United States: Trading And Markets Enforcement Report

The last several years have seen law enforcement and regulatory bodies sharpen their focus on trading activity in the securities and derivatives markets. This focus has coincided with the advent of new and expanded reporting, surveillance, and enforcement powers that arose from responses to the financial crisis. Prosecutors and regulators are using those powers daily to enforce both newer and longstanding restrictions on trading activity. New developments and precedents emerge nearly every day, and the key events merit full attention in the design of trading strategies, the implementation of compliance programs, and— when necessary—the development of legal defenses. The following report serves as a practical guide intended to keep asset managers, broker-dealers, and other trading firms current on important legal developments in this area.


FINRA Issues Inaugural Round of Cross-Market Spoofing and Layering Report Cards

In late April, FINRA made available to its member firms the inaugural round of monthly cross-market equities supervision report cards focused on spoofing and layering. FINRA's report cards are designed to help firms track compliance with certain equity trading rules, such as trade reporting, best execution, and now, spoofing and layering. The recently issued report cards are specifically designed to help firms identify and halt spoofing and layering activity by summarizing such potential activity and related exceptions and trends during the prior six months. The report cards better enable firms to flag suspicious trading patterns by providing access to FINRA's "cross-market data" and advanced surveillance technology.

The spoofing and layering report cards are not made public; rather, they are sent to firms at which FINRA identifies potential spoofing or layering by the firms or entities provided with market access by the firms. FINRA has stated that the report cards do not represent findings that any violations have occurred. Nevertheless, firms should be on notice that FINRA will expect them to use the report cards to bolster surveillance in this area and take necessary action to prevent spoofing and layering. This is especially true if the report cards disclose potential problems at a firm. Firms that are not responsive to signs that they may be engaging in or facilitating spoofing and layering may find themselves in FINRA's crosshairs during future examinations or potential disciplinary actions. FINRA's latest initiative thus marks yet another layer of scrutiny that firms are facing, as regulators attempt to root out spoofing and other deceptive trading practices.

FINRA Staff Keeps Focus on Manipulative Trading

Manipulative trading prevention was a key area of focus at the May 2016 FINRA annual conference. The conference highlighted new technology and cross-market surveillance that make it easier for regulators to detect illicit trading patterns, including spoofing and layering. This sophisticated technology will make it more difficult for firms to argue that potential manipulations are isolated incidents. As noted above, Jon Kroeper, the executive vice president of FINRA's market regulation department's quality of markets section, explained that FINRA has sent out—and will continue to send out—report cards to each firm detailing instances of suspected layering and spoofing. FINRA intends these written warnings to help firms detect and stop manipulative conduct, giving them the opportunity to correct violations early on, potentially before enforcement action is taken.

The head of FINRA's market regulation department's legal group, Robert Marchman, said FINRA will remain vigilant regarding compliance with Rule 15c3-5 of the Securities Exchange Act of 1934—the "Market Access Rule"—the purpose of which is to (1) ensure that firms do not give unauthorized traders access to the market and (2) require firms to monitor for manipulative conduct. Violators of Rule 15c3-5 may face seven-figure fines for insufficient controls to identify manipulative practices. According to Mr. Marchman, fines will be determined based on the specific facts and circumstances of each matter. Firms that self-report violations or provide FINRA with helpful information regarding the enforcement action may be eligible for smaller fines.

At the annual conference, discussion regarding FINRA's Trading and Financial Compliance Examination Program focused on trading algorithms. Against the backdrop of the SEC's approval of a new FINRA rule requiring algorithmic trading developers to register as securities traders, Peter Stoeher, the vice president of the program, discussed how FINRA will continue to monitor algorithms in order to determine whether adequate controls are in place. Possible controls include "kill switches" that can shut down algorithms if they malfunction or exceed trading limits.

BATS and NASDAQ Adopt Rules Prohibiting Spoofing and Layering

In February, Bats BZX Exchange, Inc. (BATS) received SEC approval of a proposed rule change to prohibit disruptive quoting and trading activity that constitutes spoofing or layering. Shortly thereafter, BATS' affiliated exchanges submitted "copycat" rule filings to implement the same proposed rule change. In June, the NASDAQ Stock Market LLC (NASDAQ) submitted a substantially similar proposed rule change.

While the new rules do not explicitly reference spoofing, "Disruptive Quoting and Trading Activity Type 1" includes a frequent pattern in which the following facts are present:

  • a party enters multiple limit orders on one side of the market at various price levels (the Displayed Orders); " following the entry of the Displayed Orders, the level of supply and demand for the security changes;
  • the party enters one or more orders on the opposite side of the market of the Displayed Orders (the Contra-Side Orders) that are subsequently executed; and
  • following the execution of the Contra-Side Orders, the party cancels the Displayed Orders. Similarly, the new rules do not explicitly reference layering. However, "Disruptive Quoting and Trading Activity Type 2" includes a frequent pattern in which the following facts are present:
  • a party narrows the spread for a security by placing an order inside the National Best Bid and Offer; and
  • the party then submits an order on the opposite side of the market that executes against another market participant that joined the new inside market established by the order described above.

The exchanges also adopted separate rules designed to permit the exchanges to initiate expedited suspension proceedings for members found to be engaged in spoofing and layering. The new rules also give the exchanges the authority to order their members to cease and desist from providing access to the exchanges to the members' clients that are conducting disruptive quoting and trading activity.

The exchanges noted that the existing process of identifying disruptive and potentially manipulative activity and then bringing the matter to a final resolution often takes years—a lengthy period the exchanges believe is generally appropriate to guarantee members adequate due process, particularly when dealing with complex cases. However, the exchanges cited "certain obvious and uncomplicated cases of disruptive and manipulative behavior or cases where the potential harm to investors is so large that the Exchanges should have the authority to initiate an expedited suspension proceeding in order to stop the behavior from continuing on the Exchange[s]."

FINRA Amends Definition of "Securities Trader" to Include Developers of Algorithmic Trading Strategies

In early April, the SEC approved FINRA's proposed amendment to NASD Rule 1032 to require registration as a Securities Trader for any individual who is (1) primarily responsible for the design, development, or significant modification of an algorithmic trading strategy relating to equity, preferred, or convertible debt securities; or (2) responsible for the day-to-day supervision or direction of such activities. FINRA announced a January 30, 2017 effective date in early June in Regulatory Notice 16-21, which also included additional insight into the implications of this change.

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