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January 7, 2008

Passing the Buck: Regulators Say All Introducing Broker-Dealers Must Ensure Reg NMS Compliance

Clearing Quarterly & Directory

By John Hintze

Assume nothing.

That’s the approach that clearers and their clients should take as Regulation National Market System rules are in force, according to clearing consultants and regulators.  They warn that Reg NMS ignorance will be no defense when Securities and Exchange Commission examiners start looking at the clearers’ books.


Reg NMS, a controversial rule passed by the SEC on a 3-2 vote, stipulates a set of trade-through policies and procedures. The rule is designed to ensure that the investor receives the best price.


And in this new Reg NMS world, those relying on their clearers or other parties to execute their trades are cautioned that they also have significant compliance responsibilities.  And these responsibilities are still trickling down, even as the next round of regulatory examinations approaches.  The largest Wall Street firms, with their legions of compliance officers and attorneys—who in many cases played a role in developing the new rules—should have no problems. But smaller broker-dealers can’t just palm off Reg NMS responsibility to their clearers, cautions one regulator.


Broker-dealers can’t push compliance off on the executing broker, says Lori Richards, director in the SEC’s Office of Compliance Inspections and Examinations, since traditionally each broker-dealer is ultimately responsible for its own regulatory compliance. She says the rule requires trading centers, including exchanges, ECNs and market makers, to conduct regular surveillance to ascertain the effectiveness of the trade-through rule. For the rest of the brokerage industry, she adds, they should have records to demonstrate they also comply.


Here Come the Examiners


“Examiners will review the firm’s records of its surveillance reviews and the firm’s procedures governing its surveillance reviews,” Richards says. “Examiners will also check to see if the firm took prompt action to remedy any deficiencies uncovered by its surveillance reviews.” Still, if Carolyn May’s experience as a consultant on compliance issues indicates the preparedness of the broker-dealer community, the SEC is likely to find plenty of Reg NMS problems.


May is a director and compliance officer at Simmons First Investment Group, a bank-affiliated broker-dealer. She is also a compliance consultant for 25 other broker-dealers and registered investment advisory firms. Her brokerage customers are all introducing firms. Many rely on their correspondent clearers to execute trades.   


She says broker-dealers that hand over control of order executions to third-party broker-dealers such as clearers are still responsible for ensuring that those parties are complying with Reg NMS—although many of her customers have yet to focus on that responsibility or are uncertain about what it involves. In fact, she says, even actively trading customers that have the trading platforms to access market centers directly to execute trades—those Reg NMS affects most directly—could have some problems.


 “I have a couple of firms that do have those resources, and quite frankly, they’re not familiar with Reg NMS. This is one of those rules that people are just not understanding,” May says. That’s problematic at this late stage, because

Reg NMS’s 523 pages of dense, technical language are difficult to incorporate into a firm’s policies and procedures. And the regulators first sought comment from the industry in early 2004, permitting several compliance-date  extensions. So a lack of time to digest the rules is not an excuse. 


The Rules

Trade Through Rules, also called the Order Protection Rules, are designed to give investors equal access to the best prices. If the best price is the displayed price, it cannot be traded through or ignored. However, orders in reserve, or hidden, can be ignored because they are not protected, even if they are better than the displayed price.


Today, introducing brokers often rely on their clearers for technology and regulatory support. Clearers, however, walk a fine line. They shy away from assuming correspondents’ regulatory responsibilities.  Those clearers that do not support trading platforms are likely to take a hands-off approach. Indeed, a spokesman for Broadridge, a clearer in Lake Success, New York, says clients haven’t asked for Reg NMS support.


Clearers that execute orders for their correspondents—like any executing bro-ker-dealer—are on the Reg NMS hook.  Their systems should already be in compliance. Joe Triarsi, co-head of brokerdealer and investment advisor services at Bear Stearns, one of the larger clearing firms, notes that many correspondents using Bear Trade—the clearer’s trading system—are relying on Bear as the counterparty.


“For this activity, our systems capture all the details a correspondent typically will need to ensure compliance with their regulatory obligations under Reg NMS. We will collect this data as a consequence of the activity going through Bear Trade,” Triarsi says.

