Schiff Hardin LLP
April 1, 2015
Financial Markets and Products Client Alert

Proposed SEC and FINRA Rules
Would Increase Regulation of Proprietary and Algorithmic Trading Firms

On March 25, 2015, the Securities and Exchange Commission (SEC) proposed an amendment to Rule 15b9-1 under the Securities Exchange Act of 1934 (Exchange Act) that would require active proprietary trading firms in securities to become members of the Financial Industry Regulatory Authority (FINRA). The proposed amendment would narrow a provision of Rule 15b9-1 that currently exempts a specified class of broker-dealers from FINRA membership if certain conditions are met. The current rule has allowed many firms that operate a proprietary-only trading business to avoid FINRA regulation.

The SEC's announcement came just days after FINRA issued its own proposal aimed at enhancing regulatory oversight of high frequency traders who are FINRA members. FINRA's proposed rule amendment would require all persons associated with a FINRA member who are primarily involved in the design, development, or significant modification of algorithmic trading strategies to register as "Securities Traders" and therefore be subject to FINRA regulation. The proposal is designed to increase the scope of trading information that FINRA receives, provide market participants and investors with more transparency into trading activities, and require employees at firms engaged in electronic trading to be trained, educated, and accountable for their role in algorithmic trading strategies.

Below is a detailed summary of each of these proposals.

SEC Proposal to Limit Proprietary Trading Exemption in Rule 15b9-1

Most SEC-registered broker-dealers are required to be members of FINRA. Section 15(b)(8) of the Exchange Act requires every SEC registered broker-dealer to become a member of a registered securities association unless the broker-dealer effects all of its transactions solely on a national securities exchange of which it is a member. However, Rule 15b9-1 exempts broker-dealers from this requirement if they: (a) are a member of a national securities exchange; (b) carry no customer accounts; and (c) have annual gross income of no more than $1,000 that is derived from securities transactions effected otherwise than on a national securities exchange of which they are a member.

Rule 15b9-1 was created in order to allow exchange-based specialists and other floor members to conduct limited activities off of the exchange where they are a member without requiring them to become members of a national securities association. The rule has not been substantively amended since 1983, when the national market system was principally made up of floor-based exchanges that were able to regulate the trading activity of their members.

However, as SEC Chair Mary Jo White stated in her remarks announcing the SEC proposal, "That is not our market today. Trading is now dominated by computer algorithms and active cross-market proprietary trading firms have emerged as significant market participants. These firms represent a significant portion of off-exchange trading, accounting for nearly half of all orders sent to alternative trading systems. The business of these firms is not focused on an exchange floor, and their off-exchange activity is far from ancillary. Yet, they may and do rely on the very same exemption under Rule 15b9-1 for floor brokers."

The SEC has proposed an amendment to Rule 15b9-1 that would require all broker-dealers to be members of FINRA, except for a limited exemption for floor-based dealers consistent with the original intent of the rule. The amendment, if adopted, would ensure that the trading activities of broker-dealers active in the off-exchange market (such as proprietary trading firms) would be subject to the same regulation as other broker-dealers. According to Chair White, the proposed exemption "is narrowly tailored for these purposes and imposes strict — but I believe workable — conditions that would enable floor-based dealers to hedge efficiently while ensuring that the exception does not swallow the rule."

The proposed amendment will be published in the Federal Register with a 60 day comment period.

FINRA Proposal to Register Associated Persons Who Develop Algorithmic Trading Strategies

On March 19, 2015, FINRA issued Regulatory Notice 15-06, soliciting comments on its proposal to require persons associated with a FINRA member who are primarily involved in the design, development, or significant modification of algorithmic trading strategies to register as "Securities Traders." This proposal is one of seven FINRA initiatives relating to equity market structure and automated trading activities, including Regulatory Notice 15-09, which contains guidance on effective supervision and control practices for firms engaging in algorithmic trading strategies.

