Even with the new areas of concern, firms should not assume they have a grace period to address these issues. It is far more likely that there are active investigations and inquiries and that disciplinary action may be brought in these areas in the near future. For this reason, firms should address these areas promptly
In recognition of multiple high-speed trading failures that resulted in market disruptions in 2012, FINRA is focused on the development and implementation of algorithms and trading systems. In particular, firms are reminded of the need to have adequate testing and controls related to trading strategies and trading systems. Moreover, firms should conduct pre- and post-launch testing to confirm that their systems and strategies do not result in potentially manipulative trading. A compliant system of tests and controls should include, among other things:
- Separate, independent and robust pre-implementation testing of algorithms and trading systems;
- Involvement on the part of the firm’s legal, compliance, and operations in the design and development of algorithms and trading systems;
- Active monitoring of the algorithms and trading systems post-launch for potential abusive trading; and
- Controlling subsequent changes after an algorithm or trading system is implemented.
Among the potential abusive trading strategies for which firms should have procedures and controls to detect are momentum-ignition strategies, defined by FINRA as any attempt to induce others to trade at artificially high or low prices. An example is “spoofing” or “layering” — the placement and immediate cancellation of orders not intended to be executed, but rather placed to trigger the execution of other orders on the opposite side of the market. Other potential abusive strategies include the entry of non bona fide orders or aggressive trading activity near the open or close. FINRA also is concerned about options mini-manipulations in which a market participant attempts to manipulate the price of an underlying equity in connection with the close-out of a pre-existing options position. Finally, FINRA continues to target high-frequency trading and algorithmic trading by foreign traders through direct and/or sponsored access and Master/Sub-account arrangements.
Firms should be aware that FINRA investigations and inquiries in this area can be very detailed and can include FINRA Rule 8210 requests for coding and other highly sensitive and confidential business and trade secret information. While FINRA has maintained that these requests will happen rarely, we believe it critical that FINRA and the industry commence a dialogue regarding assurances of the protection of such sensitive information from business competitors.
Additionally, in 2012, FINRA implemented cross-market surveillance patterns for the markets it regulates (NYSE, Nasdaq and the OTC market for listed securities). The patterns address more than 50 threat scenarios and canvass approximately 80 percent of the listed equities market.2 FINRA has also significantly enhanced its surveillance of trading strategies involving both the options and equities markets, as well as the non-listed equities and fixed income markets. As these surveillance patterns produce breaks and the Staff refines its queries to eliminate false positives, it is likely that firms will receive an increased number of inquiries for information and documentation. Moreover, as FINRA focuses on cross-market surveillance, firms should be doing the same.
Operators of alternative trading systems (ATSs) will be subject to examinations focusing on the disclosure of their operations, compensation and relationships with affiliates. ATSs also are reminded of their obligations to comply with the fair access requirements of Regulation ATS.
FINRA also highlighted several other areas of concern:
- Microcap securities. Firms should have policies and procedures to review whether activities related to high-risk, speculative microcap and low-priced OTC securities comply with FINRA rules and federal securities laws.
- Private Placement Securities. FINRA Rule 5123, effective Dec. 3, 2012, requires a firm that sells a security in a non-public offering in reliance on some exemptions from registration under the Securities Act to file with FINRA a copy of the offering document. According to FINRA, it will use the new filing requirement and the information provided to enhance its risk-based supervision of private placements and to identify high-risk transactions.
- Anti-Money Laundering. FINRA noted specific risks associated with foreign currency conversion transactions. Firms are reminded of the need to conduct due diligence and to review for potential suspicious activity when acting as intermediaries in foreign currency conversions.
- Automated Investment Advice. Firms that use software programs to provide automated investment advice should review whether investor profiles are thorough and accurate and should test and monitor the automated systems.
- Branch Office Supervision. Firms should evaluate their branch office inspection programs to review whether such programs reflect the activities and risks of each particular branch.
As is clear from the news headlines, insider trading remains a priority of FINRA and other regulators. Firms are reminded of the obligation to maintain reasonable procedures and controls to protect material, non-public information. Specific examples of risk controls cited by FINRA include:
- Routine review of electronic communications of personnel that may come into possession of material, non-public information;
- Maintenance of appropriate information barrier policies and procedures;
- Monitoring of employee trading activity both inside and outside the firm;
- Conducting regular reviews of proprietary and customer trading in securities on a watch or restricted list;
- Conducting employee training with respect to the use and handling of material, non-public information; and
- Identifying suspicious trading in the securities of a customer’s employer or corporate affiliates.
Financial and Operational Controls
In the aftermath of MF Global, FINRA remains focused on net capital issues and the protection of customer assets. In particular, firms are reminded of the following:
- Guarantees and Contingencies. Firms should review whether they identify all contingencies and guarantees and document the basis for accruing such losses as appropriate. Firms should review whether they are properly accounting for guarantees of any obligation or liability of a subsidiary or affiliate; adverse awards in arbitration proceedings; adverse SRO, administrative or court judgments/lawsuits; guarantees with respect to financial obligations of third parties or affiliates; and allowable assets pledged as collateral to secure a third party’s financial obligation.
- Margin Lending Practices. Firms should have a governance process to determine whether extensions of credit are appropriate on various asset classes and to determine the amount of margin that should be extended on less liquid positions (including whether the firm should set house margin requirements beyond the exchanges’ minimum requirements)
- Leverage and Liquidity. Firms should consider extending the maturity of their liabilities to better match their assets. Firms also should regularly assess their funding and liquidity risk at the broker-dealer as a standalone entity, and take the necessary steps to be in a position to operate under adverse circumstances.
Conflicts of Interest
Although not specifically addressed in the Priorities Letter, the Securities and Exchange Commission and FINRA have intensified their focus of potential conflicts of interest and how firms identify and address the same.3 It is our understanding that FINRA has met with the firms that were subject of the targeted examination letter regarding conflicts of interest and we expect FINRA to issue public guidance in the first quarter with best practices for identifying and addressing conflicts. The SEC Office of Compliance Inspections and Examinations (OCIE) has stated that a high priority for its examinations are identifying, among others, compensation-related conflicts and incentives,4 portfolio management-related conflicts, affiliations between investment advisers and broker-dealers and valuation. OCIE stated that firms should have an effective process, led by a cross-functional leadership team, to identify and understand all conflicts in the business model and a good compliance and ethics program to address the conflicts of interest identified and prioritized.5
The annual priorities letter provides a blueprint of FINRA’s concerns and the areas where current examinations and surveillance are focused. Member firms should review their written supervisory procedures and policies to address these issues, and firms should review whether they have fully implemented these procedures. Even if the firm is not expecting its next FINRA examination soon, it may receive surveillance-generated inquiry letters on these issues at any time.
*This alert was co-authored by W. Hardy Callcott, Michael Wolk and Timothy Nagy.
2 2012: FINRA Year in Review, FINRA News Release (Jan. 8, 2013)
3 In July 2012, FINRA issued a “Targeted Examination Letter” regarding conflicts of interest requesting firms receiving the letter to provide information regarding identified conflicts of interest and setting up a three hour meeting to discuss the same with FINRA staff. Targeted Examinations Letters, Re: Conflicts of Interest, http://www.finra.org/Industry/Regulation/Guidance/TargetedExaminationLetters/P141240
4 FINRA recently issued a Request for Comment on Recruitment Compensation Practices. Regulatory Notice 13-02, Recruitment Compensation Practices (January 2013).
5 Carlo V. di Florio, Director, Office of Compliance Inspections and Examinations, Speech Before the National Society of Compliance Professionals (Oct. 22, 2012)