FINRA Provides Update on Sweep: Option Account Opening, Supervision and Related Areas
In August 2021, FINRA launched a targeted exam (sweep) to review firms’ practices and controls related to the opening of options accounts and related areas, including account supervision, communications and diligence. FINRA’s review focuses on a cross-section of retail and diversified firms that offer options trading to their customers.
Below FINRA poses several questions for firms to consider as they evaluate whether their supervisory systems are reasonably designed to address risks related to supervising the approval of options accounts – both self-directed and full-service brokerage accounts – and monitoring the trading activity in options accounts. The questions for consideration in this update are based on FINRA’s observations to this point in our review. The questions focus on firms’: (1) processes for collecting and reviewing facts about their customers in connection with approving customers to trade options; (2) disclosures about options trading; and (3) supervision of approved options accounts. In addition, the Appendix notes additional guidance FINRA has provided regarding member firms’ obligations related to options.
Member firms that offer options trading should be aware of their regulatory obligations pursuant to FINRA Rule 2360 (Options), as well as other relevant obligations, including but not limited to FINRA Rules 2090 (Know Your Customer), 2210 (Communications with the Public), 2220 (Options Communications), 2260 (Disclosures), 2264 (Margin Disclosure Statement), 3110 (Supervision), 4210 (Margin Requirements) and 4512 (Customer Account Information). In addition, members that recommend an options account or an options transaction to a retail customer must comply with the SEC’s Regulation Best Interest (Reg BI).
This update, including the Questions for Consideration, does not create new legal or regulatory requirements or new interpretations of existing requirements, nor does it relieve firms of any existing obligations under federal securities laws and regulations. Member firms may consider the information in this update in developing new, or modifying existing, practices that are reasonably designed to achieve compliance with relevant regulatory obligations based on the member firm’s size and business model. Moreover, some questions may not be relevant due to certain firms’ business models, size or practices.
In future publications, FINRA may provide additional information on this and other sweeps, including but not limited to findings and effective practices.
Firms’ account approval practices, at a minimum, must comply with FINRA Rules 2090 (Know Your Customer), 2360 (Options), 4210 (Margin Requirements) and 4512 (Customer Account Information). As described in Rule 2360, firms must implement procedures for conducting due diligence when approving customer accounts for options trading. To comply with this obligation, firms may establish processes to, among other things, review options account applications for completeness and accuracy, compare information contained in options applications with other information available to the firm (including information contained in other options applications submitted by the same customer), and verify that customers who change their account profile information continue to be eligible to trade options. The following questions may help firms assess how they approve options accounts:
Approaches to Options Account Approval
Firms utilize different approaches for supervising the options account approval process.
- Manual Review – Some firms only implement manual reviews.
- Automated Review – Some firms rely almost exclusively on automated reviews, making sparing use of manual review.
- Dual Approach – Some firms implement a dual approach that integrates both manual and automated review.
- Has your firm established minimum criteria for approving options account applications? Are those criteria tailored to the risks associated with each options-trading strategy or options-trading level? For example, do the criteria:
- Consider whether customers’ investment objectives align with their desired options-trading levels (e.g., growth or speculation for higher levels)?
- Impose enhanced requirements for complex options trading (e.g., options spreads, uncovered options writing), such as requiring that customers:
- Attest to having extensive product knowledge?
- Have a specified amount of options-trading experience?
- Meet your firm’s requirements for the risk level of the selected option level?
- Does your firm’s options account application allow customers to select any trading level for which they may be eligible (rather than just the highest level)?
- Does your firm review options account applications for completion and for potential red flags, such as:
- Comparing the information on the account application with other customer information already held at your firm;
- Identifying potential logical inconsistencies in the application (e.g., a 21-year-old applicant who claims to have ten years of option trading experience or an applicant who selects all of the listed investment objectives; a customer who has provided the firm with conflicting information about his investment experience or objectives); or
- Identifying customers whose claimed investment experience, options-trading experience, annual income or liquid net worth, warrant further scrutiny, in light of the customers’ age or employment (e.g., a 20-year-old student who claims to have an annual income of $300,000)?
- If recommending that retail customers trade in options, does your firm ensure that such recommendations are in the retail customers’ best interest, in compliance with Reg BI?
- When a customer’s application to open an options account is rejected:
- How does your firm identify and address situations where the customer resubmits a modified application (e.g., by changing pertinent account profile information on the subsequent application), potentially repeatedly?
- Does your firm compare the rejected and resubmitted account applications to identify what types of information customers are changing, such as years of options trading experience, income and net worth?
- If your firm utilizes an automated system for approval, does it manually review subsequent applications?
- Does your firm mandate a waiting period before the customer can re-apply?
- Does your firm employ systems and controls (e.g., surveillance systems, exception reports) to identify instances in which customers were erroneously approved to trade options or are trading above their previously approved level? In such instances, how does your firm remedy and correct such errors?
- Does your firm periodically review and test its automated system to identify potential red flags in the information customers provide in their account applications?
