U.S. SEC warns brokers over market access, sub-accounts in debut “risk alert”

September 30, 2011

By Stuart Gittleman and Brett Wolf

NEW YORK, Sept. 30 (Thomson Reuters Accelus) – The U.S. Securities and Exchange Commission (SEC) issued an unexpected warning to broker-dealers to supervise trading by customers with direct market access, especially customers that trade using master- and sub-accounts.

The notice came in the first in a continuing series of risk alerts the Office of Compliance Inspections and Examinations (OCIE) staff expects to issue. The staff did not say whether OCIE found related deficiencies, or at what level, in recent exams, or in reviewing the findings of recent exams by the Financial Industry Regulatory Authority (FINRA). 

The new-style alert came as a surprise to many observers of securities industry regulation, who believed there were few firms with master/sub-account compliance issues.

“It was a surprise to me. I knew regulators were examining for master/sub-accounts, I’m just not sure what precipitated the [issuance of this alert]. I assume someone is seeing something they’re uncomfortable with,” said Betty Santangelo, a partner with New York law firm Schulte Roth & Zabel.

The issue first appeared on the radar of many anti-money laundering compliance officers in September 2010 after the SEC and Treasury’s Financial Crimes Enforcement Network took enforcement action against North Carolina-based broker-dealer Pinnacle Capital Markets LLC. FinCEN assessed a $50,000 civil money penalty against Pinnacle, alleging it failed to identify or verify the identities of the “vast majority” of its corporate customers’ omnibus accounts’ sub-account holders, even though the sub-account holders were Pinnacle’s customers for purposes of the customer identification rule. The sub-account holders were trading directly through the accounts.

“Money laundering, insider trading, market manipulation, account intrusions, unregistered broker-dealer activity, and excessive leverage are all potential risks associated with the master/sub-account trading model,” the SEC said in the alert.

The Market Access Rule, 15c3-5 under the Securities Exchange Act of 1934, requires brokers to have controls and procedures to manage the financial, regulatory and other risks associated with providing a customer with market access. The alert said compliance with the rule, most of which became effective July 14, will be part of upcoming exams.

“When a broker-dealer offers master/sub-accounts, this includes an obligation to reasonably design controls and procedures that address the types of risks that we identify in this report. Our national examination staff intends to scrutinize the controls and procedures at broker-dealers that offer market access to master/sub-account customers,” said Carlo di Florio, the director of the OCIE.

The alert warned that customers may open master accounts with a broker, then subdivide them for use by individual or groups of traders, sometimes to such an extent that the master account customer and the firm may not know who is trading in the sub-accounts. The potential risks of this model include money laundering, insider trading, market manipulation, account intrusions, unregistered brokerage activity, and excessive leverage and inadequate minimum equity for pattern day traders as defined by NASD rule 2520.

“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,” di Florio said.

Santangelo said she thought the SEC alert “sort of described master/sub-accounts in a negative way when they are used for many good purposes.” She added: “Obviously there is some form of this that concerns [regulators] and it’s good that we know that.”

The alert suggested controls and procedures for limiting the risks associated with offering market access to customers, including those with master/sub-accounts, such as:

  • Creating written descriptions of all controls and procedures for sub-account due diligence and monitoring, including a description of the review process, the frequency of reviews and the identity of those responsible for conducting them.
  • Obtaining and maintaining the names of all traders authorized to use each master account, including all sub-accounts; verifying their identities using background checks, interviews and fingerprints if appropriate; and periodically checking their names through criminal and other databases, including the special designated nationals list of the Treasury Department Office of Foreign Assets Control.
  • Establishing requirements that validate each trader’s identity, such as effective password management and IP address identification.
  • Monitoring trading patterns throughout the accounts for indications of insider trading, market manipulation or other suspicious activity.
  • Physically securing information of customer or client systems and technology.
  • Logging and tracking incidents of attempted hacking or other unauthorized system penetration by outside parties.
  • Determining that traders with access to the broker’s trading system and technology have received training in areas relevant to their activity, including market trading rules.
  • Regularly reviewing the effectiveness of all controls and procedures around sub-account due diligence and monitoring.

The alert said regulators have severely sanctioned firms and have piled on for egregious AML violations, noting the Pinnacle fines.

The alert also noted that the SEC charged another broker, GLB Trading, and its former CCO over day trading within the master account of a customer, Tuco Trading, and fined Warrior Fund for acting as an unregistered broker for day traders.

The alert said OCIE’s national exam program (NEP) will examine for compliance with the Market Access Rule by scrutinizing the broker’s system of risk management controls and supervisory procedures, and whether the firm is appropriately vetting the accounts with access to the broker’s market identifier, and trading system and technology.

The NEP may require brokers to document their risk assessment process and how they support its conclusions, including evidence that persons associated with the master account are not themselves customers for purposes of Exchange Act rule 15c3-3. This may include partnership or shareholder agreements, or documentary evidence that the relationship between the customer and the sub-account traders is an employment or trading, rather than a customer, relationship.

The alert also said OCIE will examine the so-called “blue sheets” required by rule 17a-25 for evidence of insider trading or market manipulation.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus.  Compliance Complete (http://accelus.thomsonreuters.com/solut ions/regulatory-intelligence/compliance- complete/) provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges.)


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