CLIENT MEMORANDUM RECENT SEC MARKET STRUCTURE INITIATIVES The Securities and Exchange Commission (the “SEC”), continuing its efforts in the area of market structure, recently: • voted to adopt Rule 15c3-5 under the Securities Exchange Act of 1934, which would effectively prohibit a broker-dealer from providing customers with “unfiltered” or “naked” access to an exchange or an alternative trading system (“ATS”);1 and • approved amendments to self-regulatory organization (“SRO”) rules to prohibit so-called “stub quotes.”2 The compliance date for Rule 15c3-5 is July 14, 2011. The planned implementation date for the stub quote rules is December 6, 2010. Overviews of the new rules are set out below. Rule 15c3-5 In the release adopting Rule 15c3-5 (the “Adopting Release”), the SEC states that customers of broker-dealers, particularly sophisticated institutional customers, have begun using technology to place orders “with little or no substantive intermediation by their broker-dealers,”3 giving rise to “direct market access” or “sponsored market access.” This type of market access generally involves an institutional or individual customer who uses the broker-dealer’s market participant identifier (“MPID”) or other mechanism to access an exchange or ATS electronically. “Direct market access” typically refers to a customer securities order that flows through a broker-dealer’s systems before entering the markets. “Sponsored access” typically involves a customer securities order that flows directly to the markets without first passing through a broker-dealer’s systems. Irrespective of how such orders flow to the markets, the broker-dealer is responsible for all trading that occurs using its MPID. 1 Risk Management Controls for Brokers or Dealers with Market Access, Exchange Act Release No. 63241, 75 Fed. Reg. 69792 (Nov. 15, 2010), available at http://www.sec.gov/rules/final/2010/34-63241.pdf. For additional information, see our memorandum on proposed Rule 15c3-5 at http://www.willkie.com/files/tbl_s29Publications/FileUpload5686/3213/Further%20SEC%20Action%20O n%20Market%20Structure%20Issues.pdf. 2 Self-Regulatory Organizations; BATS Exchange, Inc.; NASDAQ OMX BX, Inc.; Chicago Board Options Exchange, Incorporated; The Chicago Stock Exchange, Inc.; Financial Industry Regulatory Authority, Inc.; The NASDAQ Stock Market LLC; National Stock Exchange, Inc.; New York Stock Exchange LLC; NYSE Amex LLC; NYSE Arca, Inc.; Order Granting Accelerated Approval to Proposed Rule Changes, as Modified by Amendment No. 1, to Enhance the Quotation Standards for Market Makers; Exchange Act Release No. 63255 (Nov. 5, 2010), available at http://www.sec.gov/rules/sro/bats/2010/34-63255.pdf (the “Stub Quotes Release”). 3 Adopting Release at 69793. NEW YORK WASHINGTON PARIS LONDON MILAN ROME FRANKFURT BRUSSELS in alliance with Dickson Minto W.S., London and Edinburgh The SEC is particularly concerned about sponsored access arrangements in which a broker- dealer does not employ any pre-trade risk management controls, referred to as “unfiltered,” or “naked,” access. The concern is that if a customer has such access, the broker-dealer might be unaware of the trading activity being effected under its market identifier and therefore would be unable to control such activity.4 This lack of oversight could raise risks relating to potential breaches of credit or capital limits, the submission of erroneous orders, the failure to comply with SEC or exchange trading rules, or the failure to detect other unlawful conduct. The SEC believes that risk management controls and supervisory procedures that are not applied on a pre- trade basis or that are not under the broker-dealer’s exclusive control are inadequate to address risks associated with direct market access or sponsored access that could pose a significant danger to the U.S. national market system. General Requirements Rule 15c3-5(b) requires a broker-dealer with “market access,” as defined in the rule, or that provides another party with access to an exchange or ATS through use of the broker-dealer’s MPID or through other means, to establish, document, and maintain a system of risk management controls and supervisory procedures designed to manage the financial, regulatory and other risks associated with providing such access. The Rule applies to all securities trading on an exchange or ATS, including equities, options, exchange-traded funds, debt securities and security-based swaps. Market Access The definition of “market access” in Rule 15c3-5(a)(1), as adopted, is broader than the definition that was set out in proposed Rule 15c3-5, and determines to which broker-dealers the rule applies and the scope of the necessary risk management controls and supervisory procedures that such broker-dealer must apply on a pre-trade basis. The term “market access,” as set out in proposed Rule 15c3-5, would have applied to access to exchanges but not access to ATSs. Accordingly, it would not have encompassed a non-broker-dealer