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Recent regulatory initiatives taken on both sides of the Atlantic, in the U.S. and U.K, highlight the increased oversight of PTFs. PTFs (Principal Trading Firms) sometimes known as proprietary trading firms, engage in trading activities using their own capital and not on behalf of clients. From a regulatory standpoint, PTFs are interesting due to their multifaceted roles. They are integral players in market-making, employing sophisticated tools like high-frequency trading (HFT) and algorithmic trading.
Recently the U.S. Securities and Exchange Commission (SEC) made a significant decision to tighten the exemption that previously allowed many PTFs to not need to register with the Financial Industry Regulatory Authority (FINRA). Around the same time, the UK’s Financial Conduct Authority (FCA) offered valuable guidance on the supervision and regulatory outlook for PTFs.
SEC’s Focus on proprietary trading firms
In August, the U.S. SEC made changes that will have a significant impact on some proprietary trading firms. Specifically, the SEC revisited the Exchange Act Rule 15B9-1, which had granted certain firms’ exemption from Securities and Exchange Act regulations. This exemption applied to firms if they were members of a national securities exchange and carried no customer accounts. There was an additional requirement that firms did not trade on a different exchange; however, this rule did not apply if trading was through a registered broker-dealer, which is an approach many firms took. This meant that in practice many proprietary trading firms (who were exchange members) transacted across a variety of different exchanges without needing FINRA registration. The SEC’s revision will restrict these firms’ ability to trade across various exchanges and retain the exemption. Rationale for amending the exemption included escalating marketplace complexity, growing nature of cross-market trading, and increased adoption of technology – notably algorithmic trading.
The new U.S. exemption is: (A) does not carry customer accounts (B) is a member of at least one exchange and (C) only “effects off-member-exchange securities transactions that: (1) result solely from orders that are routed by an exchange of which the broker or dealer is a member in order to comply with 17 CFR 242.611 (Rule 611 of Regulation NMS) or the Options Order Protection and Locked/Crossed Market Plan;4 or (2) are solely for the purpose of executing the stock leg of a stock-option order”.
FCA’s Correspondence with PTFs
In a similar move, the U.K.’s FCA recently communicated with PTFs, outlining risk areas and their upcoming supervisory priorities for principal trading firms over the next two years. Among the focus areas, algorithmic trading stood out as a primary focus. The FCA also highlighted the importance of financial resilience, avoiding market disruptions arising from commodity market volatility, ensuring operational resilience, and addressing Brexit-related impacts.
The FCA emphasized the necessity for tailored controls when it comes to algorithmic trading. Specifically, they noted the importance of compliance and risk management as key oversight functions that are essential to keeping pace with the ever-increasing complexity and speed of financial markets and technological advancements. They also acknowledged the dynamic nature of technology, pointing out the significance of establishing proper controls for emerging technologies like artificial intelligence.
Impact of Regulatory Changes on PTFs
As regulatory oversight increases, proprietary trading firms in the U.S. will surely evolve and experience additional pressure. Many U.S. firms will be required to register with FINRA, potentially leading to increased reporting obligations and enhanced regulatory oversight. How FINRA engages with these firms and adjusts fees in consideration of their unique activities will be interesting to watch. The FCA’s guidance will add to the existing regulatory challenges PTFs face in the EU and U.K., which, as an Acuiti report finds, could likely accelerate considerations of these firms to exit those markets.
Moving forward, these firms will need to align more closely with regulator expectations to help ensure compliance, at the same time regulators need to work closely with these firms to ensure the rules are appropriate. With the regulatory spotlight currently focused on these firms, it is essential they have the proper controls in place to mitigate risk and reputational damage.
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