Speech by SEC Chairman:
Opening Statement at the SEC Open Meeting: Item 1 — Market Access
Chairman Mary L. Schapiro
U.S. Securities and Exchange Commission
November 3, 2010
Good Morning. This is an open meeting of the U.S. Securities and Exchange Commission on November 3, 2010.
Today, the Commission has three items on its agenda.
First, we will consider whether to adopt a new rule that would require brokers and dealers to have risk controls in place before providing their customers with access to the market.
Second, we will consider a proposed rule designed to prohibit fraud, manipulation, and deception in connection with security-based swaps.
And, third, we will consider whether to propose a rule to protect whistleblowers and to compensate individuals who come forward with information regarding serious securities fraud violations — a rule that stems from the Dodd-Frank Wall Street Reform and Consumer Protection Act.
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First, we will consider whether to adopt a rule that would effectively prohibit broker-dealers from providing customers with “unfiltered” or “naked” access to an exchange or alternative trading system. The rule also would require broker-dealers to have better risk controls when they access the market on behalf of their customers or themselves.
This is part of our effort to address the risks associated with rapid electronic trading strategies that have become more prevalent in recent years. Indeed, over the past decade, we have seen significant technological developments and advances in trading practices that have had an impact on our markets. And, for nearly a year, the SEC staff has been reviewing the structure of our markets so that we can take the steps necessary to ensure it is as fair and efficient as possible. This rulemaking is one such step.
As part of that review, in January, we issued a concept release seeking comment on a broad range of equity market structure issues. And, we have proposed a series of market-reform rules — rules that would effectively eliminate flash orders, regulate non-public trading interest, establish a large trader reporting system and implement a consolidated audit trail. In addition, we have approved single stock circuit breaker rules that would pause trading when a stock moves too far, too fast.
The rule we consider today focuses on a practice whereby broker-dealers hand their customer a special “pass” to access the markets — known as the market participant identifier. The customer, in turn, then gains access to the applicable exchange or ATS. This is known as sponsored access or direct access.
Under some access arrangements, the customer simply bypasses the broker-dealer entirely — and in the process bypasses the broker-dealer’s risk management controls as well. Through this type of arrangement, known as “unfiltered” or “naked” access, the customer places an order that flows directly into the markets. The order does not first go through the broker-dealer’s systems — and is not subject to any pre-screening by the broker-dealer.
As I said when we proposed this rule, we are concerned that order entry errors in this setting can disrupt markets and, suddenly and significantly make a broker dealer or other market participants financially vulnerable.
In fact, the potential impact of inappropriate trading has become more severe as our securities markets have become more automated, and high-speed trading more prevalent. Additionally, as the events of May 6 demonstrated, the financial markets today are highly-inter-connected, and an event in one market can rapidly spread throughout the financial system.
To address these risks, today’s rule — Rule 15c3-5 — recognizes the important gatekeeper role that broker-dealers play in our securities market, by prohibiting broker dealers from offering customers naked access.
Specifically, the rule will require broker-dealers with market access to establish risk management controls and supervisory procedures reasonably designed to limit their financial exposure and ensure compliance with regulatory requirements.
These controls and procedures should, among other things, help prevent erroneous orders from being entered into the markets, keep customer trading within appropriate credit limits, and assure the broker-dealer complies with applicable regulatory requirements.
With very limited exceptions, these risk management controls and procedures must be under the direct and exclusive control of the broker-dealer with market access. This should substantially restrict the practice by some broker-dealers of delegating the implementation and maintenance of their risk management controls to their customers, and the particular dangers that arise when a customer, effectively, is allowed to police itself.
I have previously likened this to giving your car keys to a friend who doesn't have a license and letting him drive unaccompanied. This rule would, in effect, require that the broker-dealer not only remain in the car, but also maintain control of it. In that way, we can all be assured the rules of the road will be observed before the car is ever put into drive.
The risk management controls and supervisory procedures required by this rule would substantially reduce the chance that erroneous or improper trading activity could disrupt the markets or impact the financial system as a whole.
I would like to thank the staff of the Division of Trading and Markets for their work on this matter, specifically Robert Cook, Jamie Brigagliano, David Shillman, John Roeser, Marc McKayle, Theodore Venuti, and Daniel Gien. I would also like to thank our colleagues in the Office of the General Counsel, specifically David Becker, Meredith Mitchell, David Blass, David Dimitrious, Deborah Flynn as well as in the Division of Risk, Strategy, and Financial Innovation, Henry Hu, Adam Glass, Amy Edwards, Cecilia Caglio, and Chuck Dale for their contributions and collaborative efforts. Finally, I would like to thank the other Commissioners and all of our counsels for their work and comments on the rule.
Now I'll turn the meeting over to Robert Cook, Director of the Division of Trading and Markets, to hear more about the Division’s recommendation.