SEC issues risk alert on master/sub accounts.

The SEC’s market access rule is producing consternation in the short-term as its examination staff prepares to scrutinize the controls and procedures at broker-dealers that offer market access to master/sub-account customers.

The SEC recently adopted Rule 15c3-5, which applies to broker-dealers with market access to an exchange or alternative trading system, as well as to broker-dealers that provide customers or other persons with access to trading securities directly on an exchange or alternative trading system through the use of the broker-dealer’s MPID.

Under the rule, the broker-dealer is responsible for having risk management
controls and supervisory procedures reasonably designed to ensure compliance with all laws, rules and regulations imposed under the federal securities laws or by self-regulatory
organizations (“SROs”) in connection with market access.

“Firms will need to make sure their policies and procedures are in compliance to conduct the necessary pre-trade credit checks when the rule is implemented in November,” Leonard Amoruso, senior managing director and general counsel at Knight, said at Markets Media’s Chicago Trading and Investing Summit on Thursday.

The SEC last week issued a risk alert warning of significant concerns regarding trading through sub-accounts, and offered suggestions to help securities industry firms address those risks.

Customers who open master accounts with a registered broker-dealer usually subdivide it for use by individual traders or groups of traders. In some instances, the sub-accounts may be divided to such an extent that the master account customer and the firm where the account is held might not know the identity of the traders in the sub-accounts.

“Although master/sub-account arrangements have legitimate business purposes, some customers may use them as vehicles for illegal activity, or in an attempt to avoid or minimize regulatory obligations and oversight,” said Carlo di Florio, director of the SEC’s office of compliance inspections and examinations, whose national examination staff issued the alert.

The alert includes suggestions for broker-dealers to address concerns arising from trading in sub-accounts and to comply with the  Market Access Rule, which requires broker-dealers to have controls and procedures to limit risks associated with offering market access to customers, including those with master/sub-accounts.

Possible approaches include obtaining and maintaining the names of all traders authorized to trade in each master account, including all sub-account traders; verifying the identities of all such traders, using fingerprints if appropriate, background checks and interviews; and periodically checking the names of all such traders through criminal and other databases.

“Well-designed criteria and state-of-the-art technology to achieve speed and independence are essential elements of the solution,” D’Vari said. “Fully outsourced surveillance functions may not ultimately be deemed acceptable by the SEC. Nevertheless, most dealers will invariably be using third-party financial technology companies to implement practical solutions addressing these control and conflict issues.”

The market access rule requires broker-dealers to have a system of risk
management controls and supervisory procedures reasonably designed to manage the financial, regulatory and other risks of this business activity associated with providing a customer or other person with market access, including restricting access to the broker-dealer’s trading systems and technology that provide access to persons pre-approved and authorized by the broker-dealer.

“The SEC’s new market access control rule has created potential client-dealer conflict, friction and interpretation issues,” Ron D’Vari, CEO and co-founder, NewOak Capital, told Markets Media.

“The inherent conflicts between dealers active in high-frequency trading as principal and contemporaneously controlling and limiting access of clients, such as hedge funds and asset managers are leading to different changes in surveillance and implementation,” he said. “The key issues are the time delay and specific credit criteria for setting limits for different types of clients.”