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February 1, 2011

Clearing Brokers Face Uncertainty

By James Ramage

Some clarity, please. The Securities and Exchange Commission may have effectively banned the practice of "naked" sponsored access with its recent rule. But industry sources say the regulator left somewhat vague the matter of whether brokers granting sponsored access to other brokers must provide an additional layer of risk checks.

Jeff Bell

Brokers such as Penson Financial Services and Wedbush Securities do not provide pre-trade risk checks for broker-dealer clients. This, they said, is because their broker-dealer clients are already required to provide them, and because the clearing firms also monitor risks on a real-time basis immediately post-trade.

The language in the SEC rule is somewhat unclear about whether orders coming through broker-dealer sponsors of broker-dealer clients are excluded from the requirement, said Jeff Bell, executive vice president of the clearing and technology group at Wedbush. The industry hopes the SEC will clarify the matter soon through a Frequently Asked Question, or FAQ, he added.

"That's an area that needs a little more clarity, through an FAQ, to understand what [the SEC's] expectation was," Bell said.

Regardless of the exemption, Wedbush and Penson are hedging their bets. Both said they are signing up a third-party vendor's pre-trade risk-check technology.

"It's possible we still need to have an additional risk control for the broker-dealer clients we sponsor," Bell said. "That's the lack of clarity at this point. We think there's an exemption, but we're not positive about it."

The SEC rule requires broker-dealers who permit their non-broker-dealer clients to trade directly in the markets under their names to scrutinize each order on a pre-trade basis. The rule therefore effectively bans unfiltered, or naked, access.

Sponsored access involves a large portion of the markets' volume. By one industry estimate, about half of all order flow reaches the markets through sponsored-access arrangements.

The SEC rule became effective on Jan. 14, or 60 days after it was published in the Federal Register--which was on Nov. 15. Firms have six months after that date, or until July 14, to comply with the rule.

Penson and Wedbush said their broker-dealer clients do their own risk checks already, to protect themselves. These firms prefer to rely on their own technology to protect orders that involve their own money, Bell said.

And firms like Penson monitor those checks, said Sean Malloy, a senior vice president and director of global sales and marketing there. Penson either has access to customers' systems, or runs real-time "echo" risk checks, which occur as trades happen. Either way, Penson certifies, examines and documents the pre-trade controls its broker clients have in place.

"The question is: Can brokers continue to sponsor brokers as long as we have access to their risk control screens and access to kill switches?" Malloy asked. "Or do we need to put an additional layer of pre-trade checks on top of what's in place now? That needs to be clarified."

Pre-trade checks, according to the SEC, help prevent erroneous orders and enforce preset credit or capital thresholds. The SEC has said that pre-trade risk checks protect the integrity of the markets.


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