Why brokerages prefer proprietary trading over winning new clients
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Consistent with the increased regulatory scrutiny of proprietary trading firms — and high frequency trading firms in particular—the Securities and Exchange Commission SEC recently proposed amendments to SEC Rule 15b also referred to herein as the "Rule" under the Securities Exchange Act of "Exchange Act" that would, if adopted in their current form, require virtually all proprietary trading firms that currently are registered as broker-dealers with the SEC to become members of the Financial Industry Regulatory Authority FINRA.
In particular, any registered broker-dealer that engages in "off-exchange" trading would be required to join FINRA unless one of the very narrow exemptions in the proposed amended version of the Rule applied. As set forth in greater detail below, FINRA membership would impose upon such firms a variety of new obligations and associated costs. Off-exchange trading refers to any securities transaction in an exchange-listed security:.
The SEC has proposed that the contemplated amendments become effective days after publication in the Federal Register of the final rules.
Under Section 15 b 8 of the Exchange Act, an SEC-registered broker-dealer may not effect transactions in, or attempt to induce the purchase or sale of, any security  unless the firm is a member of a registered national securities association or effects transactions in securities solely on a national securities exchange of proprietary trading brokers it is a member.
FINRA currently is the only registered national securities association. However, Proprietary trading brokers 15 b 9 of the Exchange Act allows the SEC, by rule or order, to exempt broker-dealers from the obligation to become a member of a national securities association under Section 15 b 8. Pursuant to this authority, the SEC adopted Rule 15b Currently, Rule 15bexempts a broker-dealer from the obligation to become a FINRA member if it meets each of the following requirements:.
Accordingly, a proprietary trading proprietary trading brokers that is registered with the SEC as a broker-dealer, is a member of a national securities exchange and carries no customer accounts may engage in unlimited proprietary trading off-exchange without triggering any proprietary trading brokers to be a member of FINRA.
The SEC takes the position that as a general matter an exchange is typically best suited to regulate trading on the exchange, and a registered national securities association i. Rule 15b was adopted in accordance with these principles by exempting broker-dealers that engage only in non-customer business and exclusively or almost exclusively on an exchange of which they are a member, from the requirement of becoming a member of a securities association.
Broadly speaking, this exemption proprietary trading brokers based on the theory that the exchange of which such a firm is a member is best-situated to effectively regulate the firm, and additional regulation by a securities association is therefore proprietary trading brokers. Notwithstanding this general viewpoint, the SEC explains in its proposed rulemaking release  that the inclusion of the de minimis allowance in the Rule was meant to permit a firm that does only non-customer business and does virtually all of its business on an exchange of which it is a member such as a floor broker or exchange specialistto engage in limited off-exchange business without becoming obligated to join FINRA.
For example, the Rule permits an exchange specialist to receive a nominal amount of commissions on occasional off-exchange transactions for accounts it refers to other broker-dealers. In other words, the essential purpose of the Rule, according to the SEC, was to allow floor brokers and exchange specialists to engage in very limited off-exchange activities associated with or ancillary to their floor-based activities. Despite the fact that the purpose proprietary trading brokers the Rule was to accommodate limited ancillary activities of floor-based businesses, the Rule itself does not explicitly so limit its scope.
Instead, the Rule as currently written allows a member of a national securities exchange that has no floor presence whatsoever to engage in unlimited off-exchange proprietary trading activity without becoming a member of a national proprietary trading brokers association.
Accordingly, as the nature of the nation's securities markets has changed over time from primarily manual to primarily automated, many broker-dealers began relying on the Rule 15b exemption. The SEC notes that these firms often engage in high-frequency trading strategies and effect transactions across the full range proprietary trading brokers exchanges and off-exchange markets by using complex electronic trading strategies and technology that generate proprietary trading brokers order and transaction volume on the national market system.
