NEW FOR 2023
Regulatory Obligations and Related Considerations
A number of FINRA rules prohibit member firms from engaging in impermissible trading practices, including manipulative trading—for example, Rules 2010 (Standards of Commercial Honor and Principles of Trade), 2020 (Use of Manipulative, Deceptive or Other Fraudulent Devices), 5210 (Publication of Transactions and Quotations), 5220 (Offers at Stated Prices), 5230 (Payments Involving Publications that Influence the Market Price of a Security), 5240 (Anti-Intimidation/Coordination), 5270 (Front Running of Block Transactions), 5290 (Order Entry and Execution Practices) and 6140 (Other Trading Practices).
Under Rule 3110 (Supervision), member firms are required to supervise their associated persons’ trading activities, and a firm’s supervisory procedures must include a process for the review of securities transactions that is reasonably designed to identify trades that may violate the Exchange Act, SEC rules or FINRA rules prohibiting insider trading and manipulative and deceptive devices.
Among other obligations, FINRA Rule 5210 prohibits member firms from publishing or circulating communications regarding transactions and quotations unless they believe the information is bona fide; Rule 5270 prohibits trading in a security that is the subject of an imminent customer block transaction while in possession of material, non-public market information concerning that transaction; and Rule 6140 contains a number of requirements to ensure the promptness, accuracy and completeness of last sale information for NMS stocks and to prevent that information from being publicly trade reported in a fraudulent or manipulative manner.
- Do your firm’s surveillance systems monitor for patterns of suspicious order entries and trading activity across multiple customers, multiple days or both? Does the surveillance system identify trading that appears to lack legitimate economic sense?
- Does your firm monitor for red flags of potential coordination among customers (e.g., numerous unrelated accounts being opened or depositing shares at the same time, multiple customers being referred to a firm by an issuer or third-party representative, multiple customer accounts accessed from the same IP address)?
- How does your firm determine thresholds for its surveillance controls to detect potentially manipulative trading?
- Does your firm take into consideration its business, client base and structure when establishing its surveillance thresholds?
- Do your firm’s supervisory procedures adequately address steps to analyze, document the review of, and escalate surveillance alerts where appropriate?
- What processes and procedures does your firm have in place to regularly assess whether changes in its business model or the addition of new customers require changes in supervisory controls to detect possible manipulation?
- Does your firm test changes to its surveillance controls before placing them into production, and monitor the changes for unanticipated impacts?
- Does your firm document changes to surveillance controls and the rationale for such changes?
Findings and Effective Practices
- Inadequate WSPs: Not identifying specific steps and individuals responsible for monitoring for manipulative conduct; and not outlining escalation processes for detected manipulative conduct.
- Non-Specific Surveillance Thresholds: Not reasonably designing and establishing surveillance controls to capture manipulative trading (e.g., thresholds not designed to capture the appropriate market class of securities or type of securities, or include both customer and proprietary trading; thresholds set too low or too high to identify meaningful activity).
- Surveillance Deficiencies: Not adequately monitoring customer activity for patterns of potential manipulation; not reviewing surveillance exception reports; not documenting review findings; not considering non-surveillance sources for red flags (e.g., inquiries from regulators or service providers; not training responsible staff).
- Manipulative Schemes: Maintaining and reviewing customer and proprietary data to detect manipulative trading schemes (e.g., momentum ignition, layering, front running, trading ahead, spoofing, wash sales, prearranged trading), including those that involve correlated securities, such as stocks, exchange-traded products (ETPs) and options.
- Multiple Platform and Product Monitoring: Monitoring activity occurring across multiple platforms that also may involve related financial instruments or multiple correlated products.
- Algorithmic Trading: Using Regulatory Notice 15-09 (Guidance on Effective Supervision and Control Practices for Firms Engaging in Algorithmic Trading Strategies) to inform a firm’s surveillance program in areas such as general risk assessment and response; software/code development and implementation; software testing and system validation; trading systems; and compliance.
- Momentum Ignition Trading: Designing a robust surveillance program to detect firms’ customers engaging in potential momentum ignition trading, including:
- layering and spoofing activity in which a customer places a non-bona fide order on one side of the market (e.g., above the offer or below the bid) to bait other market participants to react and trade with an order on the other side of the market; and
- transactions in cross-product securities that manipulate the price of an underlying security, thereby influencing the price at which a market participant can either establish or close an overlying options position (e.g., marking the close, mini-manipulation).
- ETPs: Developing and maintaining a robust supervisory system to safeguard material, non-public information to prevent front running and trading ahead by:
- establishing effective information barriers and controls to prevent information leakage and the misuse of material, non-public information;
- reviewing for manipulative strategies that exploit the unique characteristics of ETPs (e.g., their creation and redemption processes) and strategies that exploit information leakage related to portfolio composition files; and
- tailoring the firm’s compliance program to align with how the firm trades ETPs.
- Wash Trading: Monitoring activity to identify firms’ customers engaging in wash trading to collect liquidity rebates from exchanges by:
- monitoring accounts identified as related (or in concert) in the firm’s wash/pre-arranged trading surveillance reports; and
- reviewing trading activity that relates to information provided on account opening documents.
- Algorithmic Trading Key Topic Page
- Regulatory Notice 21-03 (FINRA Urges Firms to Review Their Policies and Procedures Relating to Red Flags of Potential Securities Fraud Involving Low-Priced Securities)
- Regulatory Notice 18-25 (FINRA Reminds Alternative Trading Systems of Their Obligations to Supervise Activity on Their Platforms)
- Regulatory Notice 17-22 (FINRA Adopts Rules on Disruptive Quoting and Trading Activity and Expedited Proceedings)
- Regulatory Notice 16-21 (Qualification and Registration of Associated Persons Relating to Algorithmic Trading)
- Regulatory Notice 15-09 (Guidance on Effective Supervision and Control Practices for Firms Engaging in Algorithmic Trading Strategies)