Bear has also proactively developed educational materials to inform correspondents about Reg NMS. It has held seminars and visited firms. Although activity conducted through Bear’s smart order router is similarly captured to facilitate Reg NMS compliance, Triarsi says, it’s still up to the introducing broker to ensure compliance.


The Ruckus

And that’s where the ruckus may start. May says one of her clients clears and executes trades through Bear; the clearer said it is Reg NMS compliant.  But until the correspondent’s traders and compliance officers are versed in the new rule’s many facets, they have to take their clearer’s word for it. And that may not be good enough for the regulators. “Because the traders at that firm don’t truly understand the rules, they have no way of knowing if they’re Reg NMS-compliant,” May says. Still, some firms see little effect.


 Ron Spaeth, head trader at JonesTrading, Westlake Village, Cal., says Reg NMS has so far not had much effect on his firm’s core business of executing illiquid block trades through its trading desk. In the displayed markets, including the NYSE Hybrid market, he says, algorithms rapidly take the other side of a bid or offer, moving the stock’s price away from the investor. And since Reg NMS only protects investors for what they display, he says, they appear to be displaying smaller quotes. John Vaccaro, CEO of Westport Resources Investment Services in Westport, Conn., says an area of uncertainty is whether an amendment to his firm’s clearing agreement is necessary. The issue is this: Does the amendment clarify if Westport has outsourced day-today Reg NMS responsibilities to its clearer, which is also its executing broker?


Then the brokerage must be sure the compliance tools provided by the executing broker are sufficient, according to Vaccaro, former chairman of the Securities Industry and Financial Markets Association’s smallfirms committee. Westport must also certify that the clearer is adequately monitoring those tools’ performance to ensure compliance.


Vaccaro says National Financial, its clearer, provides monthly execution reports that the brokerage can compare against industry benchmarks National posts publicly on its Web site. National Financial is a clearer that benefits from Fidelity Investments’ massive annual expenditure on state-of-the-art technology, so those reports should be good, he says. But that probably assumes too much. He wonders whether receiving that data directly from the executing broker may represent a conflict of interest.  Other clearers may have only a fraction of Fidelity’s budget and trading floor. That raises questions about the quality of the execution data provided.



Vaccaro sought to contact his local Financial Industry Regulation Authority (FINRA) representative to ask about those issues. He hadn’t heard back by the time CQ&D went to press. If, however, introducing brokers can rely on executing brokers for most Reg NMS grunt work, then much of the regulatory burden is covered.


 That’s the argument made by a broker.  “That’s where we step in: We store all the routing data, all the quotes that come in, where the best bid and offers were at the time of the order, and where we got best execution,” says Kyle Zasky, president of EdgeTrade, a New York based broker-dealer offering direct-access and algorithmic services to brokerages and institutional investors.


 OES Market Group, based in Princeton, N.J., provides agency-execution services, as well as routing to market centers. Its smart routing tool complies with Reg NMS at a base level, generating the required order-routing data and quote “snapshot.” It also allows users to set their own parameters.  For example, a broker-dealer that finds best price at several market centers can adjust the system, sending the order to the market centers with the lowest fees. OES’s Reg NMS-compliant routing technology is used by several exchanges and market centers, OES officials say.


Not Prudent

BNY ConvergEx is an agency brokerage formed last year. It combined units of BNY Securities’ agency brokerage with the Eze Castle order management system. Those executing with the combined brokerage receive Reg NMS compliant reports and data. Joseph Cangemi, managing director and cohead of BNY ConvergEx’s electronic

trading group, notes, however, “It would not be prudent for any broker-dealer to rely on anyone else for compliance oversight.”

Cangemi chairs the Reg NMS taskforce for BNY ConvergEx. It was established to prepare trading and customer support for implementation of the rule. It is a rule, he says, whose obligations can’t be assigned.


