Each year, FINRA releases its Report on FINRA’s Examination and Risk Monitoring Program, previously known as FINRA’s Exam Priorities.  In this podcast, Oyster experts Jeff Gearhart, Evan Rosser, Ralph McGee, and Frank Childress share their insights and thoughts on what firms should be doing around the Market Integrity portions of the report. This includes Consolidated Audit Trail (or CAT), Market Access, Best Execution, and Order Routing and Execution


Transcript provided by Temi transcript services

Libby Hall:  Hi everyone, and welcome to the Oyster Stew podcast. Each year, FINRA releases its report on FINRA’s Examination and Risk Monitoring Program, previously known as FINRA’s Exam Priorities.  In this podcast, our experts, Jeff Gearhart, Evan Rosser, Ralph Magee, and Frank Childress share their insights and thoughts on what firms should be doing around the market integrity portions of the report. This includes Consolidated Audit Trail or CAT, market access, best execution and order routing and execution. Let’s get started. Jeff,

Jeff Gearhart:  Ralph, we’ll  start with you on the CAT topic. Obviously it’s been a focus for FINRA and now that OATS is officially gone, it’s going to be CAT from here on out. So it’s been a heavy lift and it can be quite confusing. Can you explain what FINRA will be focusing on and what steps firms can take to prepare for this?

Ralph Magee:  Sure. Jeff, thanks. That’s a great question. I think for industry members, it really comes down to and starts with awareness over the past year and a half. We’ve seen the industry complete the implementation of transactional CAT reporting that included phases two, a two B, two C and most recently in December phase two D.  To me, it’s been abundantly clear from FINRA that CAT reporting will be one of their future areas of focus.  Regardless of whether your firm reports to CAT, or how they report to CAT, it’s important to note that the firm itself is ultimately responsible to adequately surveil their CAT reporting and that can never be contracted outside of their firm and their direct control. We expect FINRA to generally be interested in firms written policies and procedures, as well as their CAT surveillance policies. This can be particularly important for firms who utilize CAT reporting agents, CRAs, as they’re referred to.  These firms need to be prepared to demonstrate how they monitor and surveil their CAT reporting, that’s being done on their behalf by the CRA.  As an example if you have BD One. So Broker Dealer One uses a Clearing Firm A who acts as the CRA for a Broker Dealer One.  What kind of tools does the Clearing Firm A provide to their introducing brokers? How does Broker Dealer One work with their Clearing Firm A to maintain their CAT compliance? Does Clearing Firm A provide Broker Dealer One access to source files, which will allow comparative review of CAT submissions versus their order record files that they keep internally.

Jeff Gearhart:  Ralph. Since firms can’t contract their responsibilities away, regardless of someone else doing the reporting for them, I’m hearing you say they need to keep a dashboard or a report card or something to keep track of their performance and make sure things are fine. Is that right?

Ralph Magee:  That is 100% correct. Yeah. They cannot contract that surveillance or compliance to any other firm or entity. It resides at the firm itself.

Jeff Gearhart:  Okay. And so since CAT is fairly new and the industry’s coming to grips with it, FINRA’s coming to grips with it, what do you sense FINRA’s approach is going to be on the whole topic? What are they going to focus on?

Ralph Magee:  So what we’ve seen recently is the expected items such as what the rule is based on clocks synchronization, and how that will relate to the audit trail of an equity or option order from start to finish. We’ve most recently seen with some clients that we’re working with increase related to the new material that’s highlighted by FINRA and the CAT section of their 2022 report on FINRA’s Examination and Risk Monitoring Program exam.  Examples of that would be field values, such as account holder type, department type, time and force, manual flag indications, order handling instructions and representative indicators. We’ve also seen some recent focus on fractional share trading and the related CAT reporting events that are associated with that type of business. But I guess, in general, the summary is – be aware, right? Now’s a great time, the perfect time to review your CAT compliance and supervisory programs.

