2014 broker-dealer report

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2014 broker-dealer report

Staying nimble in an uncertain future





2014 broker-dealer report: Staying nimble in an uncertain future

2013 brought significant operational changes to the broker-dealer industry. 2014 will see the continuing implementation of regulations across such areas as technology safeguards; financial responsibility; customer protection; systems requirements; and investment suitability. Continuing compliance with these regulations—plus discussions on high-frequency trading and market structure—will also evolve and may lead to further changes.



rule 17a-5



Rule 2111


15c3-3 Rule 2111



rule 17a-5


Key debates shaping the future for broker-dealers

The economic downturn, coupled with new and uncharted technological advances, have left lingering questions about how to avoid future market difficulties. Government officials, industry groups and broker-dealers are discussing the best ways to approach a number of issues and continue to rebuild public confidence.

“I believe that we must constantly strive to ensure that the U.S. equity markets continue to serve the interests of all investors. That mutual challenge must come fully of age and address today’s, not yesterday’s, markets



— Mary Jo White, Securities and Exchange Commission Chair

Two key debates are top of mind:

1. Building a consensus on HFT

High-frequency trading (HFT) takes advantage of technology advances, allowing traders to process electronic data feeds, make trading decisions, and send orders to electronic exchanges extremely quickly, which can cut trading costs and maximize price advantages. Broker-dealers must make a major investment in HFT technology to get the advantage, and the bigger players have more money to invest and can build or buy better systems. Smaller broker-dealers could potentially be left behind, so many will be looking at what can be accomplished at a reasonable cost in 2014.

After many years of looking for an advantage through advanced algorithmic trading techniques, broker-dealers have been rocked by HFT’s possibilities. HFT reduces trading time to milliseconds and slashes trading costs for broker-dealers and individual investors. For markets, higher transaction speeds can also increase liquidity, ultimately trimming the corporate cost of capital. With HFT swiftly evolving, regulators are looking at the potential for unfair advantages, with an eye to protecting smaller broker-dealers that might not be able to make these huge technology investments.

1 White, Mary Jo. Security Traders Association 80th Annual Market Structure Conference, Washington, D.C., Oct. 2, 2013, http://www.sec.gov/News/Speech/Detail/Speech/1370539857459#.


HFT critics argue that the ability to get ahead of markets when material news about companies or market-making trades are released may cause systemic risks. In response, exchanges are beginning to look at new rules that would delay trading after major news breaks or limit the amount of information that can be released (e.g., size of trades) in order to mitigate risks.

Another concern is that investor confidence will erode due to front running or the inability of all but the largest firms to compete in such a high-tech marketplace.

It seems clear the HFT debate will continue, and building consensus will take time and regulatory involvement. HFT proponents argue that adding more limits will create more problems than it solves, while critics haven’t come up with any clear-cut solutions that will protect both investors and broker-dealers. Meanwhile, some large broker-dealers are taking a risk and making huge technology investments — if this method of transacting is ultimately restricted by regulation, some or all of these costs could be passed on to individual investors. Future regulation is probable, and broker-dealers (and their clients) may end up paying large amounts for unusable or obsolete technology.

2.The market structure debate

Market complexities have increased over time, and a significant amount of business is now done through private deals via private companies. Since public markets are competitive and have higher potential to self-correct, there is much concern over this shift. A debate rages as to what types of changes will best serve investors.

The Securities and Exchange Commission has been actively examining this issue for several years. SEC Chair Mary Jo White and proponents of market structure reform stress the importance of technology and operational integrity, the need to test assumptions about market structure and the need for regulatory decisions to be based on empirical data.

Dissenters, like Paul Jiganti of TD Ameritrade, question whether additional regulation is the solution: “Economic choice is vital to healthy markets, because without it, innovation and price competition suffer2.” Jiganti and other dissenters believe that retail investors achieve low costs through commission rates; high speed and quality (in terms of price and fill) in trade execution; and access to advanced trading tools and technologies that should not be limited by regulation.

The SEC has indicated that market structure is a high-priority item. Broker-dealers should remain cautious — according to a recent Wall Street Journal article. “To help inform its thinking on market structure issues, Ms. White said the SEC would soon launch a public website to publish the kind of market data, research and analysis previously unavailable to mom-and-pop investors. For the first time, the agency plans to publicly release a feed of all orders posted on national exchanges, as well as trade executions, cancellations and off-exchange trades. ‘We expect this new tool to transform the debate on market structure by focusing as never before on data, not anecdote,’ she said3.”

2 Jiganti, Paul. “TD Ameritrade’s Jiganti warns against market structure changes” Securities Technology Monitor, Oct. 24, 2013.

Available at www.securitiestechnologymonitor.com/news/TD-Ameritrades-Jiganti-Warns-Against-Market-Structure-Changes-31882-1.html.

3 Ackerman, Andrew. “SEC weighing overhaul of how exchanges regulate themselves, White says — Update,” The Wall Street Journal, Oct. 2, 2013.

Available at http://online.wsj.com/article/BT-CO-20131002-709707.html.