market participant that subscribes to ATSs or a broker-dealer that operates an ATS and provides access to the ATS to non-broker-dealer market participants. As adopted, however, Rule 15c3-5(a)(1) defines “market access” to include “access to trading in securities on an alternative trading system provided by a broker-dealer operator of an alternative trading system to a non-broker-dealer.” According to the SEC, a “broker-dealer operator of an ATS is the best positioned broker-dealer to implement the risk management controls, particularly pre-trade controls.”5 A broker-dealer operator of an ATS would have market access for purposes of the rule if it provides non-broker-dealer subscribers access to the ATS and it would, therefore, be subject to the requirements of Rule 15c3-5. 4 Adopting Release at 69793. 5 Id. at 69797. - 2 - As adopted, Rule 15c3-5(a) also adds an exception to the definition of market access. The SEC notes that exchanges and ATSs use both affiliated and unaffiliated broker-dealers to provide outbound order routing services to access other trading centers with protected quotations so that the exchanges and ATSs may comply with Rule 611 of Regulation NMS or a national market system plan for listed options.6 Orders subject to outbound routing would fall within the definition of market access and therefore be subject to Rule 15c3-5, even though such orders would first have to flow through broker-dealer systems subject to risk controls required by Rule 15c3-5 before being submitted to an exchange or ATS. To address this issue, the SEC adopted an exception from the definition of “market access” in paragraph (b) of Rule 15c3-5 for broker- dealers that provide outbound routing services for the sole purpose of accessing other trading centers with protected quotations on behalf of an exchange or ATS in order to comply with Rule 611 of Regulation ATS or with a national market system plan for listed options. Risk Management Controls Rule 15c3-5(c) outlines the financial and regulatory risk management controls and supervisory procedures that a broker-dealer providing direct market access should adopt. Financial Risk Management Controls A broker-dealer’s financial risk management controls and supervisory procedures should be designed to limit the broker-dealer’s financial responsibility arising from granting market access to others. Rule 15c3-5(c)(1) requires such controls and procedures to be reasonably designed to (i) prevent the entry of orders that exceed appropriate credit or capital limits in the aggregate for each customer and the broker-dealer, and (ii) prevent the entry of erroneous orders by rejecting orders that exceed specified price or size parameters, either on an order-by-order basis or over a short period of time, or that indicate duplicative orders. Given the speed of electronic markets, the SEC believes that a broker-dealer’s financial risk management controls and supervisory procedures should be “systematized and automated” and applied on a pre-trade basis. Such controls should block orders that do not comply with the controls from being routed to a securities market. Controls should be reasonably designed to detect malfunctions of automated systems that could lead to erroneous orders, as well as to block the routing of erroneous orders entered manually. Moreover, the broker-dealer is required to set a credit threshold for each customer with market access, as well as to set appropriate capital thresholds for the broker-dealer’s proprietary trading, and to institute controls and procedures to help ensure that the credit or capital thresholds are not exceeded. If appropriate, credit and capital limits could be established by sector, security, or otherwise. 6 Adopting Release at 69799. Rule 611, commonly referred to as the “trade through rule,” requires exchanges and ATSs to, among other things, establish, maintain, and enforce written policies and procedures reasonably designed to prevent trade-throughs on such exchanges and ATSs of protected quotations in NMS stocks. Exchanges and ATSs typically comply with this requirement, in part, by using an affiliated or unaffiliated broker-dealer to route orders that the exchanges and ATSs receive to other trading centers displaying protected quotations. - 3 - Rule 15c3-5(c)(1)(i) permits a broker-dealer to set a reasonable aggregate credit limit for each customer, then set sub-limits to be applied at each exchange or ATS to which the broker-dealer provides access that, when added together, equal the aggregate limit.7 The SEC notes that the sub-limit approach “would necessarily require that, when assessing the customer’s credit exposure at one market center, the broker-dealer assume that the maximum credit limit has been reached by the customer at all other exchanges and ATSs to which it provides access.”8 That is, a customer’s credit sub-limit at one market center could not be increased to reflect an unused but still available credit sub-limit at another market center.