It really starts with your current WSPs and your desk procedures. What are you doing or are you doing the things that those policies say that you’re doing? Do those policies meet the expectation of FINRA and identifying at a minimum who’s responsible for those reviews, what reviews are being performed and how often, and how does the firm actually evidence those reviews?  At that point, I think really what you can do at that point, is do a deeper dive into your CAT reporting on a full analysis of your current CAT reporting to FINRA CAT and focus on focus. Certainly some on those values that we’ve mentioned in the above fields, and whenever possible, we recommend you doing the source file validation as to the degree of access that you have to that information.

Jeff Gearhart:  Do you sense FINRA, well, it’s already a priority. But do you sense they’re going to become stricter on the enforcement or are we going to see more fines, more letters of caution, more issues?

Ralph Magee:  Yes. To all of those things. I mean, this was in the sanction guidelines, for the year as well. I kind of detailed what kind of fines would be expected for first time violators, second time violators, perpetual violators. Those types of things are in that guideline. And now I believe that the transactional CAT reporting section of this is done, from an industry implementation perspective, the focus of the regulators isn’t necessarily getting through this implementation, right? So now they can start doing these bigger scale sweeps across the industry and reporting. I mean, obviously, those firms that are not meeting the minimum requirement of being under 5% on an error rate and those types of things, those are immediate targets of course, and have been throughout the implementation phase. But now that it’s done, we are seeing firms that have excellent compliance rates get informal increase. And I don’t anticipate that doing anything but increasing as we move forward.

Jeff Gearhart:  So there was flexibility, it was a learning curve, but we’re past that stage.

Ralph Magee:  Yeah, and the only thing that we’ve got left in this implementation is really phase two E, which comes into compliance in July of this year. And that’s really more of a reporting function. And it’s for the CAIS. And that’s an acronym, as we have many acronyms in CAT, but it’s customer and account information system. So now is where the industry will be able to tick and tie the transactional CAT data with the actual in customer who originated those order events that have been submitted to CAT.  And that’ll allow the regulatory body to surveil across the industry. So, you know, Jeff, if you have an account in multiple broker dealers and in some way, we’re trying to manipulate that market through transactions, it’ll allow them to put all of those pieces of the puzzle together.

Jeff Gearhart:  Okay. Well, it’s, it’s only going to get more intense from here on out, I suppose.

Ralph Magee:  Agreed.

Jeff Gearhart:   All right. We’ll switch topics under the market integrity section of FINRA’s Examination and Risk Model program.  Best X always pops up and that’s Frank’s favorite topic, right. We actually have quite a few engagements centered around best execution.  What are we seeing as their current focus areas and where firms may have some vulnerabilities.

Frank Childress:  Yeah, great. Jeff you’re exactly right. FINRA has been focusing on best ex concerns for the better part of 20 years with their annual compliance letter. And this year is certainly no different. Starting right at the top of the list, as you might imagine, is disclosure. They also highlight certain topics that we always see like written supervisory procedures, and they continue to love and embrace the phrase regular and rigorous, so your regular and rigorous reviews and how you go about documenting those reviews. So those continually pop up through all their considerations and we see that in findings as well where firms don’t meet FINRA standards. And the disclosure isn’t just limited to the disclosures that we’ll talk about a little bit later for routing rule 606 disclosures. But they also reference how you’re treating customers Best Ex requirements with respect to extended hours.  So both pre and post market order surveillance and how you’re reviewing execution quality. And are you properly closing how you treat execution quality within the extended hours timeframe?

Also Ralph alluded to, and a little bit newer to us, is how we look at fractional shares. So do you have a fractional share disclosure? How do you treat best execution responsibilities as they relate to fractional shares?  Also not new this year, but how you treat conflicts of interest. These things continually pop up on FINRA’s reports because they continually have findings in these areas. We’re how you’re addressing or not addressing all the conflicts that may exist.  For example your routing practices to potentially an affiliate broker dealer or considering all aspects in different types of inducements that might be involved in a relationship. So not just the traditional payment for order flow but could also include other types of exchange-based rebates or rebates between firms or even exchange tiering arrangements, where you get discounts based on volumes that might go to an exchange or a market center.

