Exam Priorities: Investor Protection, Market Integrity

Terry Flanagan

Financial regulators will focus their examination efforts in 2015 on investor protection, market integrity and operational risk. The SEC’s and Finra’s examination priorities provide a blueprint for firms on what to expect when examiners come calling, and also serve as fair warning.

The priorities include “personal accountability of the people in charge and sanctions, which are fines that will not just be slaps on the wrists,” Walter Ferstand, regulatory compliance expert at NICE Actimize, told Markets Media. “There will be zero tolerance for repeat violations.”

As a compliance subject matter expert, Ferstand works closely with clients and prospects to evaluate, educate, and advise on trading compliance requirements. “The way that I approach Finra, SEC, CFTC and NFA examination priorities is to group them together and try to distill all this information to find out where the common themes are.”

For example, both the SEC and Finra have prioritized a review of investment-related issues affecting the growing senior population. The objective of both regulatory bodies is designed to implement protections for senior investors, address sales practices and suitability, and regulate broker communications with seniors.

“The issue is whether these clients suitable for certain types of products,” Ferstand said. “We’re not talking about buying 100 shares of Apple. Most of the time it’s more complex products that are comprised of options, stocks, futures, and swaps. Are the clients informed of the risks associated with it, the markup and markdown? How much commission the firm is going to be getting on this product? How much time is it going to take for me to make these returns?”

The SEC also will address abusive trading algorithms, high-frequency trading, cross-market and cross-product manipulation, order-routing practices, and market access controls.

In the case of market access controls, the SEC’s rule 15c-3, which requires broker-dealers to have a system of risk management controls associated with providing a customer with market access, has been on the books for a number of years, but only recently has become an examination priority, according to Ferstand.

“Anybody who has just been in the business even a month can see the risks associated with that. That’s why 15c3-5 came into being,” he said. “A couple of years goes by and now it becomes an examination priority because they want to make sure that the integrity of the market is not breached.”

He added, “When an HFT client sends out a program into the market that has no risk management, no checks, that’s bad. The point is the rule came out. It’s been a few years and then they have their army of examiners go out and do the examination process to make sure that companies have systems in place to be able to capture this.”

Finra views abusive trading algorithms and deficient supervision for potential manipulation as among the most significant risks to the integrity of the markets. Finra said it will continue to pursue firms whose traders or customers use algorithms to manipulate the markets, including through layering, spoofing, wash sales and marking the close.

“A system that was good enough several years ago may not be good enough today,” said Ferstand. “Because they’ll look at a quarter’s worth of data and detect potential wash trades and ask why these weren’t picked up. All relevant institutions – after carefully reading over the new exam priorities – should re-visit their plans and polices to be sure they are all up to date.”

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