealer as part dealers, it is critical that a broker-dealer meaning of the Paperwork Reduction 189 of its books and records in a manner with market access charge its most Act of 1995 (‘‘PRA’’). In accordance consistent with Rule 17a–4(b) under the senior management—specifically the with 44 U.S.C. 3507 and 5 CFR 1320.11, Exchange Act. CEO or an equivalent officer—with the the Commission submitted the In the Proposing Release, the responsibility to review and certify the provisions to the Office of Management Commission stated that, when efficacy of its controls and procedures at and Budget (‘‘OMB’’) for review. The establishing the specifics of this regular regular intervals.185 The Commission title for the proposed collection of review, it expects that each broker- believes that this certification information requirement is ‘‘Rule 15c3– dealer with market access would requirement is an integral component of 5, Market Access.’’ An agency may not establish written procedures that are the risk management controls and conduct or sponsor, and a person is not reasonably designed to assure that the required to respond to, a collection of broker-dealer’s controls and procedures Officer, Lek Securities Corporation, February 21, information unless it displays a are adjusted, as necessary, to help 2010 (‘‘Lek Letter’’) at 3; Christopher Carter, April currently valid control number. 19, 2010 (‘‘Carter Letter’’) at 7; Andrew C. Small, assure their continued effectiveness in In the Proposing Release, the General Counsel, Scottrade, Inc., March 30, 2010 Commission solicited comments on the light of any changes in the broker- (‘‘Scottrade Letter’’) at 1; ITG Letter at 9–10; dealer’s business or weaknesses that Deutsche Bank Letter at 6–7; ABA Letter at 5–6; collection of information requirements. The Commission noted that the have been revealed. EWT Letter at 5; Engmann Letter at 3; Pershing Letter at 4; BIDS Letter at 4; Goldman Letter at 7. estimates of the effect that the Rule The Commission received eleven 180 See Lek Letter at 3; ITG Letter at 9–10; ABA comment letters that discussed the would have on the collection of Letter at 5–6; Carter Letter at 7. information were based on data from proposed requirements for a regular 181 Deutsche Bank Letter at 6–7. various industry sources. As discussed review of the effectiveness of a broker- 182 See EWT Letter at 5; see also Carter Letter at dealer’s risk management controls and 7. above, the Commission received 47 supervisory procedures, and 183 See Engmann Letter at 3; Pershing Letter at 4; BIDS Letter at 4; Goldman Letter at 7. 186 See Proposing Release, 75 FR at 4015. particularly the annual certification of 184 See Engmann Letter at 3; Pershing Letter at 4; 187 See Proposing Release, 75 FR at 4010. 179 the CEO (or equivalent officer). A few BIDS Letter at 4; ITG Letter at 9–10; Deutsche Bank 188 The Commission also notes that Rule 15c3– Letter at 6–7; ABA Letter at 5–6; SIFMA Letter at 5(e)(2) may apply to broker-dealers that are not 179 See letters to Elizabeth M. Murphy, Secretary, 9; Scottrade Letter at 1. FINRA members. Commission, from Samuel F. Lek, Chief Executive 185 Proposing Release, 75 FR at 4015. 189 44 U.S.C. 3501 et seq.

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comment letters on the proposed ATS through use of its MPID or Rule 17–4(e)(7) under the Exchange Act rulemaking. Of the comment letters the otherwise, to establish, document, and will help to assure that appropriate Commission received, some maintain a system for regularly written records were made, and will be commenters addressed the collection of reviewing the effectiveness of the risk used by the Commission staff and SRO information aspects of the proposal.190 management controls and supervisory staff during an examination of the procedures required under the Rule and broker or dealer for compliance with the A. Summary of Collection of for promptly addressing any issues. Rule. Information Among other things, the broker or dealer The requirement to maintain a system Rule 15c3–5 will require a broker or will be required to review, no less for regularly reviewing the effectiveness dealer with market access, or that frequently than annually, the business of the risk management controls and provides a customer or any other person activity of the broker or dealer in supervisory procedures required under with access to an exchange or ATS connection with market access to assure the Rule will help to ensure that the risk through use of its MPID or otherwise, to the overall effectiveness of such risk management controls and supervisory establish, document, and maintain a management controls and supervisory procedures remain effective. A broker- system of risk management controls and procedures and document that review. dealer will use these risk management supervisory procedures to assist it in Such review will be required to be controls and supervisory procedures to managing the financial, regulatory, and conducted in accordance with written fulfill its obligations under the Rule, as other risks, such as legal and procedures and will be required to be well as to evaluate and help ensure its operational risks, of this business documented. The broker or dealer will financial integrity more generally. The activity. The system of risk management be required to preserve a copy of such Commission and SROs will use this controls and supervisory procedures, written procedures, and documentation information in their exams of the broker among other things, shall be reasonably of each such review, as part of its books or dealer, as well as for regulatory designed to (1) systematically limit the and records in a manner consistent with purposes. The requirement that a broker financial exposure of the broker or Rule 17a–4(e)(7) under the Exchange or dealer preserve a copy of written dealer that could arise as a result of Act,192 and Rule 17a–4(b) under the procedures, and documentation of each market access, and (2) ensure Exchange Act, respectively.193 such regular review, as part of its books compliance with all regulatory In addition, the Chief Executive and records in a manner consistent with requirements that are applicable in Officer (or equivalent officer) of the Rule 17a–4(e)(7) under the Exchange connection with market access. The broker or dealer, on an annual basis, Act, and Rule 17a–4(b) under the financial risk management controls and will be required to certify that such risk Exchange Act, respectively, will help to supervisory procedures must be management controls and supervisory assure that the regular review was in reasonably designed to prevent the entry procedures comply with the Rule, that fact completed, and will be used by the of orders that exceed appropriate pre-set the broker or dealer conducted such Commission staff and SRO staff during credit or capital thresholds, or that review, and such certifications shall be an examination of the broker or dealer appear to be erroneous. As a practical preserved by the broker or dealer as part for compliance with the Rule. The matter, the Rule will require a of its books and records in a manner requirement that the Chief Executive respondent to set appropriate credit consistent with Rule 17a–4(b) under the Officer (or equivalent officer) of the thresholds for each customer for which Exchange Act.194 broker or dealer, on an annual basis, it provides market access and certify that such risk management B. Use of Information appropriate capital thresholds for controls and supervisory procedures proprietary trading by the broker-dealer The requirement that a broker or comply with Rule 15c3–5, that the itself. The regulatory risk management dealer with market access, or that annual review was conducted, and that controls and supervisory procedures provides a customer or any other person such certifications be preserved by the must be reasonably designed to prevent with access to an exchange or ATS broker or dealer as part of its books and the entry of orders that do not comply through use of its MPID or otherwise, records in a manner consistent with with regulatory requirements that must establish, document, and maintain a Rule 17a–4(b) under the Exchange Act be satisfied on a pre-order entry basis, system of risk management controls and will help to ensure that senior prevent the entry of orders that the supervisory procedures that, among management review the efficacy of its broker-dealer or customer is restricted other things, shall be reasonably controls and procedures at regular from trading, restrict market access designed to (1) systematically limit the intervals and that such review is technology and systems to authorized financial exposure of the broker or documented. This certification will be persons, and assure appropriate dealer that could arise as a result of used internally by the broker or dealer surveillance personnel receive market access, and (2) ensure as evidence that it complied with the immediate post-trade execution reports. compliance with all regulatory Rule and possibly for internal Each such broker or dealer will be requirements that are applicable in compliance audit purposes. The required to preserve a copy of its connection with market access, will certification also will be used by supervisory procedures and a written help ensure that such brokers or dealers Commission staff and SRO staff during description of its risk management have sufficiently effective controls and an examination of the broker or dealer controls as part of its books and records procedures in place to appropriately for compliance with the Rule or more in a manner consistent with Rule 17a– manage the risks associated with market generally with regard to evaluation of a 4(e)(7) under the Exchange Act.191 access. The requirement to preserve a broker or dealer’s risk management In addition, the Rule will require a copy of its supervisory procedures and control procedures and controls. broker or dealer with market access, or a written description of its risk C. Respondents that provides a customer or any other management controls as part of its books person with access to an exchange or and records in a manner consistent with In the Proposing Release, the Commission estimated that the 190 See, e.g., Pershing Letter at 4; Fortis Letter at 192 Id. ‘‘collection of information’’ associated 9; STANY Letter at 4; Lek Letter at 3. 193 See supra note 25. with the Rule would apply to 191 See supra note 23. 194 Id. approximately 1,295 brokers-dealers