The disclosures and related informational material that firms distribute to customers about options accounts and options trading must comply with FINRA Rules 2210 (Communications with the Public), 2220 (Options Communications), 2260 (Disclosures), 2264 (Margin Disclosure Statement), if applicable, and FINRA Rule 2360 (Options). The following questions, where applicable, may help firms assess how they communicate with, and send disclosures to, customers regarding options accounts and options trading:
- Do your firm’s promotional communications concerning options include risk disclosures required by Rules 2210 and 2220?
- Does your firm tailor the communications it uses to promote options accounts to potential customers with different backgrounds (e.g., your firm provides introductory options communications at a general firm-sponsored event and more advanced communications at a firm-sponsored event focused on investors who are experienced in options trading)? Does your firm otherwise limit promotional options communications to customers who meet the firm’s options eligibility criteria?
- To the extent that your firm makes representations to customers about the “maximum loss” or “max loss” of particular options transactions at the time of order entry, does your firm also include relevant caveats (e.g., the estimated “maximum loss” does not account for possible dividend risk)?
- Does your firm provide a copy of the Options Disclosure Document (ODD) to each customer at account opening and subsequently, as required? Does your firm provide additional options-related disclosure material to customers at account opening (e.g., information regarding how your firm handles expiring options contracts or both the automatic and customer-initiated exercise of options contracts)? Has your firm implemented policies and procedures for distributing and tracking disclosures?
- Does your firm’s record retention system identify the Registered Options Principal (ROP) or Limited Principal—General Securities Sales Supervisor who reviewed each options application and confirm that disclosures were provided to each customer at account opening as required?
- Does your firm disclose the risks associated with options trading (and expiration), whether on its options account application or in other documentation?
- Does your firm send supplementary information to customers when they open an account that is approved to trade complex options strategies (e.g., disclosures about dividend risk, expiration risk or the risks associated with owning a margin account or writing uncovered options)? Does your firm send additional information to a customer upon receiving a request to increase the customer’s existing options-trading level?
- Does your firm offer guidance and educational opportunities about options accounts and trading (e.g., seminars, videos, articles, guides)? If so, does your firm share this information with customers at account opening or when a customer is approved for a higher level of trading?
- If recommending that a retail customer open an options account or engage in an options transaction or investment strategy involving options, does your firm provide the disclosures required by Reg BI?
Options Trading Supervision
Firms’ supervisory procedures, processes, systems and controls for options trading may consider the firm’s overall risk profile, and firms must comply with FINRA Rules 3110 (Supervision) and 2360 (Options), including with respect to options account openings and the trading activity in options accounts. The following questions may help firms assess their options supervision:
- Does your firm have a specialized options review group that centralizes the supervision of higher-level options activity, or all options activity, to ROPs, Limited Principal—General Securities Sales Supervisors or a combination of both?
- Does your firm conduct periodic, ongoing reviews of customers’ trading activity to confirm they meet eligibility criteria and do not engage in trading beyond their approved trading authorization? Does your firm periodically evaluate customer account trading levels or send validation letters to existing customers in order to renew their ability to trade options?
- Does your firm surveil customer account information and profiles to determine if certain accounts should be downgraded, deemed ineligible or denied for further options trading? If so, does your firm surveil self-directed accounts and accounts that have been approved to trade complex options strategies (e.g., spreads, uncovered writing) more frequently than other accounts (e.g., daily or weekly, rather than monthly or semi-annually)?
- Does your firm review customers’ trading eligibility as market conditions change? If so, does your firm downgrade customers’ trading levels if their account profiles do not continue to meet certain criteria (e.g., decrease in total net worth)?
- Does your firm restrict customers from trading above their approved trading level, or review for instances in which customers trade above their approved trading level (e.g., automatically flagging and blocking trades for which customers are ineligible; performing daily, manual reviews of options-related exception reports)?
As noted throughout this update, the requirement that a member firm maintain a reasonably designed supervisory system and associated WSPs extends to options account approval, trading supervision, communications and diligence. The information presented in this update is intended to remind member firms of the relevant rules and provide them with ideas and questions that they can use to enhance their supervisory programs. Additional helpful resources can be found in the Appendix.
- FINRA Rule 2090 (Know Your Customer)
- FINRA Rule 2210 (Communications with the Public)
- FINRA Rule 2220 (Options Communications)
- FINRA Rule 2260 (Disclosures)
- FINRA Rule 2264 (Margin Disclosure Statement)
- FINRA Rule 2360 (Options)
- FINRA Rule 3110 (Supervision)
- FINRA Rule 4210 (Margin Requirements)
- FINRA Rule 4512 (Customer Account Information)
- Regulatory Notice 22-08 (FINRA Reminds Members of Their Sales Practice Obligations for Complex Products and Options and Solicits Comment on Effective Practices and Rule Enhancements)
- Regulatory Notice 21-15 (FINRA Reminds Members About Options Account Approval, Supervision and Margin Requirements)
- SEC’s Regulation Best Interest
Publications and Other Resources
- Communications with the Public section of the 2022 Report on FINRA’s Examination and Risk Monitoring Program
- FINRA’s SEC Regulation Best Interest Topic Page
- SEC’s SEC Regulation Best Interest Guidance Page
- Margin Regulation Topic Page
- Suitability Topic Page
- Supervision Topic Page
- FINRA Investor Alert: Investing with Borrowed Funds: No “Margin” for Error (November 2019)