For example, statistics cited by proprietary trading brokers SEC indicate that duringand32 percent, 40 percent, and 48 percent, respectively, of orders sent directly to alternative trading systems ATSs came from non-FINRA members. From the SEC's perspective, many of the largest and most active cross-market proprietary trading firms, which typically have no exchange floor presence at all proprietary trading brokers that account for a substantial amount of the activity in off-exchange markets, have avoided FINRA membership.
Therefore, the SEC believes that amendment of Rule 15b proprietary trading brokers necessary "to better align the scope of its exemption, in light of today's market activity, with Section 15 b 8 of the Exchange Act and the Commission's original purpose in adopting Rule 15b, which was to accommodate broker-dealer activities ancillary to proprietary trading brokers floor-based business while preserving the traditional role of the exchange as the entity best suited proprietary trading brokers regulate member conduct on the exchange" and to provide for oversight of the significant off-exchange activities of various proprietary trading firms by the self-regulatory organization SRO best-suited for that role-FINRA.
As proposed, the amended Rule will narrow the scope of off-exchange activities in which a broker-dealer may engage and still rely upon the Rule to avoid becoming a member of FINRA. The amended Rule does this by eliminating the de minimis allowance and replacing it with provisions limiting the off-exchange trading of a firm seeking to rely on the Rule to transactions designed to hedge risks arising from floor-based activities and transactions that prevent trade-throughs in accordance with Regulation NMS.
In particular, the changes to the Rule as contemplated by the SEC proposal are reflected in the following chart:. Current Rule 15b Is a member of a national securities exchange. Proposed Amended Rule 15b Is a member of a national securities exchange.
Effects transactions in securities solely on a national securities exchange proprietary trading brokers which it is a member,  except that:. The Floor Member Hedging Exception is narrowly tailored to satisfy the underlying purpose of the Rule as described by the SEC—that is, to allow very limited activities arising from the floor-based activities of a floor-based firm, on markets other than an proprietary trading brokers on which such firm is a member.
A broker-dealer seeking to rely on the Floor Member Hedging Exception proprietary trading brokers be required to adopt and enforce written policies and procedures reasonably designed to:. The Regulation NMS Routing Exception would replace the provision in Rule 15b stating that gross income derived from transactions through the Intermarket Trading System need not be counted for purposes of compliance with the de minimis allowance.
Generally, Rule of Regulation NMS protects automated quotes that proprietary trading brokers the bed bid or offer of a national securities exchange or registered national securities association. National securities exchanges route orders through broker-dealers to other trading centers to comply with Rule Accordingly, the Regulation NMS Routing Exception would allow a broker-dealer to effect off-exchange transactions solely to comply with Rule without falling outside of the Rule 15b exemption and being required to become a FINRA member.
The proposed amendments would severely limit the scope of the Rule proprietary trading brokers exemption as it exists today and effectively render the exemption unavailable for proprietary broker-dealer firms. In particular, the revised exemption would apply to a broker-dealer that effects transactions other than on a national securities exchange of which it is a member only for the purpose of either: Consequently, and because there is no de minimis exception of any sort in the proposed rule, a single off-exchange trade, including on an exchange of which the proprietary broker-dealer firm is not a member even if through another broker-dealer that is a member of such exchange proprietary trading brokers, presumably would trigger the obligation to become a FINRA member.
The FINRA membership requirement would apply regardless of whether the proprietary trading broker-dealer trades exclusively on ATSs or other off-exchange markets, on exchanges of which it is not a member or some combination of the two.
Accordingly, if the proposed Rule amendments are adopted, a proprietary trading firm likely could avoid FINRA membership only if: With respect to the first such option, a proprietary trading firm's ability to operate without triggering an obligation to register with the SEC as a dealer requires careful consideration. Under the Exchange Act, a dealer is "any person proprietary trading brokers in the business of buying and selling securities … for such person's own account through a broker or otherwise" and is required to register with the SEC as such.
However, "a person that buys or sells securities … for such person's own account, either individually or in a fiduciary capacity, but not as a part of a regular business," is excluded from the definition of "dealer" under the Exchange Act. The second option above i. The FINRA membership application process can be a time-consuming undertaking, typically requiring significantly more time than the exchange membership approval process.
