The Financial Industry Regulatory Authority (“FINRA”), the principal U.S. self-regulatory organization for securities dealers in the United States, has adopted new supplementary material to Rule 5210, which generally imposes a requirement that reported transactions in securities reflect bona fide purchase and sale transactions. This supplementary material, described in Regulatory Notice 14-28 (June 2014), provides that matched or “self” trades originating from unrelated algorithms and distinct trading strategies within the same firm would generally be considered bona fide trades. However, commencing August 25, 2014, firms will need to have in place policies and procedures that are reasonably designed to review their trading activities, and to prevent, a pattern or practice of self-trades originating from “a single algorithm or trading desk, or related algorithms or trading desks.” This change is intended to address the risk that such self-trades may create a false impression of trading interest, especially where the trades account for a material amount of the volume in particular securities.
The supplementary material presumes that algorithms or trading strategies within the most discrete unit of an effective system of internal controls at a firm are “related” for this purpose. This presumption is based on the fact that communication could be expected to occur within such units free of information barriers and because the unit may be expected to have common supervisors. FINRA acknowledges that this is a presumption only, which may be rebutted by changes in supervisory structure, including effective information barriers. This presumption does not, on the other hand, mean that trades involving multiple units would not be viewed as related if, for example, information barriers were not robust, supervisors were in a position to coordinate activities of multiple units or the design or operation of multiple algorithms resulted in trades accounting for a material amount of volume in a security.
Many FINRA members have established “aggregation units” under the Securities and Exchange Commission’s Regulation SHO in determining their net long or short position in particular securities, so orders can be correctly marked as long, short or short-exempt, and mandatory securities borrowing and close-out requirements can be monitored and implemented, in each case, on an aggregation unit basis. The use of aggregation units avoids the need to aggregate all positions across the firm. Aggregation units are required to be supported by the following practices:
- A plan that identifies each unit, specifying its trading objectives, and supporting its separate identity
- Each unit determines its net position at the time of each sale
- All traders in the unit pursue only that unit’s trading objectives and do not coordinate strategy with any other unit
- Individual traders are assigned to only one unit at a time
In its new supplementary material, FINRA does not refer to the applicability of the elements applicable to Regulation SHO aggregation units. However, the purposes of the aggregation unit concept and FINRA’s guidance are similar. Both are designed to impose an appropriate degree of separation between trading units if trading is not to be aggregated for purposes of two sets of anti-manipulation rules, one involving short sales, the other “wash trades”.
Firms will likely conclude that trading and algorithms within aggregation units will be related for purposes of FINRA’s supplementary material. That determination, however, will not the end of the inquiry. Firms will also have to consider whether algorithms or trading strategies in different aggregation units are nonetheless related for this purpose based, in part, upon an analysis of the market impact of the combined trading.
FINRA also reminded members that “wash trading” – trading involving no change in beneficial ownership that is intended to produce the false appearance of trading, is separately and strictly, prohibited by US federal securities laws and FINRA rules.
Although not expressly dealt with in this rule change, given the anti-manipulation policy considerations supporting FINRA’s action, it will be prudent for firms to review the effect of trading strategies and algorithms operating through separate entities and in multiple jurisdictions to assess the market impact of the combined trading activity and to impose controls if appropriate.