Every year, the Financial Industry Regulatory Authority releases a regulatory oversight report which, “provides member firms with key insights and observations from recent activities of FINRA’s regulatory operations to use in strengthening their compliance programs.”
The 2024 version, which was released in late January, includes coverage of multiple topics: Financial Crimes, Cryptocurrency, Firm Operations, Communications & Sales, Market Integrity, and Financial Management.
To help our readers understand the significance of the report, we’ve summarized the main sections and provided insight into FINRA’s findings. The first blog of the series covered Financial Crime and Cryptocurrency, while the second blog took a deep dive into Firm Operations and Communications & Sales. Today, we will take a look at the sections on Market Integrity and Financial Management.
Market Integrity
Consolidated Audit Trail (CAT)
FINRA identified six findings regarding consolidated audit trail compliance: incomplete submission of reportable events; failure to repair errors timely (by T+3 deadline); failure to submit corrections; inaccurate or incomplete reporting of CAT orders; unreasonable vendor supervision; and recordkeeping. Effective practices were identified as follows:
- Mapping Internal Records to CAT-Reported Data – Show how firm’s internal record correspond to CAT reporting fields
- Archiving CAT Feedback – Within 90-days so corrections can be submitted, if needed
- CAT Supervision – WSPs to review submissions, etc.
- CAT Clock Synchronization – Obtain synchronization logs daily for review
- Customer and Account Information Systems (CAIS) Supervision
- Reporting deadline extension – August 2023, CAT NMS announced revised CAIS reporting deadlines:
- May 24, 2024, for Interim Reporting Obligation
- May 31, 2024, for Full CAIS Compliance
- Reporting deadline extension – August 2023, CAT NMS announced revised CAIS reporting deadlines:
- Self-Reporting – FINRA CAT self-reporting erroneous events form
T+1 Settlement was adopted by the SEC via rule changes on February 15, 2023.
- May 28, 2024, also will be the date for firms to begin to comply with updates to FINRA rules conforming to the T+1 settlement cycle
- T+1 has implications for compliance with numerous rules and regulations (for example: Reg SHO, financial responsibility rules, Reg T, recordkeeping, etc.)
- Firms should review rule changes closely to ensure that they are prepared to comply by the compliance date
Best Execution
The findings noted by FINRA related to best execution (as required by Rule 5310) were largely focused on insufficient reviews and oversight: no assessment of execution in competing markets; no review of certain order types; unreasonable “regular and rigorous reviews; and not considering and addressing conflicts of interest.
Effective practices were listed as:
- Exception Reports
- Full and Prompt Execution of Marketable Customer Orders
- PFOF Order Handling Impact Review
- Risk-Based “Regular and Rigorous Reviews”
- Support of Analysis
- Continuous Updates
- Best Execution Committees
- Supervision
- Monitoring Orders
Disclosure of Routing Information
FINRA Rules 6151 (Disclosure of Order Routing Information for NMS Securities) and 6470 (Disclosure of Order Routing Information for OTC Equity Securities) were adopted on August 2, 2023. The new rules require new monthly order routing disclosures at least quarterly and submission of order routing reports for OTC and NMS securities under Rule 606 to FINRA for publication on the FINRA website.
Common findings around disclosure routing information were: inaccurate quarterly reports; incomplete disclosures; incomplete disclosure when incorporating by reference; deficicent communications; failing to provide Rule 606(b)(3) “Not Held” reports in a timely manner; and insufficient WSPs.
The effective practices identified by FINRA are focused on due diligence and supervison:
- Conducting regular, periodic supervisory reviews
- Due diligence on identifying execution venues
- Due diligence on vendors
Reg SHO – Bona Fide Market Making Exemptions
Rules 203(b) (Short sales) and 204 (Close-out requirement) of Regulation SHO provide exceptions for bona fide market making activity. The findings were related to non-bona fide market making, primarily: failing to distinguish between bona fide market making and other proprietary trading activities.
The list of effective practices includes:
- Supervision of Bona Fide Market Making
- Supervision of Rule 204 Close Out Activity
Fixed Income Fair Pricing
FINRA’s priorities noted findings related to: incorrect determination of prevailing market price (PMP); outdated mark-up/mark-down grides (no periodic review to ensure accuracy); failure to consider impact of mark-up on yield to maturity; and unreasonable supervision.
