On December 2, 2013, FINRA filed with the Securities and Exchange Commission (the “SEC”) an amendment to a proposed rule change concerning FINRA Rule 5210, which prohibits non-bona fide order and trading activity (“Amendment”).1 The Amendment addresses comments that FINRA received about the proposed rule change (“Proposal”).2 If approved by the SEC, the Proposal would explicitly require FINRA member firms to implement policies and procedures to detect and prevent unintentional transactions in a security that involve no beneficial change in ownership of the security, i.e. self-trades.3 The SEC, however, has expressed concerns about whether some of the broad terms used in the Proposal, as currently constituted, would achieve the stated purpose of the Proposal: to prevent potential misimpressions about trading activity in affected securities.4
This Alert summarizes the key aspects of the Proposal and recommends that firms undertake a review of their current policies and procedures in this area to determine if any updates are needed. Interested parties also should avail themselves of the current comment period, which closes on December 30, 2013, and raise any potential concerns about the Proposal to the SEC.5
I. FINRA’s Initial Proposal
FINRA explained that with the rise of algorithms and automated trading strategies, it has observed an increase in the number of transactions where a firm’s proprietary account is on both sides of the same transaction.6 FINRA is concerned that such transactions can distort the level of legitimate trading interest in a security even where the transactions are unintentional.7 According to FINRA, self-trades can account for a material percentage (e.g., over 5%) of the consolidated trading volume in a security on a particular day.8 FINRA also expressed concerns that unintentional self-trading activity could adversely affect price discovery.9
FINRA recognized, however, that some self-trading activity results from “separate or distinct underlying trading strategies” at a firm.10 According to FINRA, the Proposal is not intended to address those situations where the underlying trading strategies deliberately do not interact with one another prior to generating orders.11 Rather, FINRA’s stated objective is to address self-trades attributable to a firm’s single algorithm or the unintentional interaction of multiple, related algorithms at a firm.12 According to FINRA, there would be a rebuttable presumption that trading strategies or algorithms “[w]ithin the most discrete unit of an effective system of internal controls at a member firm” are related.13 FINRA also proposed that firms should focus on detecting and preventing a pattern or practice of self-trades as opposed to isolated self-trading activity.14
II. FINRA’s Amendment No. 1 and the SEC’s Reaction
FINRA received comments to the Proposal, and in response, proposed the following changes:15
• Replace “wash sale” with “self-trade” in the Proposal;16
• Clarify that self-trades involve unintentional conduct and are bona fide transactions;
• Explain that policies and procedures should seek to prevent and detect a pattern or practice of self-trades resulting from a single algorithm or trading desk, or related algorithms or trading desks;
• State that transactions resulting from unrelated algorithms or separate and distinct trading strategies generally would be considered bona-fide; and
• Remove examples in the rule concerning the types of algorithms or trading strategies that FINRA would presume to be related under Rule 5210.
The SEC, however, noted that the Proposal would not apply to orders attributable to “unrelated” algorithms or “separate and distinct” trading strategies.17 According to the SEC, the foregoing terms are broad and FINRA did not provide enough guidance to help narrow their application.18 As a result, FINRA likely will make additional refinements to the Proposal, and interested parties should use the current comment period to influence any forthcoming changes.
Firms should take the time now to review their current policies and procedures to assess how self-trades are prevented and detected notwithstanding the potential for additional changes to the Proposal. In particular, firms should consider whether additional policies and procedures are needed to provide adequate coverage for unintentional, non-manipulative self-trades in both equity and fixed income securities.
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1 Amendment No. 1 to Proposed Rule Change Relating to Wash Sale Transactions and FINRA Rule 5210 (Publication of Transactions and Quotations), SR-FINRA-2013-036 (“Amendment”), available at http://www.finra.org/web/groups
/industry/@ip/@reg/@rulfil/documents/rulefilings/p398506.pdf; Proposed Rule Change Relating to Wash Sale Transactions and FINRA Rule 5210 (Publication of Transactions and Quotations), SR-FINRA-2013-036 (“Proposal”), available at http://www.finra.org/web/groups/industry/@ip/@reg/@rulfil
/documents/rulefilings/p323462.pdf. The term “wash sale” was initially used throughout the Proposal, and the Amendment proposes to replace the term with “self-trade” based on feedback received during the comment period, discussed infra.
2 Self-Regulatory Organizations; Financial Industry Regulatory Authority, Inc.; Notice of Filing of Amendment No. 1 and Order Instituting Proceedings to Determine Whether to Approve or Disapprove a Proposed Rule Change Relating to Wash Sale Transactions and FINRA Rule 5210 (Publication of Transactions and Quotations), Exchange Act Release No. 70966 at 5 (“Notice”), available at http://www.sec.gov/rules
3 Id. Intentional wash sale activity that involves manipulative or fraudulent intent is already prohibited under the federal securities laws and FINRA rules, and firms are already required to implement a reasonably designed supervisory system to address such trading activity. See Proposal at 6.
4 Notice at 14 -15; Proposal at 5.
5 78 FR 73900 (Dec. 9, 2013).
6 Proposal at 5.
9 Id. at 6.
10 Id. at 5.
12 Proposal at 5. FINRA noted that algorithms could be related if they directly interact with one another or if one algorithm takes into account another algorithm’s activity when making trading decisions. See FINRA’s December 2, 2013 Response to Comments at 5 n.10, available at http://www.finra.org/web
13 See Proposal at 8.
15 Notice at 5. Notably, however, FINRA rejected a suggestion to limit the Proposal to transactions in equity securities as FINRA believes that the Proposal is equally applicable to transactions in fixed income securities. Id. at 7.
16 One commentator stated that “wash sale” connotes manipulative activity, which are distinct from unintentional self-trades. Id. at 9 (citation omitted).
17 Id. at 14 -15.