FINRA proposes to define an algorithmic trading strategy as "any program that generates and routes (or sends for routing) orders (and order-related messages, such as cancellations) in securities on an automated basis." This includes, but is not limited to:

  • Arbitrage strategies, such as index or exchange-traded fund (ETF) arbitrage;
  • Strategies that involve simultaneously trading two or more correlated securities due to the divergence in their prices or other trading attributes;
  • Order generation, routing and execution programs used for large-sized orders that involve dividing the order into smaller-sized orders less likely to result in market impact;
  • Order routing strategies used to determine the price, size and destination for routed orders, the use of “parent” and “child” orders, and displayed versus non-displayed trading interest;
  • Trading strategies that become more or less aggressive to correlate with trading volume in specified securities;
  • Trading strategies that minimize intra-day slippage in connection with achieving volume-weighted average prices and time-weighted average prices;
  • Strategies that create or liquidate baskets of securities, including those that track indexes or ETFs; and
  • Trading strategies that generate orders for alternative trading systems or other internal order matching engines.

A standard order router that routes retail orders and is designed to be Regulation NMS compliant would not fall under FINRA’s definition of an "algorithmic trading strategy," nor would an algorithm that solely generates trading ideas or investment allocations.

In order to alleviate concerns that this proposal would require anyone involved in the development of an algorithmic trading strategy to register as a Securities Trader, FINRA has proposed to limit the registration requirement to those individuals who are primarily responsible for its design, development, or significant modification (or for supervising or directing such activities). FINRA proposes to define primarily responsible individuals as "one or more key persons who possess knowledge of and responsibility for both the design of the intended trading strategy and the technological implementation (e.g. coding) of that strategy, sufficient to evaluate whether the resultant product is designed not only to achieve business objectives, but also regulatory compliance." This would not include junior developers who solely write code to implement design or modification instructions at the direction of another.

This proposal is designed to increase the scope of trading information that FINRA receives, provide market participants and investors with more transparency into trading activities, and require employees at firms engaged in electronic trading to be trained, educated, and accountable for their role in algorithmic trading strategies. FINRA is concerned that persons involved in the algorithmic development process may lack adequate knowledge of the securities rules and regulations applicable to FINRA members, and that this lack of knowledge can contribute to the employment of algorithms that do not comply with applicable rules. In the past, FINRA has observed "problematic conduct" stemming from algorithmic trading strategies, such as: failure to check for order accuracy, inappropriate levels of messaging traffic, wash sales, failure to mark orders as "short" or perform proper short sale "locates," and inadequate risk management controls. This proposal aims to eliminate this type of conduct by providing training and education to those persons primarily responsible for the development of algorithmic trading strategies.

FINRA recognizes that its proposal would impose costs on member firms that are engaged in algorithmic trading strategies by requiring certain persons to register as Securities Traders and requiring the firms to develop policies and procedures to monitor compliance with such requirement. Under the FINRA proposal, the persons involved in the design, development, or significant modification of an algorithmic trading strategy would be required to pass a proficiency exam. The FINRA Notice asks for comment on whether the Securities Trader exam is appropriate for this purpose or whether a new exam should be developed.

The comment period for Regulatory Notice 15-06 expires on May 18, 2015.

Implications of SEC and FINRA Proposals

Most proprietary trading firms that trade securities on a regular and active basis are already registered as broker-dealers with the SEC, and many of them are already members of FINRA. For those firms, the main consequence of these proposals is the cost and regulatory burden associated with FINRA's proposal to require registration for an additional group of employees. However, proprietary trading firms that are not FINRA members would incur the additional burdens of FINRA’s time-consuming membership application process, becoming subject to FINRA's rules (many of which are oriented toward firms conducting a customer business), and being required to post a fidelity bond that is designed to protect customers against theft of customer funds or other dishonest acts (which seems unnecessary for firms without any customers).

In 2013, the Commodity Futures Trading Commission (CFTC) published a concept release in which it discussed the possibility of requiring firms that operate an electronic trading platform for high-frequency trading to register with the CFTC. See 78 Federal Register 56542 (Sept. 12, 2013). Currently, firms that use algorithmic trading strategies to trade futures only for their proprietary account are not required to register with the CFTC in any capacity. If the CFTC were to require such firms to register and to join the National Futures Association and to require their associated persons to pass a proficiency exam, that would be a significant change that would require such firms to incur substantial costs in order to comply with those requirements.

If you would like to learn more about the SEC and FINRA proposals, or you are thinking about submitting written comments on either proposal, please contact a member of Schiff Hardin’s Practice Group.

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