SEC Proposes to Tighten Market Access Rules

The SEC yesterday approved the issuance of two proposals, one of which would prohibit broker-dealers from providing customers with unfiltered access to an exchange or an alternative trading system. The second proposal is in the form of a concept release seeking comments on the U.S. equity markets. Chair Mary Schapiro said these latest initiatives continue the SEC’s efforts to restore investor confidence and ensure that the markets are fair and efficient.

The proposal relating to market access responds to the Commission’s concerns about some sophisticated customers that use broker-dealers’ market participant identifiers to place their own orders and execute their own high speed trades, known as direct market or sponsored access. In some arrangements, customers may place an order without passing through the broker-dealers’ systems and without being pre-screened, which is referred to as unfiltered or naked access. Some reports have estimated that naked access accounts for 38% of the daily volume for equities traded in the U.S. markets.

Orders that bypass the broker-dealer completely may lead to entry errors and could make a broker-dealer or other market participants financially vulnerable, according to Schapiro. She referred to an incident in September 2008 in which a market participant submitted numerous erroneous orders that led to a significant market drop in the value of a company’s shares. The trades had to be canceled and the closing price of the shares had to be adjusted.

A broker-dealer that provides access is legally responsible for all trading activity that occurs under its market participant identifier. Under the proposed rules, broker-dealers would have to adopt effective pre-trade risk management controls and supervisory procedures if they provide market access to others. The controls would prohibit unfiltered access and would ensure more supervision over customers who are given access.

The proposal would require broker-dealers to design controls that would help prevent the entry of orders that exceed the pre-set credit or capital thresholds, or that appear to be erroneous. The controls must be designed to ensure compliance with all regulatory requirements that apply to market access, and must be applied on a pre-trade basis before orders are routed to an exchange or an ATS. The proposal would also require that broker-dealers regularly review the effectiveness of their risk management controls and promptly address any problems.

The comment period will be open for 60 days.

Concept Release on Equity Market Structure

The SEC’s concept release on the equity market structure will seek comments on the performance of the current market structure, the strategies and tools used by high frequency traders, and dark liquidity in all of its forms. The questions include whether the current highly automated, high speed market structure is fundamentally fair for investors. Among the goals of the review is an assessment of how all sizes of investors are faring in the current market structure. The comment period will be open for 90 days.