Listen to the Article: How Will Prop Trading Firms Navigate the U.S Regulatory Landscape After SEC Narrows Exemption

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On August 23, 2023, the U.S. Securities and Exchange Commission (SEC) adopted amendments to Rule 15b9-1 under the Securities Exchange Act of 1934 in a 3-2 split. In a nutshell, the amendments significantly narrowed an exemption for prop trading brokers from the requirement to become a member of the Financial Industry Regulatory Authority (FINRA).

Today, almost all prop trading brokers that engage in over-the-counter (OTC) securities transactions are subject to the oversight by FINRA, the primary regulator of the OTC markets for securities and currently the only registered national securities association.

So SEC Stepped Up Regulations on Prop Trading, What Comes Next?

According to the commission, the move to expand the remit of FINRA to cover previously exempt prop trading firms, and require all impacted brokers to report post-transactional activity is because greater transparency and strengthened oversight of prop trading firms were needed.

In fact, many industry insiders pointed out in a Fazzaco's January Q&A on prop trading market​ that the market lacks an effective regulatory system and most of the time it is up to the internal controls and risk management measures of these companies to ensure the fairness and transparency of transactions.

So, in a following statement they made, SEC commented that the reason why some firms were able to engage in unlimited prop trading off-member-exchange without FINRA oversight was related to the National Association of Securities Dealers, or NASD, the predecessor of FINRA.

Under the rules before August 2023, prop trading firms which were solely members of an exchange were subject to less rigorous oversight and operated in a less transparent manner than firms that were FINRA members and that were required to report their Treasury trades.

Many prop trading brokers conducted significant cross-exchange or off-exchange activity. Yet, some of them continued to rely on an exemption from national securities association registration that's older than the cell phone era. This has led to a regulatory gap whereby a number of firms that have cross-market, monthly trading volume valued in the hundreds of billions of dollars were exempt from national securities association oversight.

With the new amendments in place, however, for the U.S market, approximately 64 prop trading firms are affected. These firms were previously not FINRA members but they routinely transacted in the OTC securities market. They have to become FINRA members through the new membership application process and comply with all applicable rules.

Besides, the affected firms will become subject to the reporting obligations for trading in US Treasury securities and other fixed-income securities subject to report to FINRA's Trade Reporting and Compliance Engine (TRACE).

Applause vs. Backlash

Although SEC managed to pass the amendments, it does not mean that the market fully agrees with what it is doing. There are even disagreements coming from inside. Most commissioners are on the approval side, believing that the new rules will not only improve OTC transparency, but also creates a level playing field for firms that provide liquidity on and off the exchange. It is a reform that promotes fairness, efficiency, transparency and resilience of the market.

Those who oppose, on the other hand, are questioning the effect the rules may have on liquidity. Mark Uyeda, a SEC commissioner, stated his staunch opposition on August 23, pinpointing the substantial downside risk the amendments pose, believing that it could result in a reduction in liquidity, particularly in sectors of the market that can least afford it.

He also added that the real reason why SEC backed up FINRA was because it was for the FINRA's own interest. Because with the new rules installed, FINRA will be benefited greatly in terms of increased revenues from the new memberships.

Current Regulatory Landscape for Proprietary Trading

As mentioned above, prop trading firms in the U.S. are subject to strict supervision by agencies such as the SEC and FINRA. This is why some prop brokers that have not yet met compliance requirements have chosen to suspend serving U.S. clients.

In addition, one of the main rules that all financial institutions engaged in prop trading must abide by is the Volcker Rule. The rule was proposed by former Federal Reserve Chairman Paul Volcker, hence its name. The core of this rule is to restrict banks from using their own capital for proprietary trading.