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that have market access or provide a commenter believed that the number of standard for risk management controls customer or any other person with registered broker-dealers would and supervisory procedures. The extent market access. Of these 1,295 brokers- increase, because some algorithmic to which a respondent will be burdened dealers, the Commission estimated that trading firms would need to register as by the proposed collection of there are 1,095 brokers-dealers that are broker-dealers in order to continue to information under the Rule will depend members of an exchange. This estimate implement their current trading significantly on the financial and was based on broker-dealer responses to strategies in the face of increased regulatory risk management controls FOCUS report filings with the latency times.195 On the other hand, that already exist in the respondent’s Commission from 2007 and 2008. The various commenters asserted that the system as well as the respondent’s Commission estimated that the Rule will prevent small broker-dealers business model. As stated in the remaining 200 broker-dealers are from using sponsored access as a means Proposing Release, the Commission subscribers to ATSs but are not to aggregate trading volume, obtain believes that in many cases, particularly exchange members. This estimate was tiered pricing from exchanges, and with respect to proprietary trading, based on a sampling of subscriber remain competitive with larger liquidity more traditional agency brokerage information contained in Exhibit A to providers, and therefore will drive activities, and direct market access, the Form ATS–R filed with the smaller liquidity providers from the Rule may be substantially satisfied by a 196 Commission. market. If true, this will potentially respondent’s existing financial and The Commission continues to reduce the number of registered broker- regulatory risk management controls estimate that there are 1,095 brokers- dealers that provide market access. and current supervisory procedures. As dealers that are members of an In addition to making an adjustment noted in the Proposing Release, these exchange, and that there are an in the number of respondents to account brokers-dealers likely will only require additional 200 broker-dealers that are for broker-dealer ATS operators that limited updates to their systems to meet subscribers to ATSs but are not provide market access to non-broker- the requisite risk management controls exchange members. However, the dealers, as described above, the specified in the Rule, and as such, will Commission is revising its initial Commission acknowledges that the estimate of the total number of implementation of the Rule may incur minimal additional reporting and respondents in a different respect. As introduce competitive effects that lead recordkeeping burdens. stated above, the Commission is well to a change in the number of registered The Commission continues to believe aware that the same regulatory and brokers-dealers with market access. that the majority of respondents have financial risks are present when a non- However, the Commission notes that of risk management systems with pre-trade broker-dealer subscriber directly the two speculative outcomes noted by financial and regulatory controls, accesses an ATS as when a broker- commenters above, both caused by although the use and range of those dealer accesses an exchange or ATS. increased latency times, one would controls may vary among firms. As Accordingly, the Commission believes increase the number of registered noted in the Proposing Release, certain that a broker-dealer operator of an ATS broker-dealers, while the other would pre-trade controls, such as pre-set should be required to implement the decrease the number. Although the trading limits or filters to prevent financial and regulatory risk Commission should anticipate either or erroneous trades, may already be in management controls required by the both of these trends occurring, it is place within a respondent’s risk rule with regard to non-broker-dealer difficult to speculate which trend would management system. Similarly, the subscriber’s access to its ATS. The predominate, if one does indeed take extent to which receipt of immediate Commission notes that currently there precedence over the other. The post-trade execution reports creates a are approximately 80 ATSs that are Commission ultimately believes that burden on respondents would depend registered with the Commission and although the Rule may lead to short- on whether a respondent already provide market access, and the broker- term increases or decreases in the receives such reports on an immediate, dealer operators of these ATSs should number of registered broker-dealers, post-trade basis or on an end-of-day be included among the respondents. such increases and decreases may offset basis. For broker-dealers that rely This number is based on the number of each other over the longer term. Because largely on ‘‘unfiltered’’ or ‘‘naked’’ ATSs that have filed an initial operation of this, the Commission continues to access, the Rule could require the report (‘‘Form ATS’’) with the believe that 1,375 brokers-dealers that development or significant upgrade of a Commission and also currently submit have market access or provide a new risk management system, which quarterly reports of alternative trading customer or any other person with would be a significantly larger burden system activities (‘‘Form ATS–R’’). market access is an appropriate estimate on a potential respondent. Therefore, With the 80 additional respondents, of the number of entities that will be the burden imposed by the Rule will the Commission now estimates that the subject to the rule for the current PRA differ vastly depending on a broker- ‘‘collection of information’’ associated analysis. dealer’s current risk management with the Rule will apply to system and business model. approximately 1,375 brokers-dealers D. Total Initial and Annual Reporting that have market access or provide a and Recordkeeping Burdens Rule 15c3–5 will also require a customer or any other person with For the purposes of the PRA analysis, respondent to update its review and market access. the Commission considered the burden compliance procedures to comply with In the Proposing Release, the on respondents to bring their risk the Rule’s requirement to regularly Commission solicited comments on the management controls and supervisory review its risk management controls and estimated number of respondents. procedures into compliance with the supervisory procedures, including a Several commenters stated that the Rule. The Commission continues to note certification annually by the Chief Commission’s estimate does not take that among brokers-dealers with market Executive Officer (or equivalent officer). into account how the Rule’s enactment access, there is currently no uniform The Commission notes that a will subsequently change the number of respondent should currently have registered brokers-dealers that provide 195 See ABA Letter at 6–7. written compliance procedures market access. For example, one 196 See id. at 7, Jane Street Letter at 2. reasonably designed to review its

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business activity.197 Rule 15c3–5 will dealer decides to forego internal approximately $26,800 if outsourced.202 initially require a respondent to update technology development and instead The Commission believed the ongoing its written compliance procedures to opts to purchase technology from a burden of complying with the proposed document the method in which the third-party technology provider or rule’s collection of information would respondent plans to comply with the service bureau, the technology costs include, among other things, updating Rule. would also depend on the risk systems to address any issues detected, management controls that are already in updating risk management controls to 1. Technology Development and place, as well as the business model of reflect any change in its business model, Maintenance the broker or dealer. Based on and documenting and preserving its In the Proposing Release, the discussions with various industry written description of its risk Commission estimated that the initial participants, the Commission noted that management controls. burden for a potential respondent to technology for risk management For hardware and software expenses, comply with the proposed requirement controls is generally purchased on a the Commission estimated that the to establish, document, and maintain a monthly basis. In the Proposing Release, average initial cost would be system for regularly reviewing the the Commission’s staff estimated that approximately $16,000 per broker- effectiveness of the risk management the cost to purchase technology from a dealer,203 while the average ongoing controls and supervisory procedures, on third-party technology provider or cost would be approximately $20,500 average, would be 150 hours if service bureau would be approximately per broker-dealer.204 performed in-house,198 or $3,000 per month for a single The Commission also considered how approximately $35,000 if outsourced.199 connection to a trading venue, plus an permitting broker-dealers to allocate This figure was a weighted estimate additional $1,000 per month for each regulatory risk management controls to based on the estimated number of hours additional connection to that exchange. customers that are registered broker- for initial internal development and For an estimate of the annual dealers would affect the Commission’s implementation by a respondent to outsourcing cost, the Commission noted calculations of total initial and annual program its system to add the controls that for two connections to each of two reporting and recordkeeping burdens. needed to comply with the requirements different trading venues, the annual cost Although commenters have noted that of the proposed rule, expand system would be $96,000.200 The potential such market access arrangements capacity, if necessary, and establish the range of costs would vary considerably, consisting of multiple broker-dealers are ability to receive immediate post-trade depending upon the business model of commonplace,205 establishing an execution reports. Based on discussion the broker-dealer. estimate for the average additional with various industry participants, the Moreover, the Commission noted that technology burden is a challenging task. Commission expected that brokers- on an ongoing basis, a respondent Numerous uncertainties, including the dealers with market access currently would have to maintain its risk number of broker-dealers involved in have the means to receive post-trade management system by monitoring its any given transaction or contractual executions reports, at a minimum, on an effectiveness and updating its systems agreement, create difficulties in end-of-day basis. to address any issues detected. In developing estimates. The Commission noted in the addition, a respondent would be After carefully evaluating the types of Proposing Release that if the broker- required to preserve a copy of its written compliance responsibilities that could description of its risk management be allocated, the technological 197 See supra note 57. controls as part of its books and records capabilities required, and the tasks 198 This estimate was based on discussions with in a manner consistent with Rule 17a– associated with risk compliance various industry participants. Specifically, the 4(e)(7) under the Exchange Act. The allocation, the Commission determined modification and upgrading of hardware and software for a pre-existing risk control management Commission estimated that the ongoing system, with few substantial changes required, annualized burden for a potential people therefore would work 1,920 hours × 1.5 would take approximately two weeks, while the respondent to maintain its risk people = 2,880 hours per year. Based on discussions development of a risk control management system management system would be with industry participants, the Commission from scratch would take approximately three estimated that 4% of the team’s total work time months. approximately 115 burden hours if would be used for ongoing risk management 201 Based on discussions with industry participants, performed in-house, or maintenance. Accordingly, the total number of × the Commission estimated that a dedicated team of burden hours for this task, per year, is 0.04 2,880 1.5 people would be required for the system 200 12 months × $4,000 (estimated monthly cost hours = 115.2 hours. development. The team may include one or more for two connections to a trading venue) × 2 trading 202 See infra note 228. programmer analysts, senior programmers, or senior venues = $96,000. This estimate was based on 203 Industry sources estimate that to build a risk systems analysts. Each team member would work discussions with various industry participants. For control management system from scratch, hardware approximately 20 days per month, or 8 hours × 20 purposes of this estimate, ‘‘connection’’ was defined would cost $44,500 and software would cost days = 160 hours per month. Therefore, the total as up to 1,000 messages per second inbound, $58,000, while to upgrade a pre-existing risk control number of hours per month for one system regardless of the connection’s actual capacity. management system, hardware would cost $5,000 development team would be 240 hours. For the conservative estimate above, the and software would cost $6,517. Based on A two-week project to modify and upgrade a pre- Commission chose two connections to a trading discussions with industry participants, the existing risk control management system would venue, the number required to accommodate 1,500 Commission estimates that 95% of all respondents require 240 hours/month × 0.5 months = 120 hours, to 2,000 messages per second. The estimated would require modifications and upgrades only, while a three-month project to develop a risk number of messages per second was based on and 5% would require development of a system control management system from scratch would discussions with various industry participants. from scratch. Therefore, the total average hardware require 240 hours/month × 3 months = 720 hours. 201 Based on discussions with industry and software cost for an initial internal Based on discussions with industry participants, participants, the Commission estimated that a development project would be approximately × × the Commission estimated that 95% of all dedicated team of 1.5 people would be used for the (0.95 $11,517) + (0.05 $102,500) = $16,066, or respondents would require modifications and ongoing maintenance of all technology systems. The $16,000. upgrades only, and 5% would require development team may include one or more programmer 204 Industry sources estimate that for ongoing of a system from scratch. Therefore, the total analysts, senior programmers, or senior systems maintenance, hardware would cost $8,900 on average number of burden hours for an initial analysts. In-house system staff size varies average and software would cost $11,600 on internal development project would be depending on, among other things, the business average. The total average hardware and software approximately (0.95 × 120 hours) + (0.05 × 720 model of the broker or dealer. Each staff member cost for ongoing maintenance would be $8,900 + hours) = 150 hours. would work 160 hours per month, or 12 months × $11,600 = $20,500. 199 See infra note 227. 160 hours = 1,920 hours per year. A team of 1.5 205 See supra note 107.

