On April 7, the Securities and Exchange Commission (SEC) approved the Financial Industry Regulatory Authority’s (FINRA) proposed amendment to NASD Rule 1032(f) that would require algorithmic trading developers to register as Securities Traders. Under the approved rule, associated persons of trading firms who are “primarily responsible for the design, development, or significant modification of algorithmic trading strategies, or who are responsible of the day-to-day supervision or direction of these activities” will have to pass a qualification exam, register as a Securities Trader, and adhere to continuing education requirements applicable to Securities Traders. FINRA member firms will be required to designate a principal to be responsible for supervising the algorithmic trading strategy activities.
The approved rule is part of a series of FINRA initiatives aimed at addressing the explosion of automated trading activities and the use of such trading algorithms to manipulate markets through increased transparency and qualification requirements. FINRA has advocated that improved education regarding securities regulations for certain individuals involved in the algorithm design and development process could reduce or prevent problematic conduct stemming from algorithmic trading, such as inaccurate orders, inappropriate levels of messaging traffic, wash sales, and inadequate risk management controls. The proposed rule was first submitted in February 2015 and met with mixed reviews. FINRA submitted a slightly amended version in February 2016, stating it had sought to focus the rule’s scope in an effort to balance those concerns with the goal of ensuring compliance with investor protection rules.
FINRA defines an “algorithmic trading strategy” as an automated system that generates or routes orders or order-related messages—such as routes or cancellations—but does not include an automated system that solely routes orders received in their entirety to a market center. The definition does not include an algorithm that solely generates trading ideas or investment allocations (including an automated investment service that constructs portfolio recommendations) but that is not equipped to automatically generate orders and order-related messages to effectuate such trading. FINRA has provided a list of examples of algorithmic trading strategies and, as the SEC noted the approval order, the definition could evolve in the future.
Where a firm engages a third party to build an algorithmic trading strategy, the associated person responsible directing the third party in designing and developing the algorithmic trading strategy would be required to register. Likewise, where a firm purchases an algorithm off the shelf, the associated person responsible for monitoring or reviewing the performance of the algorithm would be required to register. Registration will not be required of (i) junior developers or others who solely write code to implement design or modification instructions and (ii) supervisors not involved in day-to-day supervision of the development process. In the approval order, the SEC stated that it expects FINRA to provide more detailed guidance on implementing the registration requirement.
Although the approved rule only applies to FINRA member firms, the SEC has proposed amendments to Rule 15b9-1 under the Securities Exchange Act of 1934 that would require previously exempt proprietary trading firms to register with FINRA. Additionally, the CFTC has proposed comprehensive set of regulations governing automated and algorithmic trading (known as “Regulation AT”). Generally, Regulation AT requires (i) implementation of pre-trade risk controls, (ii) development, testing, and monitoring algorithmic trading systems according to established procedures, and (iii) submission of annual compliance reports and other materials to U.S. designated contract markets. Regulation AT has received a great deal of industry criticism for being overly broad, violating due process, and threatening to destroy the confidentiality of source code.
FINRA will announce the effective date of the proposed rule change in a Regulatory Notice to be published no later than 60 days following SEC approval.