On January 22, 2019, FINRA published its Annual Risk Monitoring and Examinations Priorities Letter ("the Letter") highlighting new priorities and identifying areas of ongoing concern that FINRA will continue to focus on in the coming year. Firms should use the Letter to review their compliance and supervisory procedures carefully and make any necessary revisions. While many of 2019's focus areas are largely the same as in 2018 (sales practice risks, senior investors, cybersecurity, fraud and market manipulation), FINRA announced it is shifting its focus to include three new areas of concern. These include online distribution platforms, firms' compliance with FinCEN's Customer Due Diligence (CDD) rule and fixed income mark-up disclosures.
Among other things, FINRA will focus on the following items in 2019:
Areas of Concern
Online Distribution Platforms
In connection with the increasing involvement of firms in the
distribution of securities through online platforms in reliance on
Rule 506(c) of Regulation D and Regulation A under the Securities
Act of 1933 (Securities Act), FINRA will evaluate how firms conduct
business distributing securities through online platforms and how
they conduct their reