The Purpose of Credit and Capital Limits

A credit limit here is not a service the firm offers a customer. It is a cap the firm puts on its own exposure, and the rule says so in the sentence that requires it.

Which Two Elements Must the Controls Include?

The market access rule says the risk management controls and supervisory procedures required of a firm with market access "shall include the following elements", and it names two: financial controls and supervisory procedures, and regulatory controls and supervisory procedures.

The financial half must be reasonably designed to systematically limit the financial exposure of the broker or dealer that could arise as a result of market access, including being reasonably designed to do two things: prevent the entry of orders that exceed pre-set thresholds, and prevent the entry of erroneous orders. The two are joined by "and", so both are required.

The regulatory half is covered in the lesson on identifying pre-trade risk controls.

Exam Tip: Gotchas

• The threshold control and the erroneous-order control are not alternatives. The rule joins them with "and", so a firm cannot satisfy the financial element by building one of them well.
• The chapeau reads "including being reasonably designed to". That phrasing opens the list rather than closing it, which matters when a choice claims the two named controls are the complete financial requirement.

Why Does the Rule Require Credit and Capital Thresholds?

The purpose is written into the requirement itself: the controls exist to systematically limit the financial exposure of the broker or dealer that could arise as a result of market access.

The release widens the frame. The rule is "designed to ensure that broker-dealers appropriately control the risks associated with market access, so as not to jeopardize" four things it names:

• Their own financial condition
• That of other market participants
• The integrity of trading on the securities markets
• The stability of the financial system

The release also says the rule should "reduce the risks faced by broker-dealers, as well as the markets and the financial system as a whole", by requiring the controls to be implemented on a market-wide basis. That uniformity is itself part of the purpose, because a single set of obligations across markets reduces the potential for regulatory arbitrage.

Staff draw the vocabulary line that the rule's own phrase "credit or capital" leaves implicit. Under this rule "credit" is generally used to refer to a firm's customer activity, and "capital" to its activity for its own account.

Exam Tip: Gotchas

• The threshold caps the firm's own exposure; it is not a service to the customer. The purpose written into the requirement is to systematically limit the financial exposure of the broker or dealer that could arise as a result of market access, so a choice framing the threshold as a credit facility the firm extends misreads the sentence.
• The four things the rule protects are not all financial. Two of them, the integrity of trading and the stability of the financial system, sit outside any single firm's balance sheet.

Whose Exposure Does the Threshold Cap?

The rule requires controls reasonably designed to prevent the entry of orders that exceed appropriate pre-set credit or capital thresholds in the aggregate for each customer and the broker or dealer and, where appropriate, more finely-tuned by sector, security, or otherwise, by rejecting orders if such orders would exceed the applicable credit or capital thresholds.

That sentence puts a threshold on two parties, not one. Staff put the same split concretely: "appropriate pre-trade credit thresholds for each customer for which it provides market access, including broker-dealer customers", and a capital threshold "for trading by the broker-dealer for its own account".

The phrase "where appropriate" qualifies only the finer tuning. The release says that provision "is intended to provide a broker-dealer flexibility", and that a firm "should assess its business and its customers to determine if it is appropriate to establish more tailored credit or capital limits by sector, security, or otherwise".

Where a firm acts as an order flow consolidator for broker-dealer clients, the "customer" whose credit threshold is set is the broker-dealer client, not that client's own customer.

The firm providing access may supplement the credit limit it places on a broker-dealer customer with assurances from that customer that it has implemented controls reasonably designed to keep its own individual customers within appropriate pre-set credit thresholds. The supplement sits on top of the limit; it does not replace it.

Exam Tip: Gotchas

• Naming only the customer's credit limit answers half the sentence. The threshold applies in the aggregate for each customer and for the broker or dealer itself.
• "Where appropriate" does not soften the aggregate threshold. It attaches to the finer tuning by sector, security, or otherwise, which is where the flexibility lives.
• A broker-dealer customer still gets a credit threshold. Being a regulated firm does not move it out of the customer side of the sentence.

How Does a Firm Set the Dollar Amount?

Selecting the number requires reasonable business judgment. The Commission expects the firm to make that determination based on appropriate due diligence as to the customer's business, financial condition, trading patterns, and other matters, and to document that decision.

It also expects the firm to monitor on an ongoing basis whether the credit thresholds remain appropriate, and to promptly make adjustments to them, and to its controls and procedures, as warranted.

Staff say the firm should be prepared to show three things: why it selected a particular threshold, how that threshold meaningfully limits the financial exposure potentially generated by the customer or the firm's own trading activity, and the process by which it monitors the continued appropriateness of those thresholds on an ongoing basis.

The due diligence looks wider than the number does. Staff describe it as diligence into the customer's or its own business, financial condition, trading patterns, and other matters, taking into account trading activity across all markets and products.

The specific dollar limit selected, however, should reflect an appropriate level of potential exposure for the customer or broker-dealer generated through market access, meaning through the submission of orders in securities to exchanges or alternative trading systems (ATSs).

For the same reason, the firm only need decrement that credit or capital threshold as orders in securities are submitted to exchanges or ATSs.

Sub-limits by venue are permitted on one condition. A firm that sets a reasonable aggregate credit limit for a customer may impose it as sub-limits applied at each exchange or ATS to which it provides access that, when added together, equal the aggregate credit limit.

The condition is that when assessing exposure at one venue, the firm must assume the maximum has already been reached at every other venue, so a sub-limit cannot be increased to reflect an unused portion elsewhere. The release's example: an aggregate limit of $1,000,000 across five exchanges or ATSs supports individual venue limits of $200,000.

Once a threshold is triggered and further orders are blocked, staff say the firm may evaluate whether modifying it is appropriate in the particular circumstances and, if it is, modify it in accordance with supervisory procedures, with the reasons documented and retained as part of the firm's books and records.

The release adds that a firm "may wish to establish 'early warning' mechanisms" to alert it when a threshold is being approached. That is a step the Commission suggests, not one the rule requires.

Exam Tip: Gotchas

• The due diligence and the number have different scopes. Diligence covers trading across all markets and products, while the dollar limit and the decrementing cover orders in securities sent to exchanges and alternative trading systems.
• A venue sub-limit cannot borrow an unused allowance. The firm assesses each venue as though the customer had already used its full limit everywhere else.
• An early warning mechanism is optional. The release says a firm "may wish to" build one, which is not the same as a requirement to have one.
• A triggered threshold is not frozen forever. It may be modified in appropriate circumstances under supervisory procedures, with the reasons documented and retained.

What Does the Firm Measure Against the Threshold?

Compliance is measured on orders entered, not executions obtained, and it includes the potential exposure from open orders not yet executed. The Commission's reason is that "financial exposure through rapid order entry can be incurred very quickly in today's fast electronic markets".

A post-execution, after-the-fact determination does not satisfy the requirement. A control that blocks further orders only once executions have breached the limit fails, even though the dollar figure is identical.

One adjustment is allowed. The exposure assigned to outstanding orders may be discounted, where appropriate, to account for the likelihood of actual execution "as demonstrated by reasonable risk management models".

A firm relying on such models should monitor their accuracy on an ongoing basis and make appropriate adjustments to its method of calculating credit or capital exposures as warranted.

Exam Tip: Gotchas

• Open orders count against the limit before anything executes. The measurement runs on orders entered, so unexecuted interest still consumes the threshold.
• Discounting is permitted, not assumed. It applies where appropriate and must be demonstrated by reasonable risk management models the firm keeps monitoring.

What Must the Erroneous-Order Control Reject?

The second financial element requires controls reasonably designed to prevent the entry of erroneous orders, by rejecting orders that exceed appropriate price or size parameters, on an order-by-order basis or over a short period of time, or that indicate duplicative orders.

Read the sentence for its three moving parts. Price or size parameters are the test, the test may be applied on an order-by-order basis or over a short period of time, and duplicative orders are a separate trigger inside the same requirement.

The controls should be reasonably designed to reach both machine and human error. The Commission wants them designed to detect system malfunctions and to prevent orders entered erroneously as a result of manual errors. The release's example of the second is entering a buy order of 2,000 shares at $2.00 as a buy order of 2 shares at $2,000.00.

The release's model price control is "a systematic, pre-trade control reasonably designed to reject orders that are not reasonably related to the quoted price of the security".

