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June 18, 2008

FINRA Targets Manning for Change

By Peter Chapman

The Financial Industry Regulatory Authority recently outlined a plan to make its all-important Manning Rule look more like its counterpart at the New York Stock Exchange, Rule 92.

The move is part of a broader attempt to reduce the regulatory burden on broker-

dealers by "harmonizing" FINRA's rules with those of the NYSE. It got off the ground when the NASD merged with parts of NYSE Regulation last year to create FINRA.

Jon Kroeper, a vice president in FINRA's quality of markets division, told a recent gathering of trading executives that the regulator had targeted for change three differences between its rule governing trading ahead and the New York's.

"We have been working to see if we can bring these rules together," Kroeper told the crowd at this year's Securities Industry & Financial Markets Association market structure conference. "Yet while the rules differ in some respects, they have become closer."

Kroeper noted that the Securities and Exchange Commission recently approved an exception to Manning that allows traders to fill intermarket sweep orders (ISOs) for their own books while holding a similarly priced customer order in the same security. The trader can claim the exemption as long as he received the customer order after sending out the ISO-not before. The New York had created an ISO exception to its Rule 92 a few months prior.

In general, Manning and the NYSE's Rule 92 prohibit traders from trading for their own accounts when they hold customer orders in the same security on the same side of the market. That's known as trading ahead or front running.

Broadly speaking, the rules presume the traders have knowledge of the customer orders unless they are handled by different staffers and their firms have established "information barriers" between them. Information barriers are also known as "Chinese walls."

Kroeper said that there are three differences between Manning and the NYSE's Rule 92 that could result in changes to Manning. First, Rule 92 prohibits an NYSE member from entering a proprietary order when it has knowledge of a customer order in the same security on the same side of the market. Under Manning, the principle trading activities are evaluated at the time of the execution, not when the order is placed.

Second, under Rule 92, traders within the same department of a broker-dealer can trade for their own accounts even if an order for the same stock is also being fed into a "black box," or automated order-execution system. The NYSE will presume the principal traders have no knowledge of the black-box order as long as they have established information barriers between the personnel handling the two orders.

Under Manning, traders on a proprietary desk can trade for their own accounts in securities that may be handled on the Nasdaq market-making desk as long as they have established solid information barriers. The exception does not hold, though, for traders within a Nasdaq market-making operation. In that case, there is an assumption of "presumed knowledge" of the customer order.

Third, under both Manning and Rule 92, under certain circumstances, a trader can trade along or ahead of a customer order if the customer-typically, an institution-consents. Under Rule 92, customer consent is affirmative. Under Manning, consent is negative.

"The staff is looking to see if they can bridge these gaps," Kroeper said. The official did not offer a timeline for completion, but noted harmonization was a long-term project that also might include the merging of the OATS and OTS order reporting systems.

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