On January 11, 2013, the Financial Industry Regulatory Authority (FINRA) issued its annual Regulatory and Examination Priorities Letter (Priorities Letter) to member firms, which highlights its primary areas of focus for the coming year. As in prior years, the latest installment of the Priorities Letter provides firms with a blueprint of FINRA's regulatory priorities in the areas of market regulation, business conduct and sales practices, insider trading, financial and operational concerns.
On January 16, 2013, FINRA Chairman and CEO Richard Ketchum spoke at the Securities Industry and Financial Markets Association (SIFMA) Compliance and Legal Division monthly luncheon and expanded upon many of the key regulatory goals and target areas that were outlined in the Priorities Letter. Ketchum confirmed that the Priorities Letter reflects FINRA's ongoing efforts to assess new risks and integrate them into the scope of its regulatory programs.
MARKET REGULATION PRIORITIES
FINRA has identified algorithmic trading, high-frequency trading abuses and alternative trading systems as areas that will be carefully monitored to protect individual investors, as well as the integrity of the markets as a whole. The purpose of increased scrutiny of these systems seems to be a fear that these automated, computer-based systems may not be adequately equipped or capable of reacting to a market event without serious market disruption.
1. Algorithmic Trading
The move toward algorithmic trading in the securities industry continues to be an area of concern for FINRA. Algorithmic trading refers to the practice of designing an algorithm that is capable of executing pre-programmed trading instructions automatically and without human involvement. The ease of use and market risk factors associated with algorithmic trading make this practice appealing to market participants. However, automated trading raises significant concerns due to the perceived lack of a human fail-safe.
FINRA is concerned with the continued testing and control of these trading algorithms to avoid malfunction and associated market effect. FINRA has committed to examining firms' testing systems for algorithms both before implementation and during use. FINRA is keenly interested in involvement of a firm's legal, compliance and operations staff from development through implementation of the technology. FINRA appears to accept a firm's use of a system-wide "kill switch" to allow for human intervention to respond to significant system malfunctions. FINRA noted that it will monitor the issues associated with algorithmic trading through examinations and targeted investigations.
2. High-Frequency Trading Abuses
FINRA recognizes that many high-frequency trade (HFT) strategies are legitimate but warns that others can be used for manipulative purposes. During his address at the SIFMA luncheon, Ketchum acknowledged that although FINRA has seen significant improvements in HFT supervision, significant problems still exist. As a result, the surveillance of HFT remains a top priority for FINRA in the coming year.
As outlined in the Priorities Letter, FINRA expects firms using HFT strategies and other trading algorithms to test these strategies pre- and post-launch to guard against abusive trading. FINRA identified several areas of concern that it will target:
a. "Momentum-Ignition Strategies"
FINRA will continue to monitor the use of so-called "momentum-ignition strategies," where a market participant attempts to induce others to trade at artificially high or low prices.
"Layering" strategies are one type of Momentum-Ignition. For example, a market participant places a bona fide order on one side of the market and simultaneously "layer" non-bona fide orders on the other side of the market in an attempt to lure other market participants to react to the non-bona fide orders and trade with the bona fide order on the other side of the market.
FINRA has identified numerous variations of this strategy in terms of the number, price and size of the non-bona fide orders. However, the primary goal of these orders remains the same -- to bait others to trade at higher or lower prices.
c. Wash Sales with Layering
FINRA continues to observe wash sales used in conjunction with layering to provide the appearance of bona fide transactions at artificial prices. Additional examples of HFT or algorithmic activity include the distortion of disseminated market imbalance indicators through the entry of non-bona fide orders or forceful trading activity near the open or close. The Priorities Letter makes clear that FINRA will aggressively pursue these types of problematic HFT strategies and algorithms.
d. Activity Initiated Outside of the U.S.
Another focus of FINRA's regulatory efforts will be problematic HFT and algorithmic activity by sponsored participants who operate outside of the United States. FINRA directs members to their surveillance and control obligations under the SEC's Market Access Rule and Notice to Members 04-66, and to recognize potential issues that may result where these accounts are treated as customer accounts, anti-money laundering and margin levels. FINRA will continue to focus its attention and resources on identifying and prosecuting such conduct.
e. Options Mini-Manipulation Strategies
A key priority of FINRA's options program will continue to be "options mini-manipulation strategies," in which market participants try to manipulate the price of underlying equities, usually by HFT, to either close pre-existing options positions or establish new ones at advantageous prices.
The Priorities Letter notes that "FINRA has re-engineered its cross-product surveillance reviews to capture recently identified variations of these scenarios," and that FINRA will continue to aggressively pursue such conduct.