For duplicative orders the standard is again reasonably designed, which the Commission says "allows broker-dealers some flexibility in crafting them, so long as they are reasonably designed to achieve the stated goal". A firm should take into account the type of customer as well as the customer's trading patterns and order entry history when setting those parameters.

A control that is more tolerant for a high frequency trader than for individual investors at a retail brokerage firm can still be reasonably designed.

Finally, the firm must monitor on a regular basis whether these controls are effective in preventing the entry of erroneous orders, and promptly make adjustments to them as warranted.

Exam Tip: Gotchas

• Duplicative orders are their own trigger. A control that only tests price and size parameters leaves out the third thing the sentence names.
• The parameters need not be applied order by order. The rule allows an order-by-order basis or application over a short period of time.
• A looser parameter for a sophisticated customer is not automatically a failure. The standard is reasonable design, and the Commission points to customer type, trading patterns and order entry history.

What Does "Prevent the Entry" Actually Require?

Rejecting is the rule's own verb in both financial controls. Staff say that controls which instead "scramble" a violative order, or use "chase and cancel" functionality where a cancellation is immediately submitted after the order, are not consistent with the standard.

The reason staff give is that controls which permit malformed orders to be entered on an exchange or ATS, or orders to be entered with an attempt to quickly cancel, are not reasonably designed to prevent entry, and could create both a risk of execution and potential operational difficulties for the venue.

The Commission puts the positive requirement plainly: the controls "must be applied on an automated, pre-trade basis before orders are routed to the exchange or ATS."

Manual controls suffice only in a narrow case. Staff say an order handled on a purely manual basis that results in a manual execution, with no involvement of electronic systems prior to execution, may be subject only to manual pre-trade controls.

Even then those manual controls must be reasonably designed to ensure compliance with all financial and regulatory requirements that must be satisfied on a pre-order entry basis. The staff example is an order a floor broker receives by telephone, writes on a paper ticket and trades manually.

If any electronic system is involved in effecting an execution, automated pre-trade controls must be used. Staff give the boundary case: a trade negotiated manually on an exchange floor still needs automated pre-trade controls at the point the orders are systematized, meaning entered into a trading system to effect an execution.

The controls are required for all orders, whether entered manually by a trader or generated automatically by a computer according to a pre-programmed set of instructions. Staff say the rule applies to all orders including market maker quotes, and that it "does not provide any exclusion for market maker quotes".

Staff take the term "order" from the Regulation ATS definitions: any firm indication of a willingness to buy or sell a security, as either principal or agent, including any bid or offer quotation, market order, limit order, or other priced order. Among other things, a market maker's controls should be reasonably designed to prevent its electronic quoting system from inadvertently entering excessive quotes into the market.

Exam Tip: Gotchas

• Cancelling a bad order immediately after sending it is not prevention. Scramble and chase-and-cancel designs both let the malformed order reach the venue, which the standard forbids.
• A market maker's quotes are orders for this purpose. The definition of "order" reaches any bid or offer quotation, and staff say the rule carries no exclusion for market maker quotes.
• The manual carve-out is narrow on three facts at once. The order must be handled purely manually, executed manually, and touched by no electronic system before execution.

Are the Rule's Financial Controls a Complete List?

The Commission emphasizes that the financial controls described in the rule "should not be viewed as a comprehensive list of those that should be utilized by broker-dealers". The rule "simply sets a uniform baseline standard".

A firm may implement financial controls and supervisory procedures above and beyond those specifically described, depending on the nature of its business, customer base, and other specific circumstances.

Exam Tip: Gotchas

• A baseline is a floor and not a ceiling. Building only the two named financial controls can still fall short where a firm's business calls for more.

What Should You Check on Exam Day?

• Confirm the threshold applies to each customer and to the firm's own account, and read "credit" as generally referring to customer activity and "capital" to proprietary activity.
• Measure against orders entered, including open unexecuted orders, and reject any choice that waits for executions to breach the limit.
• On a venue sub-limit, check the sub-limits sum to the aggregate and that no unused allowance elsewhere raises one.
• Test an erroneous-order control against all three triggers: price parameters, size parameters, and duplicative orders.
• Ask whether any electronic system touched the order before execution; if so, manual pre-trade controls are not enough.