A broker-dealer must still show it is monitoring BNY ConvergEx for Reg NMS compliance. That means putting policies and procedures in place and, depending on the extent of a firm’s trading, implementing software to aid in the monitoring task. May, formerly a member of an NASD district committee providing input on regulatory proposals and currently the committee’s nominating chairwoman, has worked with her consulting customers to develop those

plans. In terms of checking for best execution, a continuing responsibility under Reg NMS, May says broker-dealers that trade less frequently can review the price-time screens of their clearers or other trading platforms. Typically, a broker-dealer can find its trades on a specific day “and then look at the executions close to that time and make sure its price isn’t way off-base, compared to those just in front of it and just after,” May says. The compliance officer can then print out those screens and attach the printout to the order information, to provide documentation to regulators.



Firms should also have best-execution committees that meet regularly to analyze the quality of their executions and determine whether it’s appropriate to route elsewhere. Larger broker-dealers that trade more frequently are more likely to have trading platforms with screens showing trading activity at the various market centers. And their traders will be monitoring in real-time the execution quality of the firm’s orders, contacting market centers if best execution is in doubt. “If a broker-dealer does contact those market centers, the regulators are going to want to see the documentation supporting that contact,” May says.


She adds that traders at a firm trading frequently may not be able to monitor each execution in real-time and may have to adopt systems that will help traders issue best-execution reports in a timely fashion. May says firms could have to develop that technology internally, because so far, few vendors appear to be offering Reg NMS-related tools.


“At the various conferences I’ve attended in the last year, I really haven’t seen any vendors pushing any software with regard to Reg NMS,” she says.


Best execution is only one part of Reg NMS compliance and, in fact, it’s long been the broker-dealer’s responsibility.  Two years ago, 80 percent of the liquidity in listed stocks was found on the NYSE floor, while today that portion

is closer to 40 percent and a wide range of alternative market centers has emerged. 


The vastly more complicated market structure has resulted from several factors. These include Regulation ATS, which paved the way for electronic communication networks, dark books and, most recently, Reg NMS.  Nevertheless, broker-dealers must still monitor those venues for best execution and show they’re achieving it. 


The task becomes more complicated in the context of Reg NMS. Although the executing broker-dealer is directly responsible for complying with the rule, the introducing brokerage must monitor it not only for best execution but to be

sure it is in compliance. Specifically, the new rule provides exemptions, and executing broker-dealers must apply modifiers when those exemptions occur.



May counts five modifiers and says that the executing firm’s compliance officers must digest them and the rest of the 523-page rule. Its traders must also be trained to apply them properly, she explains. In terms of their broker-dealers,  she asks: “Do their compliance officers and traders have to understand these modifiers in the context of their trading activity?” CQ&D posed that question to the SEC, and the answer

appears to be yes.


 “It is not sufficient to rely on the best execution policies and procedures already in place, because Reg NMS has different obligations. Broker-dealers should treat trade reporting under Reg NMS with the same care they have prior to the implementation of Reg NMS,” the SEC’s Richards says.


So far, FINRA has been comparatively limited in conveying what its examiners will expect from constituents in terms of Reg NMS compliance, at least when compared with the “road show” regulators conducted a few years ago to educate the industry about the Order Audit Trail System rules. For Reg NMS, FINRA conducted a 90-minute “phone-in” workshop on Sept. 17, a month before the final effective date for Reg NMS. Richards says, “We expect Regulation NMS will continue to be a topic at upcoming industry conferences.”


Cangemi is not surprised that at least some broker-dealers today have yet to seriously consider Reg NMS.  “Anyone that’s audited from this point will have to have Reg NMS policies and procedures in place, and as broker-dealers are examined by the SROs, they’ll have to make modifications as a result of negative audit results,” he says, adding, “Through each exam, they’re going to refine the process.”


That process, however, may involve some pain for the broker-dealers. “The problem with learning by exam,” May says, “is that you may get a letter of acceptance, waiver and consent, or a fine.” Nevertheless, there are some good

aspects to this new regulatory world.  One benefit of Reg NMS, noted by Brian Hyndman, senior vice president at Nasdaq, has been fewer locked markets. Hyndman added that locked markets at Nasdaq fell from 5.2 to 0.6 percent for Nasdaq stocks and remained at pretty much the same level for NYSE stocks.