The Securities and Exchange Commission proposed changes to an existing rule that, if adopted, would require certain proprietary trading firms registered with it as broker-dealers to become members of the Financial Industry Regulatory Authority for the first time. These would include proprietary trading firms that engage in a significant amount of trading on alternative trading systems, such as dark pools.
Registered broker-dealers are not currently required to join FINRA if they are members of a national securities exchange, carry no customer accounts and have annual gross income of US $1,000 or less attributable to securities transactions other than on a national securities exchange of which they are a member. However, income derived from trading through another broker-dealer does not count against the US $1,000 limit. The proposed amendments would eliminate this de minimis exemption.
According to Mary Jo White, Chairperson of the SEC, the original purpose of the relevant rule—Rule 15b9-1—was to enable exchange specialists and floor brokers that principally traded on the floor of an individual exchange “to conduct limited hedging or other off-exchange activities ancillary to their floor-based activities.”
Today, however, claimed Ms. White, many broker-dealers take advantage of the relevant rule whose business is not focused on an exchange floor. According to Ms. White,
[t]rading is now dominated by computer algorithms and active cross-market proprietary trading firms have emerged as significant market participants. These firms represent a significant portion of off-exchange trading, accounting for nearly half of all orders sent to alternative trading systems. The business of these firms is not focused on an exchange floor, and their off-exchange activity is far from ancillary. Yet, they may and do rely on the very same exemption under Rule 15b9-1 for floor brokers.
The proposed amendments do not require proprietary trading firms that are members of national exchanges and who conduct most of their business from such facilities’ floors to join FINRA if their activity on alternative trading systems is solely to hedge the risks of their floor-based activities and they maintain appropriate policies and procedures.
Oversight by FINRA will enhance transparency and regulation of the off-exchange market, claimed the SEC, which is impeded today because FINRA does not have jurisdiction over non-member firms. According to the SEC,
because it does not have jurisdiction over Non-Member Firms, [FINRA] is unable to enforce compliance with the federal securities laws and rules, or apply its own rules, to broker-dealers that conduct a significant amount of off-exchange trading activity, including those that engage in so-called high-frequency trading strategies. As a result, FINRA’s ability to perform comprehensive market surveillance, especially for violations of Commission rules, as well as its ability to understand and reconstruct activity in the off-exchange market generally, is limited … Accordingly, FINRA is unable to monitor the off-exchange market activity of Non-Member Firms, and detect potentially manipulative or other illegal behavior, as efficiently or effectively as it can with FINRA members.
Comments are due on or before 60 days following publication of the proposed amendments in the Federal Register.
Both FINRA and the Futures Industry Association separately published guidance to help enhance effective supervision and control of automated trading systems and algorithms.
Key among FINRA’s recommendations regarding algorithmic trading strategies is that a firm’s “supervisory efforts should be focused on every stage in the process of developing [such] strategies and not be limited to reviewing trading activity by algorithmic strategies only after they have been put into production.”
FIA’s recommendations regarding automated trading systems are more detailed, and include recommendations regarding specific pre-trade controls that should be incorporated into such systems. These include filters or capabilities that address maximum order size, maximum intraday position, market data reasonability, price tolerance, repeated automated execution limits, self-match prevention, kill switches and cancel on disconnect, among other controls.
FIA also makes detailed recommendations regarding the development and testing of algorithmic software, as well as change management and security.
Two weeks ago, FINRA proposed registration of broker-dealer’s algorithmic trading programs’ principal developers and supervisors.