3. Alternative Trading Systems
FINRA will continue to scrutinize the use of alternative trading systems, particularly with respect to investor disclosure. Alternative trading systems (ATS) are designed to match buyers and sellers outside of a standard regulated exchange. The primary benefit of these types of computer-based systems is that large-volume buyers and sellers of securities can be matched with counterparties without being impacted by market conditions such as trading volume or market capitalization. The potential for abuse in this type of arrangement makes it entirely necessary that FINRA and the Securities and Exchange Commission (SEC) diligently monitor transactions on an ATS. The SEC adopted Regulation ATS in 1998 to increase transparency and ensure proper reporting and disclosure principles in the over-the-counter market. FINRA's announcement of continued diligence with respect to ATSs indicates that firms would be well advised to ensure that they adhere to the requirements of Regulation ATS.
In 2013, FINRA will conduct examinations of broker-dealers operating ATSs and their affiliates to examine the breadth of disclosure to their subscribers with respect to:
- Mechanisms by which subscriber order flow is monitored and directed;
- ATS disclosure;
- ATS firm compensation;
- Protection of confidential subscriber data; and
- Communications between ATS firms and any affiliates.
Firms that operate an ATS should expect that FINRA will seek information with regard to these disclosure issues in the coming months.
BUSINESS CONDUCT AND SALES PRACTICES
1. Cyber-Security and Data Integrity
FINRA's stated goal of protecting investors from what can be a predatory industry likely contributes to a continued focus on cyber-security and data integrity in 2013. FINRA has noted that the increased frequency and sophistication of cyber-attacks against the securities industry is a persistent and ever-changing threat. FINRA's focus on cyber-security is also driven by the sensitivity of customer data in financial transactions. FINRA has committed to diligently monitor the information security policies and procedures of member firms. The securities industry's heavy reliance on computer-based client information and trading systems make it clear that this aspect of business conduct will be monitored very closely. FINRA will target any firms whose information security and customer data controls are lacking through examinations and targeted investigations.
2. Private Placement Securities
In the Priorities Letter, FINRA raised ongoing concerns with the sale and marketing of private placement securities. In an effort to improve FINRA's understanding of these offerings, FINRA implemented Rule 5123, which requires member firms that sell an issuer's securities in a private placement to individuals to file with FINRA a copy of the offering document. FINRA noted that it will use this new filing requirement and the information contained therein to enhance FINRA's risk-based supervision of the private placements market and better identify and assess higher-risk transactions.
FINRA also reminded members of their duty to perform reasonable due diligence on prospective issuers due to the lack of independent financial information and the uncertainty surrounding the market- and credit-risk exposures associated with many private placements. The Priorities Letter noted that due diligence should focus on:
- the issuer's creditworthiness;
- the validity and integrity of their business model; and
- the plausibility of expected rates of return as compared to industry benchmarks, particularly in light of the complex fee structures associated with many of these investments.
FINRA indicated that the primary concern is "that inadequate due diligence regarding private placements could expose customers to harm and result in insufficient disclosure." The Priorities Letter states that FINRA examiners will focus on due diligence policies and procedures, valuation processes, placing special emphasis on the integrity and independence of third-party valuation services and the timely disclosure of material risks.
The Priorities Letter notes that insider trading remains a top regulatory priority for FINRA, the SEC and federal criminal law enforcement officials in 2013. FINRA expects firms to be vigilant in safeguarding material and non-public information, which includes periodic assessments of information barriers and risk controls.
FINRA provides an illustrative list of these risk controls:
- "routine review of electronic communications of personnel within business units that may come into possession of material, non-public information during the normal course of business, such as investment banking and research departments;
- maintaining appropriate information-barrier policies and procedures that are designed to limit or restrict the flow of material, non-public information within the firm to employees on a "need-to-know" basis;
- monitoring employee trading activity both inside and outside the firm to identify suspicious activity;
- conducting regular reviews of proprietary and customer trading in securities that are placed on a watch/restricted list;
- conducting employee training with respect to the use and handling of material, non-public information; and
- a process for identifying suspicious customer trading in securities of their employer or corporate affiliates."
The Priorities Letter provides FINRA member firms with a road map of the regulatory priorities for the coming year. While FINRA may adapt its focus areas to changing market risks, there is a strong likelihood that the issues addressed in the Priorities Letter will remain fertile ground for investigations and inquiries in the near future. As a result, firms should use the Priorities Letter to assess their policies to ensure they are in compliance with applicable FINRA rules.
If you have any questions about the material presented in this Alert, please contact any member of BakerHostetler's Securities Litigation and Regulatory Enforcement Team.
Authorship Credit: Richard B. Levin, Christopher B. Gallagher and David W. Rice
 A copy of the Priorities Letter is available at: http://www.finra.org/web/groups/industry/@ip/@reg/@guide/documents/industry/p197649.pdf.
 Risk Management Control for Brokers or Dealers With Market Access, 17 C.F.R. § 240 (2010).
 See FINRA Notice to Members 04-66 at: http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p010274.pdf.
 Regulation ATS: Regulation of Alternative Trading Systems, 17 C.F.R. §§ 202, 240, 242, 249 (1998).
 See FINRA Rule 5123: Private Placement of Securities at: http://finra.complinet.com/en/display/display.html?rbid=2403&record_id=14688&element_id=10753&highlight=5123#r14688.
 Priorities Letter at p. 5.
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