Also FINRA pointed out the need for firms to review sort of next day or T plus one exception reports. And what type of reports and tools do you have to evaluate execution quality? So it’s not just enough to send your order flow to a wholesaler and expect that they’re going to take great care of you and look at the aggregate numbers. But you need to be able to identify when situations may have certain exceptions either for time or for price. So you need to establish reports with clear parameters for those types of things, speed and price, where trades would be reviewed for potential trade improvements or price improvements if they fall outside of those parameters. So how is that if you have those situations, how are you identifying them? How are you documenting them? What are the policies and procedures that are wrapped around those particular issues when you might have an exception? So those are just a couple of things that we’re seeing highlighted. There’s also lots more, as you look through the best execution section within FINRA’s report this year. And we’d be happy to talk about any of those in greater detail as needed.

Jeff Gearhart:  So these best X rules –  a couple questions, one was interesting. You can’t just rely on the aggregate statistics. You have to look for variances and address individual trades that might be outside the norm or at least document your efforts there. You can’t just sit back and look at the overall scorecard. 

Frank Childress:  Correct. FINRA is clear that they want not just reviews of the aggregate numbers, but  they’ve identified different bucket sizes that you need to review for execution quality. They want different types of orders. So whether they’re market orders, limit orders or marketable limit orders or even not held orders, which is a focus again this year not held orders outside of the execution parameters. So the routing bucket sizes that they give you up to 10,000 shares.  That doesn’t restrict your best execution responsibility on orders that might be above or below those bucket sizes. So they’re looking at all types of things on a much more micro level than just aggregate order flow.

Jeff Gearhart:  And, and these rules, whether you’re self-clearing or an introducing broker, you’re still accountable for best ex, and you still need to have appropriate controls, due diligence, or what’s the right term, regular and rigorous.

Frank Childress:  Regular and rigorous.  You certainly need to have regular and rigorous reviews not less than quarterly regardless of whether you’re introducing or self-clearing. And there is certainly a level of execution quality that you can rely on your wholesalers or clearing firm to expect, but you need to validate that they’re doing what they said they’re doing, and that they’re providing you the best execution they possibly can.

Jeff Gearhart:  I mean, it makes sense. I think for both of us in prior roles, we’ve had to deal with this directly and you definitely need to maintain a level of diligence especially when it comes to points of conflict. And I know from personal experience, anytime you’re dealing with an affiliate, there’s extra scrutiny.

Frank Childress:  Yeah, no doubt.

Jeff Gearhart:  So FINRA is also intent focus on order routing, which obviously fits in with the best ex topic. And there have been some updates specifically to rule 606.  From your perspective, what’s FINRA  looking for here again. And where do you think firms have been found to be vulnerable?

Frank Childress:  Well, a little bit surprisingly is really, your first and foremost responsibility is the firm publishing accurate and properly formatted quarterly reports, easily accessible under disclosures on their public website. And these continue to pop up as FINRA has had significant findings with firms that don’t meet those minimum requirements. So that’s important, that’s sort of the first out of the box thing to consider is to make sure and to validate that your firm is in fact publishing accurately and properly formatted rule 606 disclosures on a quarterly basis. So that’s right out the gate. Also, they’re looking more into detailed payment for order flow and order handling reviews, explain explicit and implicit contractual arrangements per share, or per order data. They’re looking for type and size of different orders. And they’re also looking for more information on any exchange relationships detailing your rebates and tierings, as I mentioned before.  So what types of rebates might you be receiving from exchanges, for example.  For limit orders, how is that being reflected?  And also, much greater detail on the actual payment for order flow arrangements that you may have with other firms?

Jeff Gearhart:  This all seems to fit pretty naturally with chairman Gensler’s priorities. So these aren’t going to go away.

Frank Childress:  No, and there’s been, more recently, there’s been additional emphasis on specifically rule 606 B 3, which has some pretty stringent requirements on if a client requests information about where their orders are being routed. So they have, so you’ve got from a FINRA perspective, this has to be well documented within your policies and procedures. And, if you actually receive a request, again, that has to be documented, and you have to be able to show that you responded to the inquiry within the timeframe, which is seven business days. So continue to focus on this area of order routing and order routing disclosure. And it certainly seems that they’re going to be looking at this closely in 2022.

