FINRA published its 11th Annual 2016 Regulatory and Examinations Letter. FINRA cut broker-dealers a break this year as the letter is only 13 pages, down from 17 pages in 2015. Does the decrease indicate that examinations will be down by almost 25 percent as well?
FINRA, like the trailers for Star Wars, gave us a preview before the major announcement. In October, FINRA Chairman and CEO Richard Ketchum previewed the 2016 FINRA Exam Priorities he noted three key issues: outsourcing, cyber risk and liquidity concerns. The preview was a bit premature as it failed to mention the opening focus of the 2016 FINRA Exam Priorities: culture, conflicts of interest and ethics.
Now for some practical guidance: Read the letter. My intent in this article is not to create a summary. Rather it is to give compliance officers practical advice in responding to the letter. My first piece of advice, no kidding, is read it. The letter is FINRA’s roadmap for examinations and FINRA expects that firms will take action on all items. Best practice is to review each item, determine if it applies to your firm and if your firm is covered or needs to take action. If a firm undertakes this review and documents its actions, it will be protecting itself and the chief compliance officer.
Two themes for 2016 take center stage throughout the letter: technology change management and data quality and fixed income transparency and liquidity. An interesting development in the letter is FINRA’s message regarding indicators of a firms’ culture. A concern with the assessments is whether FINRA will use the culture assessments to increase sanctions. Will firms now be subjected to a trade reporting finding, supervision finding and now culture finding as well?
In 2016 FINRA will formalize the exam/review Program of Firm Culture. FINRA has created a checklist, of five indicators, as a guide to firm ethics:
* Whether control functions are valued within the organization;
* Whether policy or control breaches are tolerated;
* Whether the organization proactively seeks to identify risk and compliance events;
* Whether supervisors are effective role models of firm culture; and
* Whether sub-cultures that may not conform to overall corporate culture are identified and addressed.
Firms should ask these questions before FINRA sends a street sweeper or shows up for an exam.
FINRA 2016 FOCUS
Technology: FINRA will focus on cyber security throughout 2016, and through these reviews, FINRA will focus on the protection of customer information as well as required books and records. Of specific concern are the controls around system replacements and modifications with unintended consequences. FINRA has observed that operational problems can originate from data quality and integrity issues. FINRA will examine data governance, quality and reporting controls.
Recommended Action: The main focus will be a books and records review. Firms need to know where their weaknesses are and which records are not 17a-4 compliant. Cyber security has given rise to a need to more thoroughly protect all records. What is your documented process for implementing, changing, upgrading or modifying technology? Trading firms should specifically focus on changes to algorithms. After a time, firms begin to accept certain systems and processes to produce “garbage.” Take an inventory of those systems and processes in your firm and implement a plan to address the data integrity.
AML Controls: FINRA is continuing to assess the adequacy of firms’ monitoring for suspicious activity. Firms should ensure that when they delegate AML responsibilities there is an open line of communication between the AML function and the personnel conducting reviews of trading. FINRA continues to be focused on microcap securities in regard to registration issues as well as suspicious activity monitoring.
Recommended Action: FINRA is not seeing what they believe to be the correct number of SARS being reported by broker-dealers. FINRA will be assessing review processes to determine whether instances of suspicious activity are being reported. It is likely they will look at other surveillances and determine that issues that arose should have been escalated to AML for potential SAR reporting. In regard to microcap securities, FINRA believes that microcap securities should be ranked as high risk in relation to AML.
Firm Funding: FINRA will continue to review the adequacy of firms’ contingency funding plans in light of their business models. FINRA will focus on high-frequency trading firms.
Recommended Action: Firms should review Regulatory Notice 15-33 and note of the number of firms that did not meet regulatory standards. Considering the minimal number of firms that FINRA referenced in the Notice, a significant number of firms had deficiencies. Consider whether your current funding reports are accurate.
Outside Business Activities (OBA): FINRA has determined that while firms are approving OBAs, they are not adequately assessing the OBA.
Recommended Action: Historically most OBA policies and procedures have required supervisors and compliance to review and approve OBAs. The policies and procedures need to include guidance and direction about the type of OBAs that could be problematic and describe what the supervisor should be reviewing.
Market-Maker Net Capital Exemptions: FINRA will be ensuring that firms have appropriately claimed market-maker exemptions in regard to net capital requirements.
Recommended Action: Firms should ensure, if they have claimed a net capital exemption, they are indeed making markets. In addition, if your firms has ceased making markets ensure you have retracted the market-maker exemption.
Exchange-Traded Funds (ETFs): FINRA will be reviewing Authorized Participants (APs) in the creation and redemption of ETFs to ensure they are monitoring overnight counterparty credit risk and that the results are accurately reflected in net capital computations.
Recommended Action: FINRA will focus on the computation specifically for firms that are designated as APs. Firms should ensure that the counterparty credit risk is being compiled and calculated accurately and being passed on to net capital computations.
Fixed Income Prime Brokerage: As a result of capital leverage constraints, some clients will need to find new/additional prime brokers. This will create opportunities to enter or expand the prime brokerage business. FINRA review settlement practices for fixed income to understand the management of operational and credit risks when trades are executed away from the prime broker. They will also be review industry practices with respect to disaffirming trades and financing.
Recommended Action: If you enter the fixed income prime brokerage business, thoroughly vet the business through a new products process.
Vendor Display Rule: FINRA expects firms to review their compliance with the requirement that broker-dealers provide a consolidated display of market data when providing quotation information to customers.
Recommended Action: Compliance should review traders providing quotation information, and ensure that systems utilized to transmit this information include consolidated data.
Market Access: FINRA will begin to deliver spoofing and layering report cards; they expect that firms will be reviewing the report cards and implementing needed changes.
Recommended Action: Compliance and supervisors should ensure that they add the new report cards to the suite of report cards that they currently review.
Fixed Income: FINRA will review fixed-income trading and surveillance.
Recommended Action: Fixed-income surveillance needs to include best execution reviews, wash sales, marking the close and trading ahead.
Regulation SHO: FINRA will be reviewing Rule 204 regarding close-out dates, whether buy-ins are occurring promptly, and if firms are either net flat or net long on the close out date.
Recommended Action: Review close-out procedures and supervisory procedures and ensure that dates are being calculated and positions reported accurately.
Cross-Market and Cross-Product Manipulation: FINRA continues to enhance its ability to monitor cross-market manipulation.
Recommended Action: Firms should continue to enhance their ability to monitor cross-market manipulation. Layering in equities to support options trading should be a focus. Expect inquiries tying options and equity transactions.
Audit Trail Integrity: FINRA will focus on identifying audit trail issues; they will be looking at TRACE-eligible and municipal securities as well as errors in the equity audit trail.
Recommended Action: Data quality and technology management are likely the issues that cause inaccurate TRACE and equity trade reporting inaccuracies. FINRA continues to raise the bar in regard to data quality. Firms should ensure all systems required are reporting.
In conclusion, as usual the commentary from this letter is vast. However, many of the priorities are repeated from previous years and it is likely that your firm has already addressed them. It is clear that firms should significantly focus on data quality and technology management. The product to focus on this year is fixed income.
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Elin Cherry is principal and head of capital markets practice at Compliance Risk Concepts. Previously Cherry was director and head of business unit compliance for CIT Group Inc., head of global markets compliance at Societe Generale and held senior compliance positions at Deutsche Bank Securities Inc. and Banc of America Securities.
