Broker-dealers who trade off-exchange, including high-frequency traders, will be required to register with the Financial Industry Regulatory Authority once a rule change proposed on Wednesday by the Securities and Exchange Commission is finalized.
Chairman Mary Jo White explained the reasoning behind the proposed amendment to Rule 15b9-1, as recommended by the Division of Trading and Markets. Recognizing the role of self-regulatory organizations (SROs), the Exchange Act requires broker-dealers to be members of national securities associations unless they limit their business to an exchange in which they are a member. Each exchange is an SRO with primary responsibility to regulate its members’ activity on that exchange. A national securities association, such as FINRA, is also an SRO with the responsibility for regulating off-exchange trading.
The rule, as currently written, allows many broker-dealers the ability to engage in off-exchange proprietary trading without becoming members of FINRA. The proposal “is designed to close this regulatory gap,” White said.
The current rule, she explained prior to the Commission’s vote, was implemented when equity markets were dominated by floor-based exchanges that could readily regulate all of their members’ trading activity. “That is not our market today,” she said. “Trading is now dominated by computer algorithms and active cross-market proprietary trading firms have emerged as significant market participants.” These firms, she said, account for nearly half of all orders sent to alternative trading systems, yet rely on the same exemption intended for floor brokers.
The proposed amendments would narrow the exemption that currently exempts certain brokers-dealers from membership in a national securities association if they are a member of a national securities exchange, carry no customer accounts, and have annual gross income of no more than $1,000 that is derived from securities transactions effected beyond a national securities exchange they are a member of. Income derived from proprietary trading conducted with or through another broker-dealer does not count against the $1,000 limit.
“This measure would significantly strengthen regulatory oversight over active proprietary trading firms and the strategies they use,” White said.
Commissioner Luis A. Aguilar called the proposal “an important step in improving market oversight.” “Requiring HFTs to become members of a registered national securities association or of all the exchanges on which they trade will provide a more complete and detailed picture of their cross-market trading activity,” he said, adding that this insight will “help regulators spot new types of abuses that may develop in the future.”
Although supporting the proposed amendment, Aguilar did express concerns. “The SEC currently has no data regarding the nature or extent of floor members’ current hedging activities,” he said. “Unless firms provide such data, it will be difficult for the Commission to make an informed decision as to whether the proposed hedging exemption is warranted and appropriately tailored.” The proposal also suggests that the Commission may consider expanding the hedging exemption to include other, as yet unspecified, activities. “It would not be prudent to pursue this course unless commenters demonstrate a legitimate need for such an expansion, and justify that need with reliable data,” he said.
Commissioners Michael Piwowar and Daniel Gallagher, although voting in favor of the proposal, expressed their concerns about FINRA’s growing influence and authority.
“By requiring membership in a national securities association, we will de facto be requiring membership in FINRA, which is currently the only association,” Piwowar said. “The Commission does not set FINRA’s agenda, salaries, or budget, so I worry that FINRA could use the increased fee revenue that will be generated by an influx of membership pursuant to this rulemaking in a manner that would not translate to better regulatory oversight for the new members. That would run counter to the objectives underlying the proposal, and thus undermine efforts to enhance the regulatory environment.”
“We should not treat FINRA as the SEC’s deputy federal regulator,” Gallagher said.