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August 1, 2011

Brokers Grapple with Credit Checks

By Peter Chapman

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The industry got some needed breathing room. The Securities and Exchange Commission decided in late June to postpone by four months compliance with a cornerstone of its sponsored-access rule. That gives broker-dealers time to figure out how to build credit checks into their businesses that serve high-frequency traders.

Broker-dealers engaged in a sponsored-access business now have until Nov. 30 to comply with the section of SEC Rule 15c3-5 that requires them to establish credit thresholds for their customers. All other parts of the rule dealing with the trading of equities, ETFs, options and swaps went into effect on July 14.

On that date, brokers became responsible for policing their customers' activities on an order-by-order basis. Come November, they must be able to set overarching trading limits on a customer-by-customer basis. They must also be able to manage their aggregate customer exposure across the firm.

As of July, brokers have to check each order to make sure it complies with the SEC's rules and those of the self-regulatory organizations. They also have to make sure the orders are not "erroneous." Those are orders with incorrect quantities or prices or those that are "duplicative," or entered twice.

Checking for duplicative orders has proved challenging, but for the most part brokers have had little trouble instituting risk checks to guard against regulatory breaches or simple erroneous trades. Most have been running these checks for years.

Michael O'Conor

The requirement that sponsoring brokers establish credit, or trading, limits for their customers, on the other hand, has proved taxing for many. Although some have always incorporated trading limits into their electronic platforms, many have not.

Traditionally, brokers have relied on assurances from their customers that they would not exceed certain limits. Plus, industry rules give customers three days to settle their trades. Any problems get dealt with during the settlement process.

"Some firms were able to deal with the issue of trading limits on a customer-by-customer basis," said Michael O'Conor, a consultant with Jordan & Jordan. "Others were only prepared to deal with it on a firmwide basis. "Now everyone must do it on a customer-by-customer basis."

Behind the new rule are SEC concerns over brokers offering "naked," or unfiltered, sponsored access to high-frequency traders. The practice of "renting" a broker's name to an HFT unencumbered by risk checks previously constituted the majority of sponsored access.