FREE email newsletters 
Commentary: The Changing Role of the Broker-Dealer in an Electronic Universe
Traders Magazine Online News, January 19, 2010
Last Wednesday, the SEC proposed rules on sponsored access, or to use the phrase coined by the SEC in its press release on the subject, "naked access." The new rules, if adopted, would require a broker-dealer that allows its customers to use the broker-dealer's exchange trading privileges to put in place controls and procedures to "prevent erroneous orders, ensure compliance with regulatory requirements, and enforce pre-set credit or capital thresholds."
Controls and procedures are, of course, a good thing. The process of designing and implementing procedures forces firms to think about legal and regulatory compliance. On the dark side, a requirement to institute procedures sets up a sort of double whammy: if a firm is found to have violated a legal or regulatory requirement, obviously the firm's procedures are inadequate, which instantly transforms one regulatory violation into two, justifying greater penalties.
The difficulty with the proposed prohibition on "naked access" is that there are no cases that I am aware of where customers that traded using a firm's identity submitted erroneous orders, failed to comply with regulatory requirements or breached any pre-set credit or capital thresholds--at least in any way that was particularly unusual or frightening. Errors in trading do happen from time to time, and errors are even made by broker-dealers with all sorts of elaborate controls to prevent them. But, one would have thought that with all of the market volatility we have witnessed over the last two years, the SEC would have been able to point to striking examples of erroneous errors, non-compliance with regulatory requirements and breaches in capital requirements attributable to sponsored access that cried out for the proposed regulation. In short, the proposed rules appear to provide a remedy where there is no disease.
The proposal seems to target high-frequency traders, who have been vilified lately in the financial press and attracted the attention of Congress. But, the rule does not prohibit high-frequency trading. At most, the rule will increase the costs of sponsoring high-frequency trading. To the extent those costs are passed along, high-frequency trading will be a less-profitable enterprise. If the goal is to slow markets down, this rule is unlikely to succeed and seems an odd way to go about it.
The real question is whether the broker-dealers who provide sponsored access are performing any useful function for which they should receive payment. If the middle man isn't doing anything, why are we paying him?
Sponsored access and high-frequency trading were consequences of Regulation NMS. Perhaps the SEC did not anticipate just how successful a business sponsored access would be, or how fast markets would become, but these were hardly "unintended consequences." Reg NMS contemplated that NYSE member firms would provide sponsored access to non-members, and its entire purpose was to transform slow, floor-based exchanges, like the NYSE, into fast, electronic marketplaces.
Nonetheless, the development of sponsored access calls into question the role performed by a broker-dealer in a world of electronic exchanges.
The terms "broker" and "dealer," as they are defined in the Securities and Exchange Act of 1934, are inextricably linked with the "National Securities Exchange," another Exchange Act term. Brokers and dealers were required to become members of a self-regulatory organization, and when the Exchange Act was adopted, that meant a National Securities Exchange.
For more information on related topics, visit the following channels:
