Manipulative Trading

Regulatory Obligations and Related Considerations

Regulatory Obligations

Several FINRA rules prohibit member firms from engaging in impermissible trading practices, including manipulative trading—for example, FINRA 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), Rule 5270 (Front Running of Block Transactions), 5290 (Order Entry and Execution Practices) and 6140 (Other Trading Practices).

Under FINRA Rule 3110 (Supervision), member firms are required to include in their supervisory procedures a process for the review of securities transactions that are reasonably designed to identify trades that may violate the provisions of the Exchange Act, the rules thereunder, or FINRA rules prohibiting insider trading and manipulative and deceptive devices that are effected for accounts of the member and its associated persons. The member firm must conduct promptly an internal investigation into any such trade to determine whether a violation of those laws or rules has occurred.

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; FINRA 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 FINRA Rule 6140 contains several 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.

Related Considerations

  • 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? If appropriate, do your systems also monitor the activity of proprietary traders on firm platforms?
  • Does your firm monitor for patterns of suspicious activity during the distribution of securities (if your firm is a distribution participant) as well as the aftermarket?
  • 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; multiple accounts sharing a common physical address; multiple accounts being controlled by the same officer, trustee or other authorized party)?
  • Do your firm’s surveillance systems monitor for patterns of suspicious order entries and trading activity received from foreign financial institutions?
  • How does your firm determine thresholds for its surveillance controls to detect potentially manipulative trading? Does your firm periodically assess these thresholds to determine, for example, whether they are outdated or do not adequately reflect current market conditions?
  • 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 monitor for changes in customers’ trading behavior that may prompt your firm to reassess the firms’ pre-trade or post-trade supervisory controls?
  • 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

Findings

  • Inadequate WSPs:
    • Not having procedures reasonably designed to identify patterns of manipulative conduct; not identifying specific steps and individuals responsible for monitoring for manipulative conduct; and not outlining escalation processes for detected manipulative conduct.
    • Not tailoring procedures to adequately supervise differing sources of order flow (e.g., proprietary trades, retail customers, institutional customers, foreign financial institutions).
  • 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).
    • Failing to periodically evaluate adequacy of firms’ controls and thresholds in light of changes in their customer base or the market.
  • Surveillance Deficiencies: Not adequately monitoring customer activity for patterns of potential manipulation; not reviewing surveillance exception reports; not documenting review findings; and not considering non-surveillance sources for red flags (e.g., inquiries from regulators or service providers, publicly available information about known manipulators, not training responsible staff).

Effective Practices

  • 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.
    • Tailoring supervisory systems and processes to differing types of manipulative order entry and trading activity based on product class, including listed and OTC equities, options and fixed income products (e.g., Treasuries).
  • Multiple Platform and Product Monitoring: Monitoring activity occurring across multiple platforms that also may involve related financial instruments or multiple correlated products, as well as cross-border activity in related 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.

Additional Resources

  • Algorithmic Trading Key Topics Page
  • Cross-Market Equities Supervision Manipulation Report Card
  • Regulatory Notices
    • 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 19-18 (FINRA Provides Guidance to Firms Regarding Suspicious Activity Monitoring and Reporting Obligations)
    • 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)
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