Regulators intend to look at an old problem with a new twist: a potential form of front-running by broker-dealers acting on aggregated customer order-flow information. The Securities and Exchange Commission and the Financial Industry Regulatory Authority both recently said they are interested in examining how brokers use aggregated order-flow data in their trading decisions and market-making algorithms.
The worry is that brokers may take positions in the market based on data from their aggregated customer flow that would be akin to front-running, or trading ahead of, customer orders, whether that’s done directly or indirectly through the futures market.
The issue warrants attention, said Gene Gohlke, associate director of the SEC’s Office of Compliance Inspections and Examinations, although “perhaps this isn’t enough for a sweep.” Speaking at last month’s Investment Company Institute conference in New York, he said this topic could be considered either by the SEC staff or FINRA.
In OCIE’s 2008 examinations, Gohlke said, “we’ll be taking a look at the information flows coming into the firms and how they may be managing those flows.”
Large institutions are traditionally concerned that information about their order flow may be used to disadvantage them. “We feel that is non-public information,” said Andrew Brooks, head of equity trading at T. Rowe Price Group. He said regulators should “develop best-practices guidelines about maintaining confidentiality about clients’ trading interest.”
Brooks stressed that brokers should be able to offset the risks they take on behalf of customers. However, “that’s quite different from a broker-dealer capitalizing on knowledge of customer orders,” he said. “The knowledge of our order flow is sacrosanct.”
Gohlke told Traders Magazine that it’s possible a broker could be considered to be trading on non-public information “because the counterparties with whom the broker is doing those proprietary trades don’t have that customer information and perhaps would make different decisions if they had it.”
In addition, Gohlke said, a broker trading on customer information may result in the customer getting “worse executions, arguably, than it would receive if that front-running does not occur.”
FINRA’s chief concern is that brokers may harm the interests of their customers, which they have a fiduciary responsibility to protect. According to Stephanie Dumont, vice president and director of capital markets policy in the Office of General Counsel at FINRA, brokers could run afoul of FINRA Rule 2110, which involves “just and equitable principles of trade,” and Rule 2320, which addresses members’ best-execution obligations.
Dumont noted that in 2005, FINRA, then known as NASD, addressed the issue of what brokers could and could not do with information about customers’ volume-weighted-average-price trades and other large transactions.
“We’d like to build upon that VWAP notice [to include] the use of aggregated data and market color,” she said. However, she acknowledged that FINRA is still weighing some of these issues and how customers are impacted by brokers’ use of aggregated order flow information.
Steven Stone, a partner and leader of the investment management practice group at law firm Morgan Lewis in Washington, D.C., observed that FINRA, when it takes up this issue, could be expected to issue “nuanced guidance” that “balances the sensitivity on the buyside [concerning] information handling with the need for the sellside to function in order to provide liquidity.”