Generally speaking, applying for FINRA membership requires completion and submission of, at a minimum:.
Applicants also typically are subject to a pre-membership interview conducted by FINRA staff members. The process may take up to six months or longer and often requires substantial back-and-forth with FINRA before approval is granted.
Although this oversight relates to such firms' obligations under exchange rules and federal securities laws and not FINRA rules, at a proprietary trading brokers many proprietary trading firms already are familiar with FINRA as an examination authority. Nonetheless, FINRA membership will impose upon proprietary trading firms new obligations that will require such firms to proprietary trading brokers costs and modify existing processes. The above are just a few of the new obligations that will apply to proprietary trading firms that would be required to join FINRA if the amended Rules are adopted and implemented.
Of course, once an HFT or other proprietary trading firm becomes a FINRA member, to proprietary trading brokers extent that FINRA identifies any alleged abusive proprietary trading brokers violative conduct by such firm, it will have jurisdiction to employ the full range of its investigative and disciplinary powers to hold the firm and its registered personnel accountable.
The SEC has set proprietary trading brokers deadline of June 1, for comments on the proposed rulemaking. Throughout the Rule Release, the SEC has identified various issues and questions for which comments are sought. Notably, during the open meeting concerning the proposed amended Rule, two SEC Commissioners expressed reservations regarding the need for the contemplated amendments to Rule 15b These Commissioners asked in particular that proprietary trading brokers address whether the benefits of the proposed amendments such as the provision of additional trading data to FINRA outweigh the costs such as the increased regulatory burdens and costs upon proprietary trading firms that will have to become FINRA members under the proposed amendmentsand to address whether the proposed amendments would create an additional barrier to entry for a new national securities association as FINRA currently is the only proprietary trading brokers association proprietary trading brokers existence.
By eliminating the provisions in Rule 15b that allow proprietary trading firms proprietary trading brokers are registered with the SEC to avoid becoming FINRA members, the SEC's proposal, if adopted, could significantly change the costs, burdens and regulatory risks associated with the operation of such firms. Accordingly, proprietary trading firms that are registered as broker-dealers but are not FINRA members would be proprietary trading brokers to carefully consider what impact the proposal might have on them and, if appropriate, to submit comments to the SEC.
Off-exchange does not refer to transactions in securities that are not listed on a national securities exchange. Rule Release at p. As an example, the SEC's Rule 13h-1 Large Trader Reporting expressly excludes a stock loan or equity repurchase agreement from its scope.
However, such firms have only a limited obligation to report such information. In particular, under Nasdaq Stock Market Rule A "Proprietary Trading Firms shall be required to comply with [the FINRA order data transmission requirements] … only when they receive a request from Nasdaq Regulation to submit order information with respect to specific time periods identified in such request.
Also, many firms rely upon their clearing brokers to submit OATS reports on their behalf pursuant to their clearing agreements. Aguilar, March 25, available here. Introduction Consistent with the increased regulatory scrutiny of proprietary trading firms — and high frequency trading firms in particular—the Securities and Exchange Commission SEC recently proposed amendments to SEC Rule 15b also referred to herein as the "Rule" under the Securities Exchange Act of "Exchange Act" that would, if adopted in their current form, require virtually all proprietary trading firms that currently are registered as broker-dealers with the SEC to become members of the Financial Industry Regulatory Authority FINRA.
Off-exchange trading refers to any securities transaction in an exchange-listed security: The Current Rule Under Section 15 b 8 of the Exchange Act, an SEC-registered broker-dealer may not effect transactions in, or attempt to induce the purchase or sale of, any security  unless the firm is a member of a registered national securities association or effects transactions in securities solely on a national securities exchange of which it is a member.
