Broker-dealers hit in trader reporting requirements

Author: | Published: 16 Aug 2011
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The US Securities and Exchange Commission (SEC) large trader reporting rule (Rule 13H-1) will drive up broker-dealers’ diligence requirements and ultimately increase cost burdens, according to US attorneys.

Under the rule, scheduled to take effect on October 2, large traders are required to self-identify, after which they will receive a Large Trader Identification Number (LTID) that they must disclose to their broker-dealers. The SEC will use the LTIDs to record securities trading information reported by broker-dealers.

The new reporting requirements for broker-dealers are similar to those under the Electronic Blue Sheets (EBS) system, except that broker-dealers must report the time and date of a transaction as well as the LTID of the large trader.

"During the financial crisis the regulators probably would have benefited from knowing who was shorting what stocks," said Nora Jordan, a partner at Davis Polk & Wardwell.

"Before the rule, the SEC could find out which broker was trading but not who was behind the trades. Now they’ll be able to do that."

Starting at the end of April 2012, broker-dealers will be required to monitor their clients who may be close to the large trader identifying activity level and report trading records of those clients to the SEC upon request.

Broker burden
Clarifications are needed regarding the diligence required of broker-dealers in reporting unidentified large traders. The rule requires them to keep records on persons identified as potential large traders by "reasonably designed policies and procedures".

The broker need not stop trading with the unidentified large trader or report it to the SEC or make further inquiries. "Rather, the broker can continue trading and simply keep the appropriate records – something that will certainly help the broker’s relationships with traders," she said.

"I think we need to get some questions answered to figure out whether the broker dealers need to substantially enhance their systems," she added.

Georgia Bullitt, a partner with Morgan Lewis & Bockius’ investment management group, expects broker-dealers to suffer a material additional cost burden at a time when they are already being weighed down by other significant compliance requirements.

Bullitt is concerned broker-dealers won’t have enough time to make complex systems and operational changes necessary to comply with the new rule, especially in regard to the requirement that broker-dealers must keep track of trading activity by unidentified large traders.

"It’s very difficult from a systems perspective to look across accounts based on trader or adviser activity at a single broker-dealer, since accounts are typically identified by beneficial owner and not by the individuals or firms that exercise trading discretion over the account," she said.

Who is a large trader
A person is a large trader if they have investment discretion for a total number of National Market System (NMS) securities transactions equal to or in excess of two million shares or shares with a fair market value of $20 million during any day, or NMS securities transactions equal to or in excess of 20 million shares or shares with a fair market value of $200 million during any month.

The phrase "investment discretion" in Rule 13H-1 is vague, and may need clarifying by the SEC.

"In case of a private fund formed as a limited partnership, for example, the general partner has the ultimate responsibility for all trading activities of the fund, but the investment manager has the day-to-day responsibility for fund management, including grade execution," Debevoise & Plimpton partner Byungkwon Lim wrote in a summary sent to clients.

Further regulation
The Commission is expected to finalise a rule on a proposed consolidated audit trail in the coming months, further increasing the regulatory burden imposed upon broker-dealers. The consolidated audit trail is estimated to cost $3.4 billion to implement according to the rule proposed on May 26 of last year.

"I think it is likely that the cost of the large trader reporting requirements and the consolidated audit trail requirements will somehow get passed on to the end users," Jordan said.

"It is going to be more expensive to buy and sell securities. This of course is not good news for hedge funds, mutual funds and asset managers."