Traders say their word is their bond. But that may not always apply to their IOIs, or indications of interest. The Financial Industry Regulatory Authority issued a notice Wednesday reminding traders of their obligation to send clients truthful IOIs.
The issue of accuracy in IOIs is as old as the tool itself, which is used by upstairs desks to seek out contra-side flow. Broker-dealers send out IOIs through their own systems or those of vendors such as Tradeweb’s Autex, Bloomberg and NYFIX. FINRA warned member firms that, “to the extent that they disseminate or use such services to communicate indications of interest, such indications must be truthful, accurate and not misleading.”
FINRA’s warning focused, in particular, on firms’ use of “natural” IOIs. The concern is that brokers, to elicit phone calls from buyside traders, may be playing fast and loose with the description of the flow they’re pitching as natural IOIs. Naturals historically are intended to represent agency orders a broker-dealer is working, although some sellside firms also include riskless principal trades and proprietary positions taken on to facilitate a customer order that the broker is now unwinding.
FINRA issued Regulatory Notice 09-28 to member firms after talking to institutions over the last year. “We have been hearing anecdotally from buyside firms and other market participants, at an increasing rate over the past year, regarding issues with firms’ representations as to whether an IOI is truly a natural IOI or not,” Herb Perone, a FINRA spokesman, told Traders Magazine this morning.
Perone noted that IOIs have gained more attention recently as buyside firms seek “to execute in size and the average execution size on the exchange markets and ATSs alike have generally decreased.” He added that “the less reliable the information is in IOIs broadcast by firms themselves or through vendors, the less useful it is to those seeking to execute orders.” Perone also noted that FINRA’s Office of the Whistleblower, which was established in March, has an “open matter” that “includes alleged potential misrepresentations by a firm with respect to the use of IOIs.”
This latest FINRA bulletin isn’t the industry regulator’s first cautionary note to brokers. Most recently, in September 2006, FINRA told member firms to be truthful in their advertisements of trading volume. Perone noted that the current notice tracks that earlier one (Regulatory Notice 06-50). “If firms are putting out information to the market, they have an obligation to ensure that it is truthful, accurate, and not misleading,” he said.
IOIs have been a liquidity-sourcing tool for decades. But the search for the other side, as well as the quest for color, has increasingly resulted in a more elastic approach to IOIs. As a result, all “naturals” are not always natural. Brokers may not have the order behind the indication or it may be for a much smaller size. Some brokers may be fishing for information. However, by the time the buyside firm discovers this, it’s too late because the trader has already picked up the phone and exposed his intentions. None of the IOI service providers police brokers’ use of the naturals tag on IOIs.
Large buyside institutions can receive thousands of IOIs every day. Many firms filter out non-natural IOIs to avoid even seeing them. Because of concern about what’s included in naturals, many firms also respond to so-called naturals only from brokers they know or from those whose IOIs have produced trades in the past.
FINRA, in its Wednesday guidance, defined naturals. According to the self-regulatory organization, “A ‘natural’ indication of interest may be considered to solely refer to interest a firm represents on an agency basis, or refer not only to agency interest but also proprietary interest in certain specific contexts (e.g., proprietary interest that was established as the result of the facilitation of a customer order or the execution of a customer order on a riskless principal basis).”
Jeff Alexander, an executive in charge of developing IOI and transaction-cost-analysis tools at Bloomberg LP, noted that there is a good deal of buyside frustration with the quality of the IOIs the firms receive from brokers. He expects FINRA to try to use its recent guidance “as a stick for brokers taking liberties with the term ‘natural.'” But until FINRA asks brokers for the underlying data on the IOIs they ship out, he said, the warning may not have teeth.
Alexander stressed the importance of IOIs to institutions. “Firms want IOIs to be their number-one way to get liquidity,” he said. “They want to see a contra, call the broker, get a little color and then execute against the IOI. Firms want to pay their brokers and a natural IOI is the obvious way to do it.”
Rounding out Regulatory Notice 09-28 on IOIs, FINRA alerted member firms that they could land into hot water if they run afoul of its guidance. False or misleading IOIs, FINRA said, could violate NASD Rule 3310 (Publication of Transactions and Quotations) and IM-3310 (Manipulative and Deceptive Quotations). It could also violate FINRA Rule 2020 (Use of Manipulative, Deceptive or Other Fraudulent Devices), NASD Rule 2210 (Communications with the Public) and the anti-fraud provisions of the federal securities laws.
