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November 10, 2009

Regulators Want Pre-Trade Checks

By Peter Chapman

Brokers sponsoring direct access to exchanges and ECNs are being prodded to step up their pre-trade surveillance.

John Malitzis, NYSE Regulation

At a September conference sponsored by the Investment Company Institute, officials from all three of the primary regulatory bodies said they were taking a hard look at brokerages' sponsored access arrangements. They said they were worried that brokers weren't doing enough to monitor the trades sent directly to market centers by their customers under the brokerages' names.

The regulators believe the brokers need to watch these trades as they go out the door, not after the fact. "As we move forward to try to raise the standards, I think the level of pre-trade checking will be the focal point," said James Brigagliano, co-acting director of the Securities and Exchange Commission's Division of Trading and Markets.

There are no uniform standards for how brokers must supervise the activities of their direct market access clients. Many firms, in fact, don't check these trades until after they've been submitted, said John Malitzis, a vice president in NYSE Regulation's market surveillance office, at ICI. That can be a problem from both a regulatory and a financial perspective, he said.

The SEC is trying to harmonize direct market access rules across all the market centers via a rule proposal from Nasdaq OMX Group. The three-pronged proposal would place the burden of surveillance squarely on brokers. They would have to ensure that appropriate financial controls are in place, so that the customer has adequate capital and doesn't exceed trading limits. They would have to make sure that contractual rights and obligations are adhered to. And the brokers would have an obligation to actively monitor the order flow. If approved, the Nasdaq proposal will become the model for the industry.

Under the Nasdaq proposal, "there must be some pre-trade check to ensure that the customer is not blowing through order or credit limits," Malitzis said.

Rules already exist in some form. FINRA has a supervisory rule that obligates brokers to have appropriate supervisory controls and procedures that deal with direct market access, according to Jon Kroeper, FINRA senior vice president.

"We expect firms to take a look at the order flow coming through their systems and run the necessary checks on the orders," Kroeper said at the conference. "Whether the supervision is conducted in real-time or at the end of the day depends on the circumstances."

Both FINRA and NYSE Reg expect brokers to be on the lookout for activities that are clearly illegal such as wash sales, marking the close and spoofing, or the attempt to drive prices up or down in order to profit.

Prompting the scrutiny is the evolving nature of direct market access. In the early days, say around 2000, most DMA trades went through the brokers' infrastructure. Now they may pass through a third-party infrastructure and not be monitored by the brokers. In either case, the trade enters the market center under the sponsoring broker's name.

"We see a growing lack of oversight," Malitzis said. "Firms claim they have no responsibility for these orders. That seems to me to be the wrong answer."



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