New SEC Rule 15c3-5, Risk Management Controls for Brokers or Dealers with Market Access (effective 1/14/11), effectively ended the practice of brokers providing "naked" sponsored access to their clients.  Things get somewhat vague when it comes to brokers who grant sponsored access to other brokers. Firms have until 7/14/11 - 6 months after effective date - to comply with the rule.

According to Traders Magazine's James Ramage, brokers such as Penson Financial Services and Wedbush Securities don't provide pre-trade risk checks for broker-dealer clients - they say their B/D clients already are required to provide them, and because clearing firms 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.  "That's an area that needs a little more clarity, through an FAQ, to understand what [the SEC's] expectation was."  -- Jeff Bell, Wedbush EVP for the Clearing and Technology Group.

They think there's an exemption, though they're not positive.  And, regardless of any exemption, Wedbush and Penson both are hedging their bets by signing up a 3rd-party vendor's pre-trade risk-check technology.  They also acknowledge that an additional risk control may be needed, but can't be sure because of the rule's "lack of clarity."  But firms such as Penson monitor those checks, according to Sean Malloy, an SVP and director of global sales and marketing.  Penson either has access to customers' systems, or it runs real-time "echo" risk checks, which occur as the trade happens.  Either way, Penson said it certifies, examines and documents the pre-trade risk controls its broker customers have in place.

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.

    Provisions of the Rule.   As written, B/D's who permit non-broker-dealer clients to trade directly in the markets under their names are required to scrutinize each order on a pre-trade basis. The rule, therefore, effectively bans unfiltered, or naked, access.  Sponsored access has been a large segment of the markets' volume - perhaps generating about 1/2 of all order flow reaching the markets. 

    Question in Search of an FAQ.   "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 will an additional layer of pre-trade checks on top of what's in place now be required? If additional checks are required, they should be performed by the market centers, which can create standards to ensure the application of risk metrics are uniform and the playing field is level for all. This needs to be clarified."

The ball's in the SEC's court.   For further details, go to:   [TradersMag, 1/14]