SEC bans "naked" access to markets

WASHINGTON Wed Nov 3, 2010 1:22pm EDT

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WASHINGTON (Reuters) - Unlicensed high-frequency traders will no longer be able to gain unfettered or "naked" access to public markets under a rule adopted by the U.S. Securities and Exchange Commission.

The SEC voted unanimously on Wednesday to require brokerages to have rules in place to protect against potential mishaps from unlicensed traders when brokerages rent out their access to the markets.

The SEC is also expected to propose a controversial plan that would allow it to reward whistle-blowers if the information leads to a successful enforcement case.

The SEC's decision to crack down on brokerages that rent out their market access to traders is the commission's first rule designed to level the playing field between retail investors and high-frequency traders.

"This is part of our effort to address the risks associated with rapid electronic trading strategies that have become more prevalent in recent years," SEC Chairman Mary Schapiro said at a public agency meeting.

Even before the May 6 brief market crash, the SEC had begun contemplating changes to the equity markets. The regulator has proposed rules to make anonymous trading venues known as dark pools more transparent and to ban flash orders that exchanges show to some traders before disclosing them to rest of the market.

Under the SEC rule, brokerages will have to implement controls to prevent the entry of orders that appear erroneous or exceed credit and capital thresholds.

Broker-dealers will also have to develop and maintain a system for reviewing the effectiveness of their risk management controls and for promptly addressing any issues, the SEC said.

The rule will be effective 60 days after publication in the federal government's official register and brokers will then have six months to comply with the new standard.

WHISTLE-BLOWER CONTROVERSY

As required by the Dodd-Frank financial regulatory overhaul reform bill, the SEC must set up a program to reward whistle-blowers if their tips help a commission enforcement case.

That would replace the SEC's "insider trading bounty" program, which compensates tipsters who give the agency information to file charges against those that use or pass on material nonpublic information to illegally trade securities.

The SEC is considering excluding certain players from the program. Those include foreign government officials, public accountants or lawyers who obtain information through client engagements and others who have a pre-existing legal or contractual duty to report their information.

Under the legislation, the SEC could compensate the informant between 10 percent to 30 percent of the total financial penalty -- potentially a sizable amount.

But critics say the provision undermines companies' internal controls by giving employees incentives to seek big payouts from the SEC without first going through the firm's own compliance departments.

The law could "remove many opportunities for companies to address potential issues internally before they get reported out to the SEC, and in many cases the company may not even know about the issue before getting a subpoena from the SEC," said Russell Ryan, a former assistant enforcement director at the SEC and now partner at law firm King & Spalding.

Ryan also said the SEC would most likely have to divert resources from important investigations to sift through all the tips.

Under the legislation, the SEC must also propose rules to prohibit fraud, manipulation and deception in the $615 trillion over-the-counter derivatives market.

Under the SEC's plan, such fraud would be prohibited in connection with the offering, purchase or sale of any security-based swap. Swap dealers, issuers and traders would not be allowed to mislead investors by omitting material information or engaging in manipulative devices or schemes.

The SEC and fellow market regulator the Commodity Futures Trading Commission are crafting rules to regulate the lucrative off-exchange derivatives industry. The CFTC has already laid out its plans to fight manipulation in the futures markets.

(Editing by Phil Berlowitz, Dave Zimmerman)

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