The effective practices address each of these issues as follows:
- PMP Documentation
- Mark-Up/Mark-Down Reviews
- Exception Reports – Ensure compliance with FINRA Rule 2121 and/or MSRB G-30; review and update report parameters periodically
OTC Quotations in Fixed Income Securities NEW FOR 2024
Exchange Act Rule 15c2-11 generally prohibits a broker-dealer from publishing a quotation for any security unless the broker-dealer has reviewed current and publicly available information about the issuer, and the broker-dealer believes this information is accurate and obtained from a reliable source. FINRA Rule 3110 requires that members establish and maintain a system to supervise that is reasonably designed to achieve compliance with the requirements of Rule 15c2-11. The findings noted were: inadequate supervisory controls and procedures; failing to test applicability; and failing to prevent potential quotations.
Effective practices were identified to counter these findings as follows:
- Supervisory Controls and Procedures – Reasonable controls and procedures designed to fit the firm’s business as well as training affected personnel
- Front-End Surveillance – Identify non-exempt securities and quotation mediums
- Self-Assessment – Analysis of business and systems in quoting fixed income securities
- Third-Party Vendors – Contract w/ third-party vendors to:
- Confirm availability of current information
- Identify and prevent quoting non-exempt securities
Advertised Volume NEW FOR 2024
Findings from FINRA based on Rule 5210 were: inflating trading volume and unreasonable supervision.
The effective practices noted are as follows:
- Monitoring and reviewing reported trade data
- Monitoring and reviewing disseminated trade volume data
Market Access Rule NEW FOR 2024
The Market Access Rule (Exchange Act Rule 15c3-5) requires firms to “appropriately control the risks associated with market access so as not to jeopardize their own financial condition, that of other market participants, the integrity of trading on the securities markets and the stability of the financial system.”
Findings related to this priority are: insufficient controls; failure to consider additional data; impermissible exclusions; inadequate financial risk management controls; reliance on vendors; and failure to document annual review of effectiveness.
The effective practices are noted as:
- Pre-Trade Fixed Income Financial Controls
- Intra-Day Ad Hoc Adjustments
- Soft Blocks
- Tailored Erroneous or Duplicative Order Controls
- Market Impact
- Reference Data
- Post-Trade Controls and Surveillance
- Testing of Risk Management Controls
Financial Management
Net Capital
FINRA conducted financial controls and net capital examinations in 2023 with material findings including: Supervision; Designation of a FINOP per Rule 1220; Inaccurate Books & Records; Expense Sharing Agreements; and Bank Account Access. Additional net capital findings in the FINRA Priorities are listed as: incorrect capital charges for underwriting commitments; inaccurate net capital deductions; inadequate WSPs; and inaccurate recording of revenue and expenses.
Effective practices noted by FINRA are:
- Net Capital Assessment – Confirm assets correctly classified for net capital purposes
- Moment-to-Moment and Net Capital Compliance for Underwriting Commitments
- Net Capital Deductions
Liquidity Risk Management
For this section of the priorities document, FINRA lists “observations” rather than findings as follows: establishing insufficient stresses on clearing deposit requirements; no contingency funding plans; and inaccurate SLS reporting.
Effective practices are:
- Liquidity Risk Management Updates – Ensuring practices, policies, and procedures conform to the firm’s current business activities
- Stress Tests – Conducted in a manner and frequency that accounts for the complexity and risk of the firm’s business model
Credit Risk Management
From the priorities document: “FINRA has consistently reminded member firms of the importance of properly managing credit risk.” Observations noted by FINRA are: firms did not ensure their risk management and control processes accurately capture the credit risk exposure; and firms did not monitor for concentration risk or credit exposure.
Effective practices identified are:
- Credit Risk Framework – Develop comprehensive internal control framework
- Credit Risk Limit Changes – Approval and documentation process for changes
- Counterparty Exposure – Monitor exposure to affiliated counterparties
Portfolio Margin & Intraday Trading
FINRA findings were noted in the document as: failing to maintain position records as required; incorrectly computing account equity, failing to ensure accounts maintain required minimum equity; and no internal audit review of portfolio margin process.
Effective practices are listed as:
- Internal Risk Framework
- Concentration Risk
- Client Exposure – Clear communication with clients regarding exposure
- Reporting – Ensure portfolio margin data reported to FINRA is accurate
- Global Margin Programs
- Staffing and Training
Segregation of Assets & Customer Protection
FINRA noted findings in this section as: failing to complete accurate reserve formula computations; improper withdrawals from reserve bank account; and inaccurate segregation of customer securities.
The document noted effective practices in this area as:
- Confirming Control Location Agreements
- Addressing Conflict of Interest
- Reviews and Exception Reports for Good Control Locations
- Check Forwarding Blotter Review
- Periodic Evaluation of Reserve Formula Computation Process
Have questions about the report and the implications for your firm? Schedule time to speak with an expert today!