By Buddy Doyle and Evan Rosser
2020 Exam Priorities Letters, Part 2
This week’s episode of Oyster Stew is Part 2 in a series discussing the SEC and FINRA 2020 Exam Priorities Letters. Oyster Consulting CEO Buddy Doyle, Director Evan Rosser and Consultant Joe Turner talk about Market Integrity, the Market Access Rule, and Best Execution requirements.
Future exam priorities podcast topics will include:
- Technology and Cybersecurity
- Business Continuity Plans
- Cash Management / Bank Sweeps
Transcript provided Temi transcript services
Buddy Doyle: Hi everybody. This is Buddy Doyle. I’m the Chief Executive Officer of Oyster Consulting, and welcome to this latest version of Oyster Stew, our podcast that we use to talk about the financial services industry. I’m fortunate enough today to be joined by Evan Rosser and Joe Turner, both of whom are former regulators, have worked in the broker-dealer and investment advisor business for quite a while, and have transitioned to consulting as they go through their career, and have been with Oyster Consulting for some time. So thank you, Evan. Thank you, Joe, for joining us. What we’re talking about today is the examination priorities, the SEC and FINRA. If you’re wondering what’s on their mind, it’s fortunate that they tell you every year. So moving on to market integrity, which is another major component of the Letter, what particularly jumps out to me when I think about market integrity is really down to the controls that came out of 15c3-5, the Market Access Rule.
And Evan, I know you’ve done an awful lot of work related to algorithmic trading and controls and been involved in a lot of the regulatory dust ups that have occurred in the industry. Can you give us a little bit of an overview of what firms should be thinking about when it comes to direct market access controls?
Evan Rosser: This is an issue that affects the marketplace itself. It affects the financial health of firms and it is a customer protection issue. So it really touches all aspects of what FINRA, and the SEC are meant to regulate. And it really brings the technology now of current trading practices into the compliance world. One of the most important aspects of the Direct Market Access Rule 15c3-5 is really controls. It’s very much a control rule, and one of the things that FINRA is going to look at is, what are your controls? How do you control orders entering the system? Are they in regulatory compliance? Do they, are they within preset capital and credit controls? And then are you reviewing post-trade surveillance? That’s another huge part of 15c3-5. And the issues that FINRA has and they have found it, as does the SEC, is you don’t have those controls. You don’t have a process to set adequate capital control for the firm’s trading and credit controls for the customers’ trading. Do you have a process for intra-day changes because they will happen during the course of the day for active trading firms That enact high frequency traders? So you need to have that process for creating those credit and capital controls, enforcing them, being aware when they’re being breached or nearly breached and resetting them during the course of a day for legitimate reasons. Another thing required by 15c3-5 is CEO certification.
The CEO certification really needs to be documented. Most firms do a series of sub-certifications from technology, from credit and finance, from technology and compliance. There are a number of aspects of the program that need to be reviewed, and they need to be demonstrated that the firm is in compliance with all the provisions of 15c3-5. You need to be aware of your controls, who sets the parameters, how the parameters are set. Many firms take the parameters provided by their service agencies, but they need to set them that are appropriate for their firm and based on the experience that they have. They need to have control of the controls so they can set them and monitor them and amend them as necessary. Post-trade controls and surveillance are very important. The rule requires you to surveille all activity post-trade.
And that is where firms need to look at unusual trading for hot, perhaps manipulative trading, spoofing, layering. And it’s important that firms not only capture that, have parameters to capture possible exceptions, possible red flags of activity. And they do that in a timely manner that those are reviewed and escalated when necessary, and they can document the escalation and documentation of the disposition of those escalations. So there are a lot of different pieces. If you do provide clients with the ability to directly access ECNs, market makers ATSs or exchanges, you will need to have a robust market access policy and both the FINRA and the SEC will be looking it when they examine you.
Buddy Doyle: And I would encourage you, if you’re in the direct market access business, to also look at the controls around overrides. Most of these training platforms and controls have a way to override those controls for purposes of fulfilling legitimate business.
But when people override those controls, are they doing it for the right reasons or not? Is there an approval process around that and a review process around that? That’s something to keep a close eye on as well. Really that’s the part that can get you in a lot of trouble.
Evan Rosser: Yeah, there are hard blocks and there are soft blocks. Blocks can be overwritten and it’s important to know under what circumstances you can override a soft block. Another thing that I think failed to mention was the testing of your program. You can have all the controls in place, but you must test them to make sure they’re reasonably designed to do what they’re meant to do. And in fact they are working.
Buddy Doyle: And Evan, I guess it would be inappropriate to talk about trading without talking about best execution, which is sort of at the core and heart of what the industry does. Any learning on best execution from the Letter?
Evan Rosser: I think there is a little bit. One of the things that it brings out, I don’t think there are any new developments or rules pertaining to best execution, but FINRA will continue to look at the diligence firms use to direct order flow where it goes and isn’t going to the best market given the size and the type of the order. They will also be considering what does best execution mean now, and order routing decisions mean, in this increasing environment of zero commission brokerage activity. They’ll be looking at odd lots. FINRA has seen a significant increase in odd lot activity and where is that going to the right market? I think another thing that maybe firms might not always focus on, is they’re going to be looking at the reasonableness of policies and procedures for best execution in US Treasury Securities as well as option orders.
Evan Rosser: I think it’s important that if you haven’t done so, that you make sure your best execution procedures cover those two products: fixed income securities and options. One other thing, going back to direct market access for a moment. Fixed income also falls under direct market access 15C3-5. So if you’re directing fixed income or your clients are directing fixed income orders directly to an ECN or an ATS, the trades fix income, you are subject to 15c3-5. Fixed income obviously doesn’t trade the way high frequency equity trading does, but it’s still subject to the rule.
Buddy Doyle: Well, with that, I would like to thank you all for your time. Joe. Evan, thank you so much. If you were looking for any guidance or thought on your regulatory compliance program or the focus of the regulators, feel free to reach out to us and uh, we will get back to you right away.
Oyster: Thanks again for listening to the Oyster Stew podcast. Don’t forget to subscribe so we can continue to bring you resources to help you make the best decisions for your firm. If you’re struggling with the topic and you’d like us to do a podcast on it, or you’d like a free consultation, feel free to reach out to us at (804) 965-5400 or by visiting our website at oysterllc.com.