FINRA Proposes New Rules For Algorithmic Trading Strategies

FINRA is proposing new rules that will impact algorithic trading strategies. If an individual performs a trade on another person’s behalf, that associated person is required to register with FINRA as an equity trader. The Financial Industry Regulatory Authority (FINRA) believes that certain associated persons who are involved in creating automated systems should also be registered. FINRA recently issued Regulatory Notice 15-06 requesting comments on a new proposal that would require associated persons involved in the design, development or modification of algorithmic trading strategies to register with FINRA. This, says FINRA, will help ensure that trading programs comply with applicable securities laws.

The proposals are designed to increase the scope of trading information FINRA receives, provide market participants and investors with more transparency into trading activities, and require employees at firms engaged in electronic trading to be trained, educated, and accountable for their role in algorithmic trading strategies.

It has become common for firms to trade securities using automated systems that initiate pre-programmed trading instructions based on specified variables, referred to as algorithmic trading strategies. If performed by an individual associated person, these trading activities would have required advance registration with FINRA as an Equity Trader. [FINRA is concerned that, in some cases, associated persons primarily responsible for the design, development or significant modification of an algorithmic trading strategy employed by a member firm (or for supervising or directing such activities), may lack adequate knowledge of the securities rules and regulations applicable to FINRA members operating in the securities markets, and this lack of knowledge could result in algorithms that do not comply with applicable rules.]

The prevalent use of algorithms in the marketplace has highlighted the risks that arise when such strategies are poorly designed. FINRA has observed situations in which algorithmic trading strategies have resulted in improper trading activities and potential securities law violations, including of Regulation NMS, Regulation SHO, SEA Rule 15c3-5 and other critical market and investor protection safeguards.

Problematic conduct, stemming from algorithmic trading strategies, have included failure to check for order accuracy, inappropriate levels of messaging traffic, wash sales, failure to mark orders as “short” or perform proper short sale “locates,” and inadequate risk management controls.

FINRA believes that this conduct could have been prevented, in part, through improved education; regarding securities regulations for individuals involved in the algorithm development process. Thus, to ensure that sufficient consideration may be given to the regulatory requirements around order generation and trading activities, FINRA believes it is appropriate to require associated persons primarily responsible for the design, development or significant modification of algorithmic trading strategies (or for supervising or directing such activities), to meet the same minimum competency standards for knowledge of securities regulations applicable to individual traders.

Specifically, NASD Rule 1032(f) (Limited Representative—Equity Trader) sets forth the registration requirements for associated persons who, with respect to transactions in equity (including options), preferred or convertible debt securities effected otherwise than on a securities exchange, engage in proprietary trading, execute transactions on an agency basis, or directly supervise such activities. Because algorithms that generate orders into the market perform comparable activities to those of individual traders by engaging in proprietary trading or executing orders on an agency basis, FINRA preliminarily believes that the NASD Rule 1032(f) registration category is the most appropriate for designers and developers of these algorithms.

For these purposes, an algorithmic trading strategy is any program that generates and routes (or sends for routing) orders (and order-related messages, such as cancellations) in securities on an automated basis.  While the specifics of such programs will vary from firm to firm, including the level and extent of automation within a particular program, FINRA expects that the scope would include, but not be limited to, the following automated trading programs:

• arbitrage strategies, such as index or exchange-traded fund (ETF) arbitrage;
• strategies that involve simultaneously trading two or more correlated securities due to the divergence in their prices or other trading attributes;
• order generation, routing and execution programs used for large-sized orders that involve dividing the order into smaller-sized orders less likely to result in market impact;
• order routing strategies used to determine the price, size and destination for routed orders, the use of “parent” and “child” orders, and displayed versus non-displayed trading interest;
• trading strategies that become more or less aggressive to correlate with trading volume in specified securities;
• trading strategies that minimize intra-day slippage in connection with achieving volume-weighted average prices and time-weighted average prices;
• strategies that create or liquidate baskets of securities, including those that track indexes or ETFs; and
• trading strategies that generate orders for alternative trading systems (ATS) or other internal order matching engines.

The foregoing systems generate orders into the marketplace or execute trades without material intervention by any person. For purposes of FINRA’s proposal, an order router alone would not constitute an algorithmic trading strategy. Nor would an algorithm that solely generates trading ideas or investment allocations, but that is not equipped to automatically generate orders and order-related messages to effectuate such trading ideas into the market (whether independently or via a linked router), constitute an algorithmic trading strategy for purposes of the proposal.

FINRA noted that robust supervisory procedures, both prior to and after deployment of an algorithmic trading strategy, is a key component in protecting against problematic behavior stemming from algorithmic trading. FINRA believes that an individual’s qualification and educational requirement would also help improve regulatory compliance.

The proposed registration obligation will apply to some persons not currently required to register as Securities Traders, such as quantitative and technology specialists who traditionally would not consider their role as that of a Securities Trader. The proposal is  to be narrowly construed so that the entire development and information technology teams are not required to be registered.

FINRA proposes additional bells and whistles but the idea is a simple, common sense approach, to preventing violations that may be committed by program designers unfamiliar with FINRA and SEC rules and regulations.  The agency is aware that requiring every tech expert and mathematician who works for a member firm might impose an economic burden on those firms, and for that reason suggests that only certain key members of development teams be required to register as Securities Traders.

Whatever the cost of the proposal may be, it’s likely to be less than the fines imposed for serious, even if inadvertent, securities laws violations by member firms.  If implemented properly, it will have the added benefit of assuring the markets and those who invest in them, that the rules are being followed.

For further information about this securities law blog post, please contact Brenda Hamilton, Securities Attorney at 101 Plaza Real S, Suite 202 N, Boca Raton, Florida, (561) 416-8956, by email at [email protected]. This securities law blog post is provided as a general informational service to clients and friends of Hamilton & Associates Law Group and should not be construed as, and does not constitute, legal and compliance advice on any specific matter, nor does this message create an attorney-client relationship. Please note that the prior results discussed herein do not guarantee similar outcomes.
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Brenda Hamilton, Securities Attorney
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