Major operational changes for 2014

Under the proposed rule, every SCI entity would be required to:

• Prudently design, develop, test, maintain and supervise technology systems essential to its operations

• Install policies and procedures related to technology systems that govern their capacity, integrity, resiliency and security

• Ensure that systems operate as intended and comply with applicable laws and rules

• Respond to and correct systems disruptions, compliance issues and intrusions (SCI events) in a timely manner

• Notify the SEC of any SCI event and submit an electronic report via the new Form SCI

• Report any SCI events to its members or participants

• Conduct annual reviews of SCI systems and submit annual reports of findings to the SEC

• Appoint certain members or participants to take part in the annual testing of its business continuity and disaster recovery plans, and coordinate such testing with other entities on an industry- or sector-wide basis

• Provide SEC staff with access to its systems to assess compliance with Reg SCI

2013 was a year of profound regulatory change for the financial services industry as a whole. In the coming year, several new regulations are likely to alter the landscape for broker-dealers. Firms will need to adapt to changes as they emerge.

SEC Regulation Systems Compliance and Integrity (Reg SCI) Reg SCI is designed to help protect U.S. securities markets against technology errors. Based on the assumption that the equity markets are interconnected, the rule would require key market participants to implement comprehensive policies and procedures governing core technology and proactively plan solutions for negative issues that could arise. If the rule is enacted, the SEC will have enforcement powers if a firm fails to adequately document and determine whether such procedures are operating effectively.


SEC financial responsibility Rule 17a-5

The SEC recently adopted amendments to the financial responsibility, reporting and audit rules for broker-dealers. The approved amendments to Rule 17a-5 of the Securities Exchange Act of 1934 (Exchange Act), Broker-Dealer Reports, are designed to better protect customer assets and heighten SEC supervision of broker-dealers’ custody practices4.

The amendments, effective Oct. 21, 2013, include revisions to net capital, books and records, and notification rules and requirements.

• Net Capital Rule: Broker-dealers are required to maintain minimum net capital at all times. Key changes to the rule include the requirement that affiliates have the necessary financial resources related to expense-sharing arrangements with broker-dealers. It also requires broker-dealers to immediately terminate all securities operations in the event of insolvency.

• Books and records requirements: Broker-dealers are already required to create and maintain specific records to detail their business activities. Amendments require broker-dealers with customer credits of $1 million or regulatory capital of $20 million to document risk management controls related to credit, market and liquidity risks.

• Notification requirements: Previously, broker-dealers were required to inform the SEC and its designated examining authority (DEA) of certain events, such as when net capital falls below the required minimum level. Under the new rule, broker-dealers must also report their securities lending and repurchase activities if they exceed a specific level.

4 Financial Responsibility Rules for Broker-Dealers, Securities and Exchange Commission. Available at www.sec.gov/rules/final/2013/34-70072.pdf.


SEC Rule 15c3-3: Customer Protection Rule

This rule states that broker-dealers must protect and safeguard customer funds and securities5. Major rule amendments (effective Oct. 21, 2013) require broker-dealers to protect assets held for PAB accounts, limit the amount of segregated cash deposited at a bank and refrain from segregating cash with an affiliate.

Broker-dealers exempt from Rule 15c3-3— those that normally or occasionally receive customer funds or securities — will have to develop processes to capture each occurrence and assess if the funds or securities were promptly transmitted under the rule.

Exceptions will need to be tracked and reported at year-end.

SEC Market Access Rule 15c3-5

Rule 15c3-5 is intended to strengthen investor confidence in market integrity by requiring broker-dealers to establish, document and maintain a system of risk management controls and supervisory procedures that is reasonably designed to systematically limit the financial exposure of the broker-dealer that could arise as a result of market access6.

5 Securities and Exchange Commission Rule 15c3-3 — Amendments to the Customer Protection Rule. Available at www.sec.gov/rules/final/2013/34-70072.pdf.

6 Securities and Exchange Commission Rule 15c3-5 — Risk Management Controls for Brokers or Dealers with Market Access. Available at www.sec.gov/rules/final/2010/34-63241-secg.htm.


The new requirements are extremely complex and detailed and may take some time to sort out. To make the systems and operational changes required by the amended rules, carrying broker-dealers will need to have procedures and controls in place to ensure proper change management. In addition, carrying firms must evaluate the benefits of staying in that business, as the costs to comply with the new protections will be higher — some firms may even elect to surrender carrying status rather than incur those costs.

FINRA Rule 2111 (Suitability)

The Suitability Rule, which became effective July 9, 2012, requires a firm or associated person to “have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile7.” Firms and associated persons generally must attempt to obtain and analyze customer-specific information — such as age; investment experience; time horizon; liquidity needs; and risk tolerance — when making recommendations to customers.

The rule also defines the three main suitability requirements:

1. Reasonable-basis: Requires a firm or associated person to perform reasonable diligence to understand the nature of a recommended security or investment strategy involving a security, as well as its potential risks and rewards, and determine whether the recommendation is suitable for at least some investors based on that understanding

2. Customer-specific: Requires a firm or associated person to have a reasonable basis to believe that a recommendation is suitable for a particular customer based on that customer’s investment profile

3. Quantitative: Requires a firm or associated person who has actual or de facto control over a customer account to have a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, are not excessive

7 Financial Industry Regulatory Authority Rule 2111 (Suitability). Regulatory Notice, January 2011. Available at www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p122778.pdf.




Contacts Jack Katz Global Leader Financial Services T 212.542.9660 E jack.katz@us.gt.com Nichole Jordan

National Banking & Securities Industry Leader

T 212.624.5310 E nichole.jordan@us.gt.com

2014 looks to be a busy year for broker-dealers. Debates over important issues like HFT and market structure will inevitably continue and important decisions will need to be made and regularly revisited. New and amended regulations will divert time to compliance-related activities, and firms will need to stay nimble in order to react to upcoming challenges.

Broker-dealers must carefully consider decisions about where to invest their time and money in reaction to an uncertain future.

Looking forward


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