Jeff Gearhart:  And just like one final comment, we always seem to fall on best X focused on equities, but, you know, best X standards apply to fixed income as well. Correct?

Frank Childress:  Absolutely. They apply to fixed income and options as well. And there does seem to be some emphasis within their letter this year on both those spaces.

Jeff Gearhart:  Thank you. So Evan, market access always seems to be a priority from FINRA and gets a lot of attention. Can you provide your perspective on where firms might be having trouble with the risk management controls and WSPs to govern market access? What are some of the key issues you think FINRA keeps hitting on?

Evan Rosser:  Yeah, sure. Jeff, and it’s always going to be of interest to FINRA as long as there’s technology, as long as there’s market fragmentation, they’re going to be looking at how firms are accessing the markets. 15, C 3 5, the market access rule has been with us now for quite a while. And you know that rule recognizes the rule technology plays in modern trading and the impact that high frequency trading and automated trading can have on the markets and have on firms. Firms need to have controls around that. And it’s pretty basic that firms need to have automated controls to monitor and control automated trading. You need to have specific risk-based controls. And that’s really a big part of the rule. It’s a risk-based rule so that your controls need to reflect the risks at your firm.

You cannot use the firms that, or the controls of vendors. And I think that’s one of the things that FINRA found in their exams is that firms relied on third party vendors to set their financial controls without understanding how those controls worked and not really knowing if they were the right controls for the firm’s activity. When you have automated controls, you have to test them. And when we’ve worked with firms, we know the SEC’s questions.  Are the controls reasonably designed, meaning are they controlling the right thing? And are they working effectively, meaning they’re designed to do the right thing, but are they working?  So FINRA, and others, are going to really look not just at your controls, but are you testing those controls and how are those controls rolled out? How do you deploy your software? How do you deploy your fixes, your upgrades?

Because we’ve seen instances where that roll out of trading software can have significant impact on the firm and its trading. Now it’s a technology rule in large part, but there are lots of parts of the market access rule that are not necessarily highly technical or technology related activities. Bond trading falls under 15 C 3 5. Now bond trading is becoming more automated. However, bond trading doesn’t fit well into the automated trading and vision by the rule – equity trading, high frequency trading, but it is covered. And if you’re directing trades to an ATS, fixed income trades to a bond or fixed income ATS, that activity falls under 15, C 3 5. There’s some other aspects of the rule that aren’t necessarily heavily technical, how you determine, approve, amend your capital and credit controls is not a technical determination, but it is a significant part of the rule.

You need to know your principal trading, how you allocate cap firm capital to traders, how you determine credit allotted to customers. And that’s going to depend on every security. It’s going to differ from customer to customer, from trading desk to trading desks, from security to security, and you need to have a process for that. Another significant part of the rule, it’s not just controlling orders that enter the market, but it’s orders that are executed in the market, that are entered into the market. So the post trade surveillance piece of 15, C 35 is very significant.  Firms expect the broker dealers who provide market access to look at that post trade activity to determine if there are evidences of manipulation, spoofing, layering, or some other activity that’s meant to manipulate the market. And you need to have parameters, you need to have a process by which you review that activity in the marketplace.

Jeff Gearhart:  They’re raising the bar with technology and automation, as it continues to evolve.  Do you think firms have to continue to raise the bar? You had mentioned testing earlier. It’s like you could be asleep at the switch and keep doing the same thing year over year.

Evan Rosser:  Oh, I think they are. And because you can do that, the technology itself is raising the bar. You can do more with the technology. So yes, the expectation I think, of regulators is that you can see not just the post trade activity, but you can control the activity going into your markets and what you’re sending out to the street, to the marketplace.  ATS exchanges are part of this rule too. And I think FINRA has found this, and I’ve seen it myself, is the annual certification is a significant piece of what needs to be done here. And that it’s not a perfunctory control. It’s a regular report that needs to summarize your activity for the year, what you’ve done, how your controls work, what have you seen from your market access and what you’ve seen from providing access to customers?

Jeff Gearhart:  What are some of the issues? I know we’ve actually done a lot of reviews and we engage with a lot of different firms on this effort. What are some of the pitfalls or issues that you’ve seen firms maybe slip up on the most?

Evan Rosser:  Well, I think part of it is they don’t realize when they are subject to 15, C 3 5. And I think some firms don’t always pick that up when they do fixed income trading. When they send perhaps low-price securities to an ATS over the counter, OTCBD that is all subject to the market access rule. I’ve seen firms not do a very meaningful or detailed annual certification or I’ve seen firms as, I think FINRA has, that they don’t have a rigorous process for determining credit and capital limits. They don’t review those on a regular basis, and they don’t have a process for amending those limits during the course of the trading day, when the situations require those limits to be changed. Reliance on vendors is another problem. As I noted earlier you can’t rely on someone else’s control.  The rule requires you to have direct and exclusive control over the controls that you’re using. And you can’t rely on others without the ability to amend them and make sure they work for your particular firm’s trading risks.

Jeff Gearhart:  It sounds like a lot of these issues can come up. I, and you mentioned this earlier, and it hit a note with me, when firms change a process or add a product, or you maybe even change a clearing vendor. It seems like that can cause quite a few more problems than maybe they expected and result in some issues here.

Evan Rosser:  It can. And it can certainly change the process. It can change those kind of deployments. Those kind of software changes can have significant impacts on firms. And we’ve seen it in many instances.

Jeff Gearhart:  A common theme here that I picked up on from Evan, Frank and Ralph is reliance on vendors isn’t acceptable here.  Whether it’s best X, CAT, or market access, firms have to own it, and they can’t delegate it away. I think you guys would all agree with that. I’m sure.

Ralph Magee:  Yes, absolutely.

Jeff Gearhart:  Okay.

Evan Rosser:  Well, yeah. And it’s actually in the text of 15, C 3 5 about having exclusive and direct control of those controls.  That you set them, and you make sure they are appropriate for your firm. You can’t rely on others.

Jeff Gearhart:  Right. And I do think we find that in our experience dealing with a lot of clients, a lot of times they think maybe things don’t apply and well, sometimes that’s why we actually get involved with them. But in any case,

Ralph Magee:  And in terms of CAD, it it’s specifically spelled out in FINRA notice to members 20- 31 as well. It clearly states there where that responsibility cannot be out of the direct control of the firm itself.

Jeff Gearhart:  Well I hope this was helpful and informative as we address some of FINRA’s priorities for the coming year. And thank you all for your comments.

Ralph Magee:  Pleasure.

Frank Childress:  Thank you.

Libby Hall: Thanks everyone for listening today. If you’d like to learn more about our experts or how we can help your firm in these areas, visit our website at www.oysterllc.com. If you like what you heard today, follow us on whatever platform you listen to and give us a review.  Reviews make it easier for people to find us.  Have a great day.

About The Podcast Speakers
Photo of Evan Rosser

Evan Rosser

Evan Rosser is an experienced and respected securities industry professional with over 25 years of experience managing complex securities investigations for NASD/FINRA and providing compliance expertise to both broker-dealers and investment advisors.  Evan has served as CCO for both investment advisors and broker-dealers, as well as providing compliance support to numerous broker-dealers and registered investment advisors.

Photo of Jeff Gearhart

Jeffrey Gearhart

Jeffrey Gearhart is an intuitive, analytical leader with over 30 years of experience in banking and capital markets businesses. Prior to joining Oyster, he held senior leadership roles with The Bank of New York Mellon, including business line COO, CFO, business development and relationship management.

Photo of Ralph Magee

Ralph Magee Jr.

Ralph Magee Jr. is a securities industry professional with over 25 years of experience in the financial services industry. Ralph has led multifaceted teams in large-scale client remediation and clearing platform conversion-related projects. Ralph also uses his expertise in trade reporting providing large broker dealers project management and subject matter expertise related to the Consolidated Audit Trail (CAT).

Photo of Frank Childress

Frank Childress

Frank Childress is an engaged and respected Financial Services professional with over 35 years of industry experience. Frank has extensive expertise in Equity and Fixed Income Trading, Equity Market Structure, and Capital Markets Products for retail distribution.

View Our Team