Reg SHO continues to present challenges for broker-dealers, evidenced by the numerous settlements with FINRA over the past 18 months. The SEC implemented Reg SHO in 2005 to enhance market integrity, protect investors, and mitigate manipulative practices associated with short selling. Key concerns include preventing naked short selling, promoting market confidence, curbing manipulative trading practices, and ensuring the timely delivery of securities. The requirements are not too complicated in theory, but in practice presents challenges with implementing and maintaining supervisory systems to ensure compliance.
Reg SHO compliance issues can arise from multiple sources, including:
- Onboarding procedures must correctly identify customers under common control in order to determine if the overall client position is net long or short. This can include consolidating entities reporting under multiple MPIDs. Just as important, affiliated entities shouldn’t be consolidated if the affiliate is not subject to reporting requirements. Getting this correct is essential for determining net position.
- Meeting the locate requirements requires diligence of the firm’s Easy-to-Borrow list and the systemic controls preventing short sales on open Fail-to-Deliver (FTD) items subject to the close out provisions of Reg SHO. Securities must be put in the “Penalty Box”, requiring them to be pre-borrowed before executing the short sale.
- Order marking practices must be clearly defined and communicated to relevant staff. Systemic controls and processes are essential to effective oversight of the process. In addition to creating Reg SHO concerns with the handling of true short sales, locate requirements, and settlement processes, incorrect order marking can result in trade reporting issues, increasing regulatory exposure.
The supervisory structure and control process governing Reg SHO compliance should include several key components.
- Daily processes and controls should be well defined in the firm’s policies and procedures, identifying ownership of key controls, escalation policies, and evidence of management oversight.
- Given the potential source of issues, it is important to educate staff on all aspects of compliance, starting with order entry, the locate process, loan recalls and through the settlement/close out requirements.
- Firms must have effective testing and evaluation procedures in place. FINRA has made it clear in recent Letters of Acceptance, Waiver, and Consent (AWC) that testing is required and expected to evaluate systemic controls as well as manual processes.
- Firms must employ extra diligence in technology enhancements and other change management events. Significant penalties have been assessed for Reg SHO violations that originated with system changes or upgrades.
Oyster’s team of trade reporting experts with real-world experience is uniquely positioned to offer assistance and perspective on Reg SHO compliance topics. Having served in supervisory, operations and technology roles, we are aware of the daily challenges and stress faced by the trading and lending desks, operations, and technology teams. Our experts are familiar with potential pitfalls such as determining net positions, trading with affiliates, and close-out requirements, and can effectively evaluate and test for compliance. Our consultants will conduct a comprehensive assessment of supervision practices and identify control gaps. We offer practical recommendations and solutions. Given the scrutiny and penalties that have been assessed, partnering with a team of experts to conduct an independent assessment makes sense.