Currently, Rule proprietary trading brokers a broker-dealer from the obligation to become a FINRA member if it meets each of the following requirements: The Stated Purpose of Rule 15b The SEC takes the position that as a general matter an exchange is typically best suited to regulate trading on the exchange, and a proprietary trading brokers national securities association i. The SEC's Rationale for Amending the Rule Despite the fact that the purpose of the Rule was to accommodate limited ancillary activities of floor-based businesses, the Rule itself does not explicitly so limit its scope.
In particular, the changes to the Proprietary trading brokers as contemplated by the SEC proposal are reflected in the following chart: Description Any broker or dealer required by Section 15 b 8 of the Exchange Act to become a member of a registered national securities association i. Such gross income limitation does not apply to income derived from transactions 1 for the dealer's own account with or through another registered broker or dealer or 2 through the Intermarket Trading System.
A dealer that conducts business on the floor of a national securities exchange may effect transactions off the exchange, for the dealer's own account with or through another registered broker or dealer, that are solely for the purpose of hedging the risks of its floor-based activities, by reducing or otherwise mitigating the risks thereof the Floor Member Hedging Exception ; and A broker or dealer may proprietary trading brokers transactions off the exchange resulting from orders that are routed by a national securities exchange of which it is a member to prevent trade-throughs on that national securities exchange consistent with Rule of Regulation NMS the Regulation NMS Routing Exception.
A broker-dealer seeking to rely on the Floor Member Hedging Exception would be required to adopt and enforce written policies and procedures reasonably designed to: Generally speaking, applying for FINRA membership requires completion and submission of, at a minimum: The TAF is generally assessed on FINRA-member firms for all equity sales transactions that are not performed in a broker-dealer's capacity as a registered exchange specialist or market maker. The circumstances in which Rule applies are relatively broad and member firms typically must submit continuing membership applications in connection with most, if not all, material changes in their business activities or ownership.
The Rule process is largely similar to the initial membership application process, and can require a substantial amount of time, effort and expense. Approval by FINRA is required prior to a firm engaging in any new or modified activities that otherwise require the submission of a continuing membership application.
This is a serious problem because, according to FINRA's current Chairman, certain market participants disperse their trading activity across multiple markets in an attempt to hide various forms of market abuse, including layering, spoofing, algorithm gaming, and wash sales. The proposed amendments to Rule 15b will help provide FINRA and proprietary trading brokers other associations proprietary trading brokers may be formed in the future with a richer and more detailed audit trail, which will help them spot abusive trading practices more effectively.
The SEC requests comment generally on whether narrowing or broadening the current exemption is appropriate. Are there off-exchange transactions between two non-FINRA member firms that occur that proprietary trading brokers not reported? The SEC seeks data indicating how many entities rely either on Rule 15b in its current form or exclusively on the statutory exception in Section 15 b 8 of the Exchange Act, and asks whether in lieu of the proposed amendments, the SEC should require broker-dealers relying on Rule 15b to report such reliance to the SEC or the exchange of which the proprietary trading brokers is a member.
If the SEC were instead to eliminate Rule 15b altogether, proprietary trading brokers many broker-dealers would: Would implementation of the proposed amendments have an effect on market liquidity and if so, what would that effect be? Could broker-dealers that currently rely on the Rule respond to its elimination in other ways to avoid FINRA membership? Would membership by such firms in multiple exchanges prove an efficient and effective substitute for Proprietary trading brokers membership?
Should the level of off-exchange activity affect the ability of a firm to be exempt from FINRA membership? Why or why not? Fund the general central registration depository WebCRD account from which registration and application fees will be paid. Complete and submit hard copy "entitlement" proprietary trading brokers and notarized Form BD.
Submit required registration forms, e. Submit completed Form NMA and attachments. Applicants are also required to fund, via electronic funds transfer, their proprietary trading brokers WebCRD accounts so that applicable registration and application fees can be drawn from the online account. Upon approval of the entitlement and funding of the account, applicants can begin submitting Forms U4 for all registered persons, Form BR for branch offices, and Form NMA and attachments.