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that in estimating the additional initial rule.208 The Commission notes that its includes establishing written and ongoing technology burdens, these burden and outsourcing estimates are procedures for reviewing the overall considerations would not affect calculated as weighted averages, and effectiveness of the risk management estimated burdens in a meaningful way. that these estimates skew lower because controls and supervisory procedures. The Commission expects that any the Commission estimates that, based on On an ongoing basis, a respondent additional technology burdens that discussions with various industry would have to maintain and review its broker-dealers undertake to bring their participants, the majority of broker- risk management controls and sponsored broker-dealers ‘‘on board’’ dealers that provide market access, if supervisory procedures to assure their will be offset by the sponsored broker- they are not already fully compliant, are effectiveness as well as to address any dealers’ reduced technology burdens close to full compliance and are not deficiencies found. The broker-dealer from using their sponsoring broker- expected to incur significant would have to review, no less frequently dealers’ risk management systems. outsourcing costs. Numerous industry than annually, its business activity in While the Commission recognizes that sources have stated that for many connection with market access to assure the offsetting of technology burdens smaller brokers-dealers, third-party the overall effectiveness of the risk may not fully reflect all of the hours that technology providers would take no management controls and supervisory broker-dealers may incur from preparing longer than two or three days to procedures and would be required to risk management systems for allocation, program any compliance adjustments. make changes to address any problems Commission staff believes that such an While some respondents will indeed or deficiencies found through this estimate is reasonable given the incur significantly higher technology review. Such review would be required relatively small technology burdens that outsourcing costs that would to be conducted in accordance with sponsored broker-dealers currently have correspond to commenters’ estimates, written procedures and would be as part of their status quo. The the Commission expects that these required to be documented. The broker- Commission is therefore retaining the respondents will be significantly dealer would be required to preserve a hourly burden estimates and calculation outnumbered by brokers-dealers who copy of such written procedures, and methodology for technology will incur minimal outsourcing costs. documentation of each such review, as development and maintenance as The Commission therefore continues to part of its books and records in a originally proposed. believe that its burden estimates for manner consistent with Rule In the Proposing Release, the technology outsourcing are reasonable, 17a–4(e)(7) under the Exchange Act, and Commission solicited comments on the and retains them as originally proposed. Rule 17a–4(b) under the Exchange Act, burdens of technology development and respectively. On an annual basis, the maintenance. The Commission did not 2. Legal and Compliance Chief Executive Officer (or equivalent receive any comments that directly In the Proposing Release, the officer) of the broker-dealer would be addressed the initial or ongoing burden Commission provided a separate set of required to certify that such risk for technology, as measured in hours, burden estimates for legal and management controls and supervisory for a potential respondent to comply compliance obligations. The procedures comply with the proposed with the proposed requirement to Commission noted that the majority of rule, that the broker or dealer conducted establish, document, and maintain a broker-dealers should already have such review, and that such certifications system for regularly reviewing the compliance policies and supervisory are preserved by the broker-dealer as effectiveness of the risk management procedures in place.209 Accordingly, the part of its books and records in a controls and supervisory procedures. Commission asserted that the initial manner consistent with Rule 17a–4(b) However, two commenters did burden to comply with the proposed under the Exchange Act. The ongoing address the Commission’s technology compliance requirements should not be burden of complying with the proposed outsourcing cost estimates, asserting substantial. Based on discussions with rule’s collection of information would that they were too low. For example, various industry participants and the include documentation for compliance one commenter believed that the Commission’s prior experience with with its risk management controls and Commission’s initial and ongoing broker-dealers, the Commission supervisory procedures, modification to technology outsourcing cost estimates estimated that the initial legal and procedures to address any deficiencies dramatically understated the actual compliance burden on average for a in such controls or procedures, and the costs that would be incurred, stating potential respondent to comply with the required preservation of such records. that maintenance from outside vendors proposed requirement to establish, Based on discussions with industry would cost in excess of $1 million per document, and maintain compliance participants and the Commission’s prior year for services that include ‘‘fat policies and supervisory procedures experience with broker-dealers, the finger,’’ credit, and compliance would be approximately 35 hours. Commission estimated in the Proposing controls.206 Another commenter Specifically, the setting of credit and Release that a broker-dealer’s estimated that it will cost more than capital thresholds for each customer implementation of an annual review, $2 million per year for a company to would require approximately 10 modification of its risk management buy the appropriate systems.207 hours,210 and the modification or controls and supervisory procedures to The Commission reiterates that establishment of applicable compliance address any deficiencies, and technology outsourcing costs will vary policies and procedures would require preservation of such records would depending on the size of the broker or approximately 25 hours,211 which require 45 hours per year. Specifically, dealer and the extent to which it already compliance attorneys who review, complies with the recordkeeping 208 See supra note 47. document, and update written requirements described in the Rule. As 209 See supra note 57. compliance policies and procedures stated above, Rule 15c3–5 does not 210 The Commission estimated that one would require an estimated 20 hours per employ a ‘‘one-size-fits-all’’ standard for compliance attorney and one compliance manager year; a compliance manager who would each require 5 hours, for a total initial determining compliance with the burden of 10 hours. reviews, documents, and updates 211 The Commission estimated that one 206 See ConvergEx Letter at 9. compliance attorney and one compliance manager Executive Officer would require 5 hours, for a total 207 See Wedbush Letter at 5–6. would each require 10 hours, and one Chief initial burden of 25 hours.

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written compliance policies and commenters noted that in particular, the 35 total hours required,217 on average, procedures was expected to require 20 CEO certification was duplicative while internal compliance specialists hours per year; and the Chief Executive because FINRA members are already would be responsible for the remainder Officer, who certifies the policies and required by FINRA Rule 3130 to of the initial burden.218 Such a burden procedures, was expected to require perform annual reviews of their allocation anticipates that in practice, another 5 hours per year. supervisory systems and obtain a compliance experts will oversee the Based on discussions with industry certification from the CEO.213 bulk of responsibilities for establishing participants and the Commission’s prior The Commission believes that this credit and capital thresholds and for experience with broker-dealers, the certification requirement is an integral modifying compliance policies, while Commission believed that the ongoing the Chief Executive Officer would retain legal and compliance obligations under component of the risk management controls and supervisory procedures the senior managerial responsibility to the proposed rule would be handled review the compliance experts’ work internally because compliance with contemplated by Rule 15c3–5, and should help assure their effectiveness. and certify the controls’ effectiveness. these obligations is consistent with the Moreover, the Commission reiterates type of work that a broker-dealer As noted in the Proposing Release, the Commission also believes that the CEO that these compliance obligations are in typically handles internally. The fact consistent with the type of work certification requirement should serve Commission did not believe that a that a broker-dealer typically handles to bolster broker-dealer compliance broker-dealer would have any recurring internally, especially for other programs, and promote meaningful and external costs associated with legal and certification processes such as the purposeful interaction between business compliance obligations. FINRA 3130 process, as discussed and compliance personnel.214 The After considering the effects of above. The Commission is adopting Commission would expect, in many permitting broker-dealers to enter Rule 15c3–5(e) as proposed, and with cases, the annual CEO certification contractual arrangements to allocate the exception of the additional required under Rule 15c3–5(e)(2) to be certain risk compliance responsibilities compliance burden from negotiating completed in conjunction with a firm’s to a customer that is a registered broker- and preparing risk compliance dealer, the Commission has decided to annual review and certification of its allocation agreements, is retaining its include additional hourly burden supervisory systems pursuant to FINRA legal and compliance burden per- estimates for legal and compliance staff Rule 3130. However, the CEO broker-dealer estimates as proposed. to enter into such written contracts with certification contemplated by the Rule is other broker-dealer customers. The a separate and distinct certification from 3. Total Burden Commission notes the difficulty of the FINRA 3130 certification or any Under the Rule, the total initial estimating an average hourly burden for other similar certification process.215 burden for all respondents will be contract negotiations and preparation, That said, the Commission believes a approximately 275,000 hours ([150 because (1) the total number of FINRA member could combine in the hours (for technology) + 50 hours (for contractual arrangements could vary same document the CEO certification legal and compliance)] × 1,375 brokers greatly from broker-dealer to broker- required by Rule 15c3–5(e)(2) with the and dealers = 275,000 hours) and the dealer, and (2) not all broker-dealers FINRA 3130 or other required total ongoing annual burden would be will enter into such risk compliance certifications, so long as the substance approximately 240,625 hours ([115 allocation arrangements. Based on of each of the required certifications is hours (for technology) + 60 hours (for current industry sources, the contained in that document. legal and compliance)] × 1,375 brokers Commission expects that on both an One commenter disagreed with the and dealers = 240,625 hours). For initial and ongoing basis, compliance hardware and software expenses, the attorneys will spend an average of 10 Commission’s finding that the ongoing total initial cost for all respondents will hours negotiating and preparing such legal and compliance obligations under be $22,000,000 ($16,000 per broker- risk compliance allocation contracts, the proposed rule would be handled dealer × 1,375 brokers and dealers = while compliance managers will require internally, arguing that the CEO $22,000,000) and the total ongoing an average of 5 hours on these tasks. compliance certification requirement annual cost for all respondents would The Commission again notes that its would likely require the hiring of a be $28,187,500 ($20,500 per broker- estimates are calculated as weighted consultant to review controls because dealer × 1,375 brokers and dealers = averages, and that these estimates skew the Chief Executive is not likely to be $28,187,500).The estimates of the initial lower because it anticipates that the a specialist in the area of risk and annual burdens are based on number of broker-dealers that do not management and the development of enter into such allocation arrangements computerized controls.216 discussions with potential respondents. It should be noted that the total burden will likely greatly exceed the number of However, the Commission has in fact estimate has been increased from the broker-dealers that do, even taking into accounted for the likelihood that the Proposing Release’s total burden account broker-dealers who will enter Chief Executive Officer would not be a estimate to reflect the revised number of into multiple allocation arrangements compliance specialist. In the Proposing respondents affected under the Rule. for one transaction. Release, the Commission estimated that In the Proposing Release, the the initial legal and compliance burden IV. Consideration of Costs and Benefits Commission solicited comments for a CEO would constitute only 5 of the The Commission is sensitive to the regarding the information burden costs and benefits that result from its associated with a system for reviewing 213 See Engmann Letter at 2, Pershing Letter at 4, rules. In the Proposing Release, the the effectiveness of risk management BIDS Letter at 4, ITG Letter at 9–10, Scottrade Letter Commission identified certain costs and controls. Several commenters asserted at 1, Deutsche Letter at 6–7, ABA Letter at 5–6, benefits of the Rule as proposed, and that the requirement for CEO SIFMA Letter at 9. 214 certifications was overly burdensome See Proposing Release, 75 FR at 4015. 215 The Commission also notes that Rule 15c3– 217 As stated above, the Commission now 212 and unnecessary. Many of the same 5(e)(2) may apply to broker-dealers that are not estimates that the total initial legal and compliance FINRA members. burden is 50 hours, and not 35. 212 See supra note 180. 216 See Lek Letter at 3. 218 See supra notes 210–211.

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requested comment on all aspects of the significantly make a broker-dealer and and thereby significantly increase a cost-benefit analysis, including the other market participants financially systemic vulnerability of the national identification and assessment of any vulnerable within mere minutes or market system. costs and benefits that were not seconds. Real examples of such The Commission sought comment on discussed in the analysis. The potential catastrophic events have the benefits associated with the Commission received several comments already occurred. For instance, as Proposed Rule. Most of the 47 comment relating to the Commission’s cost- discussed earlier, on September 30, letters expressed, to varying degrees, benefit analysis. For the reasons 2008, trading in Google became general agreement with the Rule’s intent discussed below, the Commission extremely volatile toward the end of the to decrease the potential for financial, continues to believe that its estimates of day trading, dropping 93% in value at regulatory, and systemic risks from the benefits and costs of Rule 15c3–5, as one point, due to an influx of erroneous sponsored access arrangements.221 set forth in the Proposing Release, are orders onto an exchange from a single B. Costs appropriate. market participant which resulted in the cancellation of numerous trades.219 The Commission also requested A. Benefits Without systematic risk protection, comment on the costs associated with Rule 15c3–5 should benefit investors, erroneous trades, whether resulting the Rule. As already stated in the PRA broker-dealers, their counterparties, and from manual errors or a faulty section above, several commenters the national market system as a whole automated, high-speed algorithm, could believed that the Commission did not by reducing the risks faced by broker- potentially expose a broker or dealer to take into account either the increase in dealers and other market participants as enormous financial burdens and disrupt trading costs to clients of exchange a result of various market access the markets. Because the impact of such members, or the decrease in available arrangements by requiring financial and errors may be most profound in the liquidity in the market.222 For example, regulatory risk management controls to ‘‘unfiltered’’ access context, but are not one commenter asserted that the Rule is be implemented on a uniform, market- unique to it, it is clearly in a broker or too far-reaching in its scope, because it wide basis. The financial and regulatory dealer’s financial interest, and the addresses types of market access that do risk management controls should reduce interest of the U.S. markets as a whole, not pose significant risks, and will risks to broker-dealers and markets, as to be shielded from such a scenario create duplicative, unnecessary and well as systemic risk associated with regardless of the form of market access. costly regulation in areas where 223 market access and enhance market The mitigation of significant systemic additional regulation is unneeded. integrity and investor protection in the risks should help ensure the integrity of Another commenter believed that the securities markets by effectively the U.S. markets and provide the Rule will impose significant costs on prohibiting the practice of ‘‘unfiltered’’ investing public with greater confidence some entities beyond just brokers and 224 or ‘‘naked’’ access to an exchange or that intentional, bona fide transactions dealers that provide market access. ATS. The Rule will establish a uniform are being executed across the national The commenter noted that the Rule’s standard for a broker or dealer with market system. Rule 15c3–5 should effect would be to increase latency times market access with respect to risk and decrease liquidity in the market as promote investor confidence as well as 225 management controls and procedures participation in the market by a whole. Other commenters which should reduce the potential for enhancing the fair and efficient anticipated that the Rule will create new regulatory arbitrage and lead to operation of the U.S. securities markets. costs for broker-dealers, who will then be forced to pass these costs along to consistent interpretation and Among other things, the requirements of end-clients in the form of increased enforcement of applicable regulatory Rule 15c3–5 should promote fairness by transaction costs.226 requirements across markets. establishing a level playing field for One of the benefits of the Rule should The Commission recognizes that, by broker-dealers that provide access to be the reduction of systemic risk requiring all orders to be subject to trading on an exchange or ATS and help associated with market access through regulatory and financial risk controls, to ensure compliance with applicable the elimination of ‘‘unfiltered’’ or Rule 15c3–5 will likely impose market ‘‘ ’’ regulatory requirements. costs related to increased latency times, naked access. As discussed in the The national market system is Proposing Release, due in large part to reduced liquidity, and increased trading currently exposed to risk that can result technological advancements, the U.S. costs for broker-dealers. The from unmonitored order flow, as a markets have experienced a rise in the recent report has estimated that ‘‘naked’’ use and reliance of ‘‘sponsored access’’ 221 See Woodbine Letter at 1; Lek Letter at 1; access accounts for 38 percent of the arrangements where customers place Engmann Letter at 1; BATS Letter at 1; Pershing daily volume for equities traded in the Letter at 1; Fortis Letter at 1; FINRA Letter at 1; orders that are routed to markets with U.S. markets.220 The Commission is Nasdaq Letter at 1; BIDS Letter at 1; FRB Chicago little or no substantive intermediation aware that a certain segment of the Letter at 1; STANY Letter at 1; MFA Letter at 1; by a broker-dealer. The risk of NYSE Letter at 1; ICI Letter at 1; Penson Letter at broker-dealer community has declined unmonitored trading is heightened with 1; Lime Letter at 1; ITG Letter at 2; Jane Street Letter to incorporate ‘‘naked’’ access at 1; EWT Letter at 1; FTEN Letter at 1; Goldman the increased prominence of high-speed, arrangements into their business models Letter at 1; Scottrade Letter at 1; Deutsche Letter at high-volume, automated algorithmic because of the inherent risks of the 1; Wedbush Letter at 1; GETCO Letter at 2; ABA trading, where orders can be routed for Letter at 1; SIFMA Letter at 2; Carter Letter at 2; JP practice. In the absence of a execution in milliseconds. If a broker- Morgan Letter at 1; Newedge Letter at 1; FIA Letter Commission rule that would prohibit at 3; letter to Elizabeth M. Murphy, Secretary, dealer does not implement strong such market access, these brokers or Commission, from Kevin Cuttica, Chief Executive systematic controls, the broker or dealer dealers could be compelled by Officer, and David T. DeArmey, Chief Operating may be unaware of customer trading Officer, Sun Trading LLC, March 26, 2010 (‘‘Sun competitive and economic pressures to activity that is occurring under its MPID Letter’’) at 1. ‘‘ ’’ 222 ‘‘ ’’ offer naked access to their customers See Fortis Letter at 14–15, STANY Letter at 5– or otherwise. In the unfiltered or 6, Jane Street Letter at 2, Scottrade Letter at 1. ‘‘naked’’ access context, as well as with 223 219 See Google Trading Incident, supra note 16. See STANY Letter at 6. all market access generally, the See also SWS Trading Incident and Rambus 224 See ABA Letter at 6. Commission is concerned that order Trading Incident, supra note 16. 225 See ABA Letter at 6–7. entry errors could suddenly and 220 See supra note 13. 226 See Carter Letter at 5.

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Commission recognizes that this could annual ongoing costs. Alternatively, a 1,295 broker-dealers. The Commission ultimately limit the algorithmic trading broker-dealer may choose to purchase a further estimated that the total annual of some smaller proprietary trading risk management solution from an ongoing cost to maintain an in-house firms, and potentially lower overall outside vendor. As stated above, it is risk control management system is trading volume. To the extent that likely that many broker-dealers with $47,300 per broker-dealer,228 or $61.3 lowered trading volume leads to lower market access would be able to million for 1,295 broker-dealers. overall market liquidity, market substantially satisfy the Rule with their For this Adopting Release, the participants may also incur additional current risk management controls and Commission is updating the total annual costs due to lost trading opportunities supervisory procedures, requiring few initial and ongoing technology costs to and the possibility that smaller broker- material changes. However, for others, reflect the revised number of dealers may not be able to aggregate the costs of upgrading and introducing respondents, which has been changed trade flow and obtain favorable tiered the required systems would vary from 1,295 to 1,375 broker-dealers.229 pricing. considerably based on their current The Commission’s per-broker-dealer Although the Commission controls and procedures, as well as their cost estimates of $51,000 for initial costs acknowledges these potential costs, it particular business models. For and $47,000 for annual ongoing costs also recognizes the significant benefits instance, the needs of a broker-dealer remain the same. Commission staff now that the Rule provides to the markets, would vary based on its current systems estimates that the total initial cost for such as the protection of market and controls in place, the internal development teams to develop integrity and efficiency. Although the comprehensiveness of its controls and or substantially upgrade existing risk Rule may indeed impose costs resulting procedures, the sophistication of its control systems would be approximately from increased latency times and client base, the types of trading $70.1 million for 1,375 broker-dealers, reduced liquidity, the Commission strategies that it utilizes, the number of while the total ongoing annual cost to believes that such costs are justified by trading venues it connects to, the maintain in-house risk control the benefits provided in preventing number of connections that it has to management systems would be unfiltered market access and enhancing each trading market, and the volume investor protection. The Rule and speed of its trading activity. account for bonuses, firm size, employee benefits requirements are intended to minimize and overhead. unnecessary and inefficient systemic Commission staff’s discussions with The Commission estimated that the average risk from the markets. industry participants found that broker- initial hardware and software cost is $16,000 per Regarding the comments that the Rule dealers who must develop or broker-dealer. Industry sources estimated that to would create duplicative, unnecessary substantially upgrade existing systems build a risk control management system from scratch, hardware would cost $44,500 and software and costly regulation, the Commission could face several months of work would cost $58,000, while to upgrade a pre-existing continues to believe that, in many cases, requiring considerable time and effort. risk control management system, hardware would particularly with respect to proprietary For example, in the Proposing Release, cost $5,000 and software would cost $6,517. Based trading and more traditional agency the Commission estimated that on discussions with industry participants, the Commission estimated that 95% of all respondents brokerage activities, the Rule 15c3–5 developing a system from scratch could would require modifications and upgrades only, may be substantially satisfied by take approximately three months, while and 5% would require development of a system existing risk management controls and upgrading a pre-existing risk control from scratch. Therefore, the total average hardware supervisory procedures already management system could take and software cost for an initial internal development project would be approximately implemented by broker-dealers. For approximately two weeks. In the (0.95 × $11,517) + (0.05 × $102,500) = $16,066, or these broker-dealers, Rule 15c3–5 Proposing Release, Commission staff $16,000. should have a minimal impact on estimated that the initial cost for an 228 See supra note 202. The Commission current business practices and, internal development team to develop estimated that the average annual ongoing cost of therefore, should not impose significant or substantially upgrade an existing risk $47,300 per broker-dealer consists of $26,800 for technology personnel and $20,500 for hardware and additional costs on these broker-dealers. control system would be $51,000 per software. The Commission estimated that the Moreover, the Commission reiterates broker-dealer,227 or $66.0 million for programmer analyst would work 40% of the total that the Rule does not require, and was hours required for ongoing maintenance, or 115 × never intended to require, multiple or 227 See supra note 199. The Commission hours 0.40 = 46 hours; the senior programmer estimated that the average initial cost of $51,000 per would work 20% of the total hours, or 115 hours duplicative layers of pre-trade controls × broker-dealer consists of $35,000 for technology 0.20 = 23 hours; and the senior systems analyst for a single order. As stated in the personnel and $16,000 for hardware and software. would work 40% of the total hours, or 115 hours × Proposing Release, the Commission As stated in the PRA section, industry sources 0.40 = 46 hours. The total ongoing maintenance × intends these controls and procedures to estimated that the average system development cost for staff was estimated to be 46 hours $193 team consists of one or more programmer analysts, (hourly wage for a programmer analyst) + 23 hours encompass existing regulatory × senior programmers, and senior systems analysts. $292 (hourly wage for a senior programmer) + 46 × requirements applicable to broker- The Commission estimated that the programmer hours $244 (hourly wage for a senior systems dealers in connection with market analyst would work 40% of the total hours required analyst) = $26,818, or $26,800. access, and not to substantively expand for initial development, or 150 hours × 0.40 = 60 The $193, $292, and $244 per hour estimates for upon them. hours; the senior programmer would work 20% of a programmer analyst, senior programmer, and the total hours, or 150 hours × 0.20 = 30 hours; and senior systems analyst, respectively, is from 1. Technology Development and the senior systems analyst would work 40% of the SIFMA’s Office Salaries in the Securities Industry × Maintenance total hours, or 150 hours 0.40 = 60 hours. The 2008, modified by Commission staff to account for total initial development cost for staff was an 1,800-hour work-year and multiplied by 5.35 to As described in the Proposing estimated to be 60 hours × $193 (hourly wage for account for bonuses, firm size, employee benefits Release, broker-dealers with market a programmer analyst) + 30 hours × $292 (hourly and overhead. wage for a senior programmer) + 60 hours × $244 The Commission estimated that the average access may comply with the Rule in (hourly wage for a senior systems analyst) = annual ongoing hardware and software cost is several ways. A broker-dealer may $34,980, or $35,000. $20,500 per broker-dealer. Industry sources choose to internally develop risk The $193, $292, and $244 per hour estimates for estimated that for ongoing maintenance, hardware management controls from scratch, or a programmer analyst, senior programmer, and would cost $8,900 on average and software would senior systems analyst, respectively, is from cost $11,600 on average. The total average hardware upgrade its existing systems; each of SIFMA’s Office Salaries in the Securities Industry and software cost for ongoing maintenance would these approaches has potential costs 2008, modified by Commission staff to account for be $8,900 + $11,600 = $20,500. that are divided into initial costs and an 1,800-hour work-year and multiplied by 5.35 to 229 See supra Section III.C.

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approximately $65.0 million for 1,375 full-time for 2 weeks, would work an the startup estimate of $6,624,000 per broker-dealers. estimated total of 120 burden hours on year. The Commission also considered how the project. The resulting staff cost to The Commission requested comment permitting broker-dealers to allocate risk upgrade and modify a pre-existing risk on the technology cost estimates. compliance responsibilities to a control management system would be Numerous commenters responded by customer that is a registered broker- approximately $27,984 per broker- asserting that the actual technology dealer would affect the Commission’s dealer, or $36.5 million for 1,306 broker- costs will be significantly higher than calculations of total initial and annual dealers. The hardware and software cost the estimates from the Proposing technology costs. As already noted to upgrade and modify a risk control Release.233 Of these, three commenters above, the Commission determined that management system would be $11,517 cited specific technology cost estimates in estimating the additional initial and per broker-dealer, or $15.0 million for of their own. One estimated that the cost ongoing technology costs, these 1,306 broker-dealers. The combined to either build or buy the appropriate considerations would not affect personnel, hardware, and software cost technology alone would be $500,000 to estimated costs in a meaningful way. As would be $51.6 million. $1 million per year; 234 another asserted concluded with the technology burdens, Rather than developing or upgrading that maintenance from outside vendors the Commission expects that any systems, broker-dealers may choose to would cost more than $1 million per additional technology costs that broker- purchase a risk management solution year, while building a solution in-house dealers accrue to add other broker- from a third-party vendor. Potential would cost roughly $750,000; 235 and dealer transactions to their risk costs of contracting with such a vendor another stated that the cost to build the management systems will be justified by were obtained from industry appropriate systems would be more the sponsored broker-dealers’ reduced participants. Here again, the potential than $2 million per year.236 technology costs from relying on other range of costs would vary considerably, The Commission recognizes that broker-dealers’ risk management depending upon the needs of the broker- technology and maintenance costs will systems. Commission staff believes that dealer. For instance, the needs of a vary depending on the size of the broker such an assumption is reasonable given broker-dealer would vary based on its or dealer and the extent to which it the relatively small technology burdens current systems and controls in place, already complies with the requirements that sponsored broker-dealers currently the comprehensiveness of its controls described in the Rule. The Commission have as part of their current risk and procedures, the sophistication of its notes that, like its initial estimates for compliance allocation arrangements. client base, the types of trading technology outsourcing costs, its initial As in the Proposing Release, we strategies that it utilizes, the number of estimates for in-house technology and reiterate that the potential range of costs trading venues it connects to, the maintenance costs are weighted would vary considerably, depending number of connections that it has to averages, and that these estimates skew upon the needs of the broker-dealer. lower because the Commission each trading market, and the volume Returning to the same example used in estimates that, based on discussions and speed of its trading activity. As the Proposing Release, we provide an with various industry participants, the discussed previously, a broker-dealer is illustrative set of calculations for a majority of broker-dealers that provide estimated to pay as much as scenario where 5% of respondents market access, if they are not already approximately $4,000 per month per under the Rule need to build risk fully compliant, are close to full trading venue for a startup contract control management systems from compliance and are not expected to depending on its particular needs. In the scratch, while the other 95% only need incur significant additional technology Proposing Release, the Commission to upgrade and modify their pre-existing costs. Numerous industry sources have estimated $8,000 per month (i.e., risk control management systems. stated that, for brokers-dealers who If 69 broker-dealers—i.e., 5% of the connection to two trading venues), or perform technology maintenance in- 1,375 broker-dealers affected under the $96,000 annually, for a startup 230 house, it would take no longer than two rule—were to build risk control contract. For instance, the or three days to program any management systems from scratch, the Commission estimates that if 69 broker- compliance adjustments. The total initial technology cost would be dealers (or, 5% of respondents) choose Commission therefore continues to approximately $18.7 million. A team of to purchase systems from a third-party believe that its cost estimates for 1.5 people, working full-time for 3 vendor as an alternative to building a technology are reasonable, and retains months, would work an estimated total risk control management system from its technology cost-per-broker-dealer 231 of 720 burden hours on the project. The scratch, the cost to the industry for estimates as proposed. However, the resulting personnel cost to build such a initial startup contracts could be industry-wide technology cost estimate 232 risk control management system would approximately $6,240,000. The has been increased to reflect the revised be approximately $167,904 per broker- Commission preliminarily believes that number of respondents affected under dealer, or $11,585,380 for 69 broker- the annual ongoing cost would be the Rule. dealers. The hardware and software cost significantly less than the initial startup to build a risk control management cost; however, to be conservative, we 2. Legal and Compliance system from scratch would be $102,500 estimate that the annual ongoing cost for Under the Rule, a broker or dealer per broker-dealer, or $7,072,500 for 69 69 broker-dealers would be the same as will be obligated to comply with all broker-dealers. The combined applicable regulatory requirements such personnel, hardware, and software cost 230 See supra Section III.D.1. as exchange trading rules relating to 231 would be $18.7 million. As stated previously, the Commission special order types, trading halts, odd- estimates that 5% of all broker-dealers will require By contrast, if the remaining 1,306 development of a system from scratch. See supra broker-dealers were to upgrade and note 198. Based on discussions with various 233 See Pershing Letter at 4, Fortis Letter at 18, modify their pre-existing risk control industry participants, the Commission believes that STANY Letter at 4–5, Scottrade Letter at 1, Deutsche Letter at 6, Wedbush Letter at 5–6, management systems, the total initial a total of 69 broker-dealers is a reasonable estimate here. ConvergEx Letter at 9, and CBOE Letter at 1, 4. technology cost for those 1,306 broker- 232 69 broker-dealers × $96,000 (annual cost for a 234 See Pershing Letter at 4. dealers would be approximately $51.6 startup contract with a third-party technology 235 See ConvergEx Letter at 9. million. A team of 1.5 people, working provider or service bureau) = $6,624,000. 236 See Wedbush Letter at 6.

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lot orders, and SEC rules under The Commission further estimated managers who participate in this Regulation SHO and Regulation NMS. that the costs of the annual review, process would cost an estimated $1,290 Accordingly, the Commission believes modification of applicable compliance per year.245 The Commission believes that the overall cost increase associated policies and supervisory procedures, that the additional compliance costs for with developing and maintaining and preservation of such records would negotiating and preparing risk compliance policies and procedures is be approximately $30,800 per broker- compliance allocation contracts will be not expected to be significant because dealer, or $39.9 million for 1,295 broker- the same for both initial and ongoing the Rule may be substantially satisfied dealers. Specifically, compliance efforts. by existing risk management controls attorneys who review, document, and Commission staff now estimates that and supervisory procedures already update written compliance policies and the total initial cost for a broker-dealer implemented by brokers-dealer that procedures would cost an estimated to comply with the proposed conduct proprietary trading, traditional $5,400 per year; 240 a compliance requirement to establish, document, and brokerage activities, direct market manager who reviews, documents, and maintain compliance policies and access, and sponsored access. Therefore, updates written compliance policies supervisory procedures would be many of the financial and regulatory and procedures is expected to cost approximately $32,200 per broker- risk management controls specified in $5,160; 241 and the Chief Executive dealer,246 or $44.3 million for 1,375 the Rule—such as prevention of trading Officer, who certifies the policies and broker-dealers. Meanwhile, the total restricted products, or setting of trade procedures, would cost $20,275.242 annual ongoing cost to maintain in- limits—should already be in place and For this Adopting Release, the house risk control management systems should not require significant additional Commission is updating the total initial would be approximately $34,800 per expenditure of resources. and ongoing legal and compliance costs broker-dealer,247 or $47.9 million for In the Proposing Release, the to reflect the revised number of 1,375 broker-dealers. Commission estimated that the initial respondents, which has been changed The Commission believed that the cost for a broker-dealer to comply with from 1,295 to 1,375 broker-dealers.243 ongoing legal and compliance the proposed requirement to establish, Moreover, the Commission is revising obligations under the proposed rule document, and maintain compliance its per-broker-dealer compliance cost would be handled internally because policies and supervisory procedures estimates to account for the additional compliance with these obligations is would be approximately $28,200 per task of negotiating and preparing risk consistent with the type of work that a broker-dealer, or $36.5 million for 1,295 compliance allocation agreements. The broker-dealer typically handles 237 broker-dealers. Specifically, the costs Commission anticipates that compliance internally. The Commission did not for setting credit and capital thresholds attorneys who prepare risk allocation believe that a broker-dealer would likely 238 would be approximately $2,640, and agreements would cost an estimated have any recurring external costs the modification or establishment of $2,700 per year,244 while compliance associated with legal and compliance applicable compliance policies and obligations. procedures would be approximately per work-year. We invited comments on whether The Commission requested comment $25,555 per broker-dealer.239 large bank Chief Executive Officer total on the estimated costs of the legal and compensation is an appropriate proxy for broker- compliance obligations. One commenter 237 dealer Chief Executive Officer total compensation, The Commission has revised the number of asserted that the cost of compliance will respondents affected by the Rule. See supra Section but received none. III.C. 240 20 hours (total annual ongoing compliance exceed 10 to 20 times the amount × 238 The Commission estimated that one hourly burden for a compliance attorney) $270 projected by the Commission. The compliance attorney and one compliance manager (hourly wage for a compliance attorney) = $5,400. commenter noted that the cost of would each require 5 hours, for a total initial The $270 per hour estimate for a compliance receiving and processing market data for burden of 10 hours. See supra Section III.B.2. The attorney is from SIFMA’s Office Salaries in the total initial cost for staff was estimated to be 5 hours Securities Industry 2008, modified by Commission hundreds of thousands of symbols × $270 (hourly wage for a compliance attorney) + staff to account for an 1,800-hour work-year and (including options) alone will exceed 5 hours × $258 (hourly wage for a compliance multiplied by 5.35 to account for bonuses, firm size, the Commission’s estimated compliance manager) = $2,640. employee benefits and overhead. costs.248 Moreover, the commenter The $270 and $258 per hour estimates for a 241 20 hours (total annual ongoing compliance compliance attorney and compliance manager, hourly burden for a compliance manager) × $258 believed that because it would be respectively, is from SIFMA’s Office Salaries in the (hourly wage for a compliance manager) = $5,160. unlikely for a CEO to be a compliance Securities Industry 2008, modified by Commission The $258 per hour estimate for a compliance specialist, a broker or dealer would staff to account for an 1,800-hour work-year and manager is from SIFMA’s Office Salaries in the more likely need to hire a consultant to multiplied by 5.35 to account for bonuses, firm size, Securities Industry 2008, modified by Commission employee benefits and overhead. staff to account for an 1,800-hour work-year and 239 The Commission estimated that one multiplied by 5.35 to account for bonuses, firm size, 1,800-hour work-year and multiplied by 5.35 to compliance attorney and one compliance manager employee benefits and overhead. account for bonuses, firm size, employee benefits would each require 10 hours, while the Chief 242 5 hours (total annual ongoing compliance and overhead. Executive Officer would require 5 hours, for a total hourly burden for a Chief Executive Officer) × 245 5 hours (allocation contracts hourly burden for × initial burden of 25 hours. See supra Section III.B.2. $4,055 (hourly wage for a Chief Executive Officer) a compliance manager) $258 (hourly wage for a The total initial cost for staff was estimated to be = $20,275. The $4,055 per hour figure for a broker- compliance manager) = $1,290. The $258 per hour 10 hours × $270 (hourly wage for a compliance dealer Chief Executive Officer comes from the estimate for a compliance manager is from SIFMA’s attorney) + 10 hours × $258 (hourly wage for a median of June 2008 Large Bank Executive Office Salaries in the Securities Industry 2008, compliance manager) + 5 hours × $4,055 (hourly Compensation data from TheCorporateLibrary.com, modified by Commission staff to account for an wage for a Chief Executive Officer) = $25,555. divided by 1800 hours per work-year. We invited 1,800-hour work-year and multiplied by 5.35 to The $270 and $258 per hour estimates for a comments on whether large bank Chief Executive account for bonuses, firm size, employee benefits compliance attorney and compliance manager, Officer total compensation is an appropriate proxy and overhead. respectively, is from SIFMA’s Office Salaries in the for broker-dealer Chief Executive Officer total 246 The new total initial compliance cost per Securities Industry 2008, modified by Commission compensation, but received none. broker-dealer is $28,200 (Proposing Release staff to account for an 1,800-hour work-year and 243 See supra Section III.C. estimate) + $2,700 + $1,290 (additional costs for multiplied by 5.35 to account for bonuses, firm size, 244 10 hours (allocation contracts hourly burden allocation contracts) = $32,190. employee benefits and overhead. The $4,055 per for a compliance attorney) × $270 (hourly wage for 247 The new total annual ongoing compliance cost hour figure for a broker-dealer Chief Executive a compliance attorney) = $2,700. The $270 per hour per broker-dealer is $30,800 (Proposing Release Officer comes from the median of June 2008 Large estimate for a compliance attorney is from SIFMA’s estimate) + $2,700 + $1,290 (additional costs for Bank Executive Compensation data from Office Salaries in the Securities Industry 2008, allocation contracts) = $34,790. TheCorporateLibrary.com, divided by 1800 hours modified by Commission staff to account for an 248 See Lek Letter at 3.

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review the controls, which would likely resources for other certification dealer,254 or $42.1 million for 1,306 cost between $500,000 and $1 million processes such as the FINRA 3130 broker-dealers. The total initial cost is per year.249 process, as discussed above. The thus estimated to be approximately The Commission continues to believe Commission is adopting Rule 15c3–5(e) $93.6 million. that the cost to develop and maintain as proposed, and is largely retaining its The total annual initial cost for all compliance policies and procedures legal and compliance burden per- 1,375 broker-dealers is estimated to be will not be significant for most brokers- broker-dealer estimates as proposed. approximately $114.4 million.255 dealers. The Commission stresses that 3. Total Cost The total annual ongoing cost for all its estimate of the compliance cost 1,375 broker-dealers to maintain a risk represents an average of the cost The Commission believes that this management control system and annual associated with all compliance Rule would have its greatest impact on review and modification of applicable requirements referenced in the Rule broker-dealers that provide ‘‘unfiltered’’ compliance policies and procedures and, on balance, believes that overall or ‘‘naked’’ access, and that the majority could be approximately as much as costs are accounted for in the $32,200 of broker-dealers with market access are $112.9 million. The annual technology initial cost and the $34,800 ongoing likely to be able to substantially satisfy cost to maintain a risk management annual costs per broker-dealer. the requirements of the Rule with much control system would be approximately Moreover, similar to the technology of their current existing risk $47,300 per broker-dealer,256 or $65 costs, the compliance cost is a weighted management controls and supervisory million for 1,375 broker-dealers, while average that skews lower because most procedures. However, for broker-dealers the cost for annual review and brokers and dealers who already that would need to develop or modification of applicable compliance maintain compliance policies and substantially upgrade their systems the policies and procedures would be procedures will not face significantly cost would vary considerably. approximately $34,800 per broker- We note that the potential range of greater costs. Although several broker- dealer,257 or $47.9 million for 1,375 costs would vary considerably, dealers may indeed incur a cost of broker-dealers. The total annual ongoing depending upon the needs of the broker- compliance that will exceed the amount cost for all 1,375 broker-dealers is dealer and its current risk management estimated in the Proposing Release, the estimated to be approximately $112.9 controls and supervisory procedures. Commission anticipates that these million. It should be noted that the total Once again, we provide an illustrative broker-dealers will be significantly cost estimate has been increased from set of calculations for a scenario where outnumbered by brokers-dealers who the Proposing Release’s total cost 5% of respondents under the Rule need will incur minimal additional costs. estimate to reflect the revised number of to build risk control management With the exception of the additional respondents affected under the Rule. systems from scratch, while the other costs to account for negotiating and The Commission believes that in 95% only need to upgrade and modify preparing risk compliance allocation many cases broker-dealers whose their pre-existing risk control agreements, the Commission retains its business activities include proprietary compliance cost estimates as previously management systems. The Commission estimates that if 69 trading, traditional agency brokerage stated in the Proposing Release. broker-dealers build risk management activities, and direct market access, As already stated above, the systems from scratch and modify their would find that their current risk Commission has in fact accounted for compliance procedures accordingly, the management controls and supervisory the likelihood that the Chief Executive total initial cost could be approximately procedures may substantially satisfy the Officer would not be a compliance as much as $20.9 million. The cost to requirements of the Rule, and require specialist. In the Proposing Release, the build the risk control management minimal material modifications. Such Commission estimated that the initial systems would be $18.7 million for 69 broker or dealers would experience the legal and compliance burden for a CEO broker-dealers,251 while the cost to market-wide benefits of the proposal would constitute only 5 of the 35 total initially develop or modify compliance with limited additional costs related to hours required,250 on average, while procedures for the same would be their own compliance. internal compliance specialists would approximately $32,200 per broker- be responsible for the remainder of the V. Consideration of Burden on dealer,252 or $2.2 million for 69 broker- initial burden. Such a burden allocation Competition, and Promotion of dealers. The total initial cost to build anticipates that compliance experts will Efficiency, Competition and Capital systems from scratch is thus estimated oversee the bulk of responsibilities for Formation to be approximately $20.9 million. establishing credit and capital 258 By contrast, the Commission Section 3(f) of the Exchange Act thresholds and for modifying estimates that if the remaining 1,306 requires the Commission, whenever it compliance policies, while the Chief broker-dealers would upgrade their pre- engages in rulemaking and is required to Executive Officer would retain the existing risk control management consider or determine whether an action senior managerial responsibility to systems and modify their compliance is necessary or appropriate in the public review and certify the controls’ procedures accordingly, the total initial interest, to consider, in addition to the effectiveness. Moreover, the cost would be approximately as much as protection of investors, whether the Commission reiterates that these $93.6 million. The cost to upgrade the action would promote efficiency, compliance obligations are in fact risk control management systems would competition, and capital formation. In consistent with the type of work that a be $51.6 million for 1,306 broker- addition, Section 23(a)(2) of the broker-dealer typically handles dealers,253 while the cost to initially internally, especially since broker- 254 develop or modify compliance See supra Section IV.B.2. dealers typically rely on internal 255 procedures for the same would be $20.9 million (initial cost for 69 broker-dealers building a system from scratch) + $93.6 million approximately $32,200 per broker- 249 Id. (initial cost for 1,306 broker-dealers upgrading pre- 250 As stated above, the Commission now existing systems) = approximately $114.4 million. estimates that the total initial legal and compliance 251 See supra Section IV.B.1. 256 See supra note 228. burden is 50 hours, and not 35. See supra Section 252 See supra Section IV.B.2. 257 See supra notes 240, 241, and 242. III.D.2. 253 See supra Section IV.B.1. 258 15 U.S.C. 78c(f).

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Exchange Act 259 requires the ‘‘naked’’ access to an exchange or an primarily ATSs, continuing to enter the Commission, when making rules under ATS where customer order flow does market. Currently, there are the Exchange Act, to consider the not pass through the broker-dealer’s approximately 50 registered ATSs that impact of such rules on competition. systems or filters prior or to entry on an trade equity securities. The Commission Section 23(a)(2) also prohibits the exchange or ATS, and to provide within the past few years has approved Commission from adopting any rule that uniform standards that would be applications by BATS and Nasdaq to would impose a burden on competition interpreted and enforced in a consistent become registered as national securities not necessary or appropriate in manner. Such requirements may exchanges for trading equities, and furtherance of the purposes of the promote competition by establishing a approved proposed rule changes by two Exchange Act. level playing field for broker-dealers in existing exchanges—ISE and CBOE—to market access, in that each broker or A. Competition add equity trading facilities to their dealer would be subject to the same existing options business. Moreover, on In the Proposing Release, we requirements in providing access. March 12, 2010, Direct Edge received considered in turn the impact of The Rule will require brokers or formal approval from the Commission Proposed Rule 15c3–5 on the market dealers that offer market access, for its platforms to operate as facilities center and broker-dealer industries. including those providing sponsored or to two newly created national securities Information provided by market centers direct market access to customers, to exchanges. We believe that competition and broker-dealers in their registrations implement appropriate risk among trading centers has been and filings with us and with FINRA management controls and supervisory facilitated by Rule 611 of Regulation informs our views on the structure of procedures to manage the financial and NMS,262 which encourages quote-based the markets in these industries. We regulatory risks of this business activity. competition between trading centers; begin our consideration of potential As noted above, we expect there to be Rule 605 of Regulation NMS,263 which competitive impacts with observations costs of implementing and monitoring empowers investors and broker-dealers of the current structure of these markets. these systems. However, we do not to compare execution quality statistics The broker-dealer industry, including believe that the costs overall will create across trading centers; and Rule 606 of market makers, is a highly competitive or increase any burdens of entry into the Regulation NMS,264 which enables industry, with most trading activity broker-dealer industry. customers to monitor order routing concentrated among several dozen large The costs to implement appropriate practices. participants and with thousands of risk management controls and small participants competing for niche supervisory procedures to manage the Market centers compete with each or regional segments of the market. financial and regulatory risks may other in several ways. National There are approximately 5,178 disproportionately impact small-or exchanges compete to list securities; registered broker-dealers, of which 890 medium-sized broker-dealers. In market centers compete to attract order are small broker-dealers.260 The particular, the costs of instituting such flow to facilitate executions; and market Commission estimates that 1,295 controls and procedures could be a centers compete to offer access to their brokers or dealers would have market larger portion of revenues for small- and markets to members or subscribers. In access as defined under the proposed medium-sized broker-dealers than for this last area of competition, one could rule.261 In addition, the Commission larger broker dealers. In addition, to the argue that the ability to access a market estimates that 80 brokers or dealers extent that the cost of obtaining through sponsored access or direct operate registered, active ATSs, bringing sponsored access increases, the market access could substitute for the total estimate of broker-dealers that increases could be a larger portion of the becoming a member or subscriber. Of would be subject to the requirements of revenues of small- and medium-sized course, there are both benefits and the rule to 1,375. Of these 1,375 brokers broker-dealers. This could impair the responsibilities in being a member or or dealers, the Commission estimates ability of small- and medium-sized subscriber that do not accrue directly to that approximately 21 of those are small broker-dealers to compete for order someone using sponsored access or broker-dealers. To limit costs and make routing business with larger firms, direct market access. Nonetheless, to the business more viable, small broker- limiting choice and incentives for extent that these forms of market access dealers often contract with larger innovation in the broker dealer are substitutes for membership, an broker-dealers to handle certain industry. However, the effect on smaller increase in the costs of sponsored access functions, such as clearing and broker-dealers could be mitigated, to or direct market access may make a execution, or to update their technology. some extent, by purchasing a risk potential member more likely to decide Larger broker-dealers typically enjoy management solution from a third-party to become a member or subscriber. At economies of scale over small broker- vendor. the same time, market centers may dealers and compete with each other to The trading industry is a highly reduce the cost of access to members or service the smaller broker-dealers, who competitive one, characterized by ease subscribers in order to attract trading are both their competitors and their of entry. In fact, the intensity of flow to their venue. customers. competition across trading platforms in The Commission solicited comments Rule 15c3–5 is intended to address a this industry has increased dramatically regarding the effect of the Rule on broker-dealer’s obligations generally in the past decade as a result of market competition among market centers and with respect to market access risk reforms and technological advances. broker-dealers. A number of management controls across markets, to This increase in competition has commenters argued that the Rule will prohibit the practice of ‘‘unfiltered’’ or resulted in substantial decreases in lead to small liquidity providers being market concentration, effective driven from the market and an increased 259 15 U.S.C. 78w(a)(2). competition for the securities concentration of firms providing market 260 These numbers are based on the Commission’s exchanges, a proliferation of trading access, thus reducing the available staff review of 2007 and 2008 FOCUS Report filings platforms competing for order flow, and reflecting registered broker-dealers. The number does not include broker-dealers that are delinquent significant decreases in trading fees. The 262 17 CFR 242.611. on FOCUS Report filings. low barriers to entry for equity trading 263 17 CFR 242.605. 261 Proposing Release, 75 FR at 4018. venues are shown by new entities, 264 17 CFR 242.606.

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choice for end-clients.265 Specifically, One commenter contended that the are subsequently broken and enhance one commenter noted in particular that Rule’s measures alone will likely have price efficiency by ensuring that without sponsored access, smaller an insignificant effect on market publicly reported transaction prices are broker-dealers will be unable to integrity and protection of the public valid. compete with larger market participants interest, as they are targeted towards because direct exchange connectivity systemic risk and not investor VI. Final Regulatory Flexibility and lower latency times are cost- protection.268 The Commission Analysis 266 prohibitive for smaller competitors. disagrees with the commenter’s The Commission has prepared the Moreover, smaller broker-dealers rely on delineation between systemic risk and following Final Regulatory Flexibility trade flow aggregation to reach the most investor protection and the implicit Analysis (‘‘FRFA’’), in accordance with favorable fee tiers and overcome the assumption that the two are mutually the provisions of the Regulatory 267 handicap of uncompetitive pricing. exclusive. The Commission strongly Flexibility Act (‘‘RFA’’),269 regarding The Commission acknowledges that believes that by helping to prevent Rule 15c3–5 under the Securities the Rule may indeed have adverse unfiltered sponsored access, the Rule Exchange Act of 1934. competitive effects on small broker- reduces the risk of disorderly markets. dealers. The Commission nevertheless The Rule is expected to bolster A. Need for Rule 15c3–5 places particular emphasis on the investors’ confidence that the markets significant benefits that the Rule are less likely to experience such Over the past decade, the proliferation provides to the markets, such as the unpredictable events, thus increasing of sophisticated, high-speed trading protection of market integrity and market participants’ incentive to remain technology has changed the way broker- efficiency. Although the Rule may invested in the markets and bolstering dealers trade for their accounts and as indeed lead to a consolidation among capital formation. an agent for their customers. Current smaller brokers and dealers that would SRO rules and interpretations governing in turn potentially reduce competition C. Efficiency electronic access to markets have sought among broker-dealers and increase By addressing broker-dealer to address the risks of this activity. trading costs for consumers, the obligations with respect to market However, the Commission believes that Commission believes that such costs are access risk controls across markets, and more comprehensive standards that justified by the benefits provided to by having the effect of prohibiting apply consistently across the markets investors, and the financial system as a ‘‘unfiltered’’ or ‘‘naked’’ access, the Rule are needed to effectively manage the whole, in preventing unfiltered market would provide uniform standards that financial, regulatory, and other risks, access. After careful consideration of the would be interpreted and enforced in a such as legal and operational risks, relevant facts and comments received, consistent manner. Rule 15c3–5 would associated with market access. the Commission has determined that help to facilitate and maintain stability The Commission notes that these risks any burden on competition imposed by in the markets and help ensure that they are present whenever a broker-dealer Rule 15c3–5 is necessary or appropriate function efficiently. trades as a member of an exchange or in the furtherance of the purposes of the In recent years, the development and subscriber to an ATS, whether for its Exchange Act noted above. growth of automated electronic trading own proprietary account or as agent for has allowed ever increasing volumes of its customers, including traditional B. Capital Formation securities transactions across the agency brokerage and through direct multitude of trading centers that A purpose of Rule 15c3–5 is to market access or sponsored access constitute the U.S. national market strengthen investor confidence and, in arrangements. For this reason, new Rule system. The Commission believes that doing so, to give investors greater 15c3–5 is drafted broadly to cover all the risk management controls and incentive to participate in the markets, forms of access to trading on an procedures that brokers and dealers resulting in the promotion of capital exchange or ATS provided directly by a would be required to include as part of formation. In deciding to adopt the broker-dealer. The Commission believes their compliance systems should help Rule, the Commission has given a broker-dealer with market access prevent erroneous and unintended significant consideration to the potential should assure the same basic types of undermining of public confidence in the trades from occurring and thereby contribute to market efficiency. For controls are in place whenever it uses securities markets resulting from its special position as a member of an disorderly markets that could result example, Rule 15c3–5 requires that a broker-dealer with market access exchange, or subscriber to an ATS, to from inadequate risk management access those markets as well as when a controls and unfiltered sponsored implement pre-trade risk management controls that, among other things, broker-dealer operator of an ATS access. The Commission believes that provides access to its ATS to a non- the mitigation of the risk of disorderly prevent the entry of erroneous or duplicative orders. These types of pre- broker-dealer. The Commission, markets should help ensure the integrity however, is particularly concerned of the U.S. markets and provide the trade risk management controls should serve to limit the number of erroneous about the quality of broker-dealer risk investing public with greater confidence controls in sponsored access that intentional, bona fide transactions or unintended orders from entering an exchange or ATS, thereby limiting the arrangements, where the customer order are being executed across the national flow does not pass through the broker- market system. Rule 15c3–5 should occurrence of erroneous or unintended executions. The Commission believes dealer’s systems prior to entry on an promote confidence as well as exchange or ATS. participation in the market by that certainty of an execution is integral enhancing the fair and efficient to the operations of an efficient market. B. Significant Issues Raised by Public operation of the U.S. securities markets, By limiting the potential for erroneous Comment thus promoting capital formation. executions, Rule 15c3–5 should serve to enhance market efficiency by In the Proposing Release, the 265 See Fortis Letter at 16, Jane Street Letter at 2. minimizing the number of trades that Commission requested comment on 266 See Jane Street Letter at 2. 267 Id. 268 See Fortis Letter at 14. 269 5 U.S.C. 604(a).

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matters discussed in the IRFA.270 While Commission continues to believe that significant systems upgrades to comply the Commission did receive comment the potentially negative competitive with the Rule. Therefore, these brokers letters that discussed the overall number effects on small broker-dealers are or dealers should only require limited of respondents that would be affected by justified by the benefits of eliminating updates to their systems to meet the the proposed new rule,271 the the substantial market risks that requisite risk management controls and Commission did not receive any sponsored access imposes on all market other requirements in the Rule. The comments that specifically addressed participants, regardless of their size. As Rule also would impact small brokers or the number of small entities that would the Commission previously stated in the dealers that utilize risk management be affected. Initial Regulatory Flexibility Analysis in technology provided by a vendor or Several commenters stated that the the Proposal, only a small number of the some other third party; however, the Rule would have an impact on smaller broker-dealers would be classified as proposed requirement to directly broker-dealers. The commenters noted ‘‘small businesses.’’ 277 Given the relative monitor the operation of the financial that sponsored access is a competitive importance of safeguarding against the and regulatory risk management tool for small broker-dealers that serves risk of disorderly markets, the controls should not impose a significant to level the playing field between competitive effects that the Rule may cost or burden because the Commission smaller and larger market impose on that small number of understands that such technology participants.272 By prohibiting respondents is appropriate. allows the broker or dealer to unfiltered sponsored access, the Rule exclusively manage such controls.281 C. Small Entities Subject to the Rule would prevent small broker-dealers D. Reporting, Recordkeeping, and Other from offering reduced latency times that For purposes of Commission Compliance Requirements larger entities are able to offer through rulemaking in connection with the RFA, direct exchange connectivity.273 a broker-dealer is a small business if its The Rule will require brokers or Moreover, some commenters believed total capital (net worth plus dealers to establish, document, and that the Rule would hinder small subordinated liabilities) on the last day maintain certain risk management broker-dealers from aggregating trade of its most recent fiscal year was controls and supervisory procedures flow with others to reach more favorable $500,000 or less, and is not affiliated reasonably designed to limit financial fee tiers.274 The commenters asserted with any entity that is not a ‘‘small exposure and ensure compliance with that as a result, the new rule may have business.’’ 278 The Commission staff applicable regulatory requirements as the unintended negative effect of estimates that at year-end 2008 there well as regularly review such controls driving small liquidity providers out of were 1,095 broker or dealers which were and procedures, and document the the market and reducing overall members of an exchange, and 21 of review, and remediate issues discovered marketplace liquidity.275 those were classified as ‘‘small to assure overall effectiveness of such Another commenter noted that for businesses.’’ 279 In addition, the controls and procedures. The financial some smaller proprietary trading firms, Commission estimates that there were and regulatory risk management the expanded risk management 200 brokers or dealers that were controls and supervisory procedures requirements in the Rule would make it subscribers to ATSs but not members of required by the Rule must be under the impossible for their current business an exchange.280 The Commission direct and exclusive control of the models to be successful. In particular, estimates that, of those 200 brokers or broker or dealer with market access. The the commenter asserted that increased dealers, only a small number would be Rule, however, permits a broker-dealer latency times required to send the firms’ classified as ‘‘small businesses.’’ providing market access to reasonably orders through a broker-dealer’s risk Currently, most small brokers or allocate, by written contract, control management systems would render their dealers, when accessing an exchange or over specific regulatory risk trading algorithms ineffective. As a ATS in the ordinary course of their management controls and supervisory result, this type of business model business, should already have risk procedures to a customer that is a would no longer be viable.276 management controls and supervisory broker-dealer, so long as the broker- The Commission recognizes that procedures in place. The extent to dealer providing market access has a small broker-dealers are faced with which such small brokers or dealers reasonable basis for determining that significant competitive concerns from would be affected economically under such customer, based on its position in larger market participants, and that the the Rule would depend significantly on the transaction and relationship with an new rule will eliminate speed the financial and regulatory risk ultimate customer, has better access advantages gained through unfiltered management controls that already exist than the broker-dealer with market sponsored access. However, the in the broker or dealer’s system, as well access to that ultimate customer and its Commission notes that all broker- as the nature of the broker or dealer’s trading information such that it can dealers will be prohibited from offering business. In many cases, the Rule may more effectively implement the unfiltered sponsored access, not just be substantially satisfied by a small specified controls or procedures than small broker-dealers. The Rule may broker-dealer’s pre-existing financial the broker-dealer providing market affect the efficacy of market participant and regulatory risk management access. Each such broker or dealer will trading algorithms. However, the controls and current supervisory be required to preserve a copy of its procedures. Further, staff discussions supervisory procedures and a written 270 See Proposing Release, 75 FR at 4028. with various industry participants description of its risk management 271 See supra Section III.C. indicated that very few, if any, small controls as part of its books and records 272 See, e.g., Jane Street Letter at 1–2; Scottrade broker-dealers with market access in a manner consistent with Rule 17a– Letter at 1; Wedbush Letter at 3–4; ABA Letter at provide other persons with ‘‘unfiltered’’ 4(e)(7) under the Exchange Act. Such 6–7; and Carter Letter at 4–5. regular review will be required to be 273 See Jane Street Letter at 1–2; Wedbush Letter access, which may require more at 3–4; Carter Letter at 4–5. conducted in accordance with written 274 See Jane Street Letter at 1–2. 277 See Proposing Release, 75 FR at 4027. procedures and would be required to be 275 See Jane Street Letter at 1–2; Scottrade Letter 278 17 CFR 240.0–10(c). at 1. 279 See Proposing Release, 75 FR at 4027. 281 The Commission’s understanding is based on 276 See ABA Letter at 7. 280 Id. discussions with various industry participants.

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documented. The broker or dealer will compliance and reporting requirements (ii) Access to trading in securities on be required to preserve a copy of such under the Rule for small entities. an alternative trading system provided written procedures, and documentation Because the Rule is designed to by a broker-dealer operator of an of each such review, as part of its books mitigate, as discussed in detail alternative trading system to a non- and records in a manner consistent with throughout this release, significant broker-dealer. Rule 17a–4(e)(7) under the Exchange financial and regulatory risks, the (2) The term regulatory requirements Act, and Rule 17a–4(b) under the Commission believes that small entities shall mean all federal securities laws, Exchange Act, respectively. should be covered by the Rule. The rules and regulations, and rules of self- In addition, the Chief Executive proposed rule includes performance regulatory organizations, that are Officer (or equivalent officer) will be standards. The Commission also applicable in connection with market required to certify annually that the believes that the Rule is flexible enough access. broker or dealer’s risk management for small broker-dealers to comply with (b) A broker or dealer with market controls and supervisory procedures the Rule without the need for the access, or that provides a customer or comply with the proposed rule, and that establishment of differing compliance or any other person with access to an the broker-dealer conducted such reporting requirements for small exchange or alternative trading system review. Such certifications will be entities, or exempting them from the through use of its market participant required to be preserved by the broker Rule’s requirements. identifier or otherwise, shall establish, or dealer as part of its books and records VII. Statutory Authority document, and maintain a system of risk in a manner consistent with Rule 17a– management controls and supervisory 4(b) under the Exchange Act. Most small Pursuant to the Exchange Act and procedures reasonably designed to brokers or dealers currently should particularly, Sections 2, 3(b), 11A, 15, manage the financial, regulatory, and already have supervisory procedures 17(a) and (b), and 23(a) thereof, 15 other risks of this business activity. and record retention systems in place. U.S.C. 78b, 78c(b), 78k–1, 78o, 78q(a) Such broker or dealer shall preserve a The Rule will require small brokers or and (b), and 78w(a), the Commission copy of its supervisory procedures and dealers to update their procedures and adopts Rule 15c3–5 under the Exchange a written description of its risk perform additional internal compliance Act that would require broker-dealers management controls as part of its books functions. Based on discussions with with market access, or that provide a and records in a manner consistent with industry participants and the customer or any other person with § 240.17a–4(e)(7). A broker-dealer that Commission’s prior experience with market access through use of its market routes orders on behalf of an exchange broker-dealers, the Commission participant identifier or otherwise, to or alternative trading system for the estimates that implementation of a establish appropriate risk management purpose of accessing other trading regular review, modification of controls and supervisory systems. centers with protected quotations in applicable compliance policies and Text of Rule 15c3–5 compliance with Rule 611 of Regulation procedures, and preservation of such NMS (§ 242.611) for NMS stocks, or in records would require, on average, 60 List of Subjects in 17 CFR Part 240 compliance with a national market hours of compliance staff time for system plan for listed options, shall not brokers or dealers depending on their Brokers, Reporting and recordkeeping 282 requirements, Securities. be required to comply with this rule business model. The Commission with regard to such routing services, believes that the business models of ■ For the reasons set out in the preamble, 17 CFR part 240 is amended except with regard to paragraph (c)(1)(ii) small brokers or dealers would of this section. necessitate less than the average of 60 as follows. (c) The risk management controls and hours. PART 240—GENERAL RULES AND supervisory procedures required by E. Agency Action To Minimize Effects REGULATIONS, SECURITIES paragraph (b) of this section shall on Small Entities EXCHANGE ACT OF 1934 include the following elements: (1) Financial risk management Pursuant to Section 3(a) of the ■ 1. The authority citation for part 240 283 controls and supervisory procedures. Regulatory Flexibility Act, the continues to read in part as follows: Commission must consider certain types The risk management controls and of alternatives, including: (1) The Authority: 15 U.S.C. 77c, 77d, 77g, 77j, supervisory procedures shall be 77s, 77z–2, 77z–3, 77eee, 77ggg, 77nnn, reasonably designed to systematically establishment of differing compliance or 77sss, 77ttt, 78c, 78d, 78e, 78f, 78g, 78i, 78j, recording requirements or timetables limit the financial exposure of the 78j–1, 78k, 78k–1, 78l, 78m, 78n, 78o, 78p, broker or dealer that could arise as a that take into account the resources 78q, 78s, 78u–5, 78w, 78x, 78ll, 78mm, 80a– available to small entities; (2) the 20, 80a–23, 80a–29, 80a–37, 80b–3, 80b–4, result of market access, including being clarification, consolidation, or 80b–11, and 7201 et seq.; and 18 U.S.C. 1350, reasonably designed to: simplification of compliance and unless otherwise noted. (i) Prevent the entry of orders that reporting requirements under the rule * * * * * exceed appropriate pre-set credit or capital thresholds in the aggregate for for small entities; (3) the use of ■ 2. Section 240.15c3–5 is added to read each customer and the broker or dealer performance rather than design as follows: standards; and (4) an exemption from and, where appropriate, more finely- coverage of the rule, or any part of the § 240.15c3–5 Risk management controls tuned by sector, security, or otherwise rule, for small entities. for brokers or dealers with market access. by rejecting orders if such orders would The Commission considered whether (a) For the purpose of this section: exceed the applicable credit or capital it would be necessary or appropriate to (1) The term market access shall thresholds; and establish different compliance or mean: (ii) Prevent the entry of erroneous reporting requirements or timetables; or (i) Access to trading in securities on orders, by rejecting orders that exceed to clarify, consolidate, or simplify an exchange or alternative trading appropriate price or size parameters, on system as a result of being a member or an order-by-order basis or over a short 282 See supra Section III.D.2. subscriber of the exchange or alternative period of time, or that indicate 283 5 U.S.C. 603(c). trading system, respectively; or duplicative orders.

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(2) Regulatory risk management procedures described in paragraph (c)(2) effectiveness of such risk management controls and supervisory procedures. of this section to a customer that is a controls and supervisory procedures. The risk management controls and registered broker or dealer, provided Such review shall be conducted in supervisory procedures shall be that such broker or dealer subject to accordance with written procedures and reasonably designed to ensure paragraph (b) of this section has a shall be documented. The broker or compliance with all regulatory reasonable basis for determining that dealer shall preserve a copy of such requirements, including being such customer, based on its position in written procedures, and documentation reasonably designed to: the transaction and relationship with an of each such review, as part of its books (i) Prevent the entry of orders unless ultimate customer, has better access and records in a manner consistent with there has been compliance with all than the broker or dealer to that ultimate § 240.17a–4(e)(7) and § 240.17a–4(b), regulatory requirements that must be customer and its trading information respectively. satisfied on a pre-order entry basis; such that it can more effectively (2) The Chief Executive Officer (or (ii) Prevent the entry of orders for implement the specified controls or equivalent officer) of the broker or securities for a broker or dealer, procedures. dealer shall, on an annual basis, certify (2) Any allocation of control pursuant customer, or other person if such person that such risk management controls and to paragraph (d)(1) of this section shall is restricted from trading those supervisory procedures comply with not relieve a broker or dealer that is securities; paragraphs (b) and (c) of this section, (iii) Restrict access to trading systems subject to paragraph (b) of this section and that the broker or dealer conducted and technology that provide market from any obligation under this section, such review, and such certifications access to persons and accounts pre- including the overall responsibility to shall be preserved by the broker or approved and authorized by the broker establish, document, and maintain a dealer as part of its books and records or dealer; and system of risk management controls and in a manner consistent with § 240.17a– (iv) Assure that appropriate supervisory procedures reasonably 4(b). surveillance personnel receive designed to manage the financial, immediate post-trade execution reports regulatory, and other risks of market (f) The Commission, by order, may that result from market access. access. exempt from the provisions of this (d) The financial and regulatory risk (e) A broker or dealer that is subject section, either unconditionally or on management controls and supervisory to paragraph (b) of this section shall specified terms and conditions, any procedures described in paragraph (c) of establish, document, and maintain a broker or dealer, if the Commission this section shall be under the direct system for regularly reviewing the determines that such exemption is and exclusive control of the broker or effectiveness of the risk management necessary or appropriate in the public dealer that is subject to paragraph (b) of controls and supervisory procedures interest consistent with the protection of this section. required by paragraphs (b) and (c) of investors. (1) Notwithstanding the foregoing, a this section and for promptly addressing By the Commission. broker or dealer that is subject to any issues. Dated: November 3, 2010. paragraph (b) of this section may (1) Among other things, the broker or reasonably allocate, by written contract, dealer shall review, no less frequently Elizabeth M. Murphy, after a thorough due diligence review, than annually, the business activity of Secretary. control over specific regulatory risk the broker or dealer in connection with [FR Doc. 2010–28303 Filed 11–12–10; 8:45 am] management controls and supervisory market access to assure the overall BILLING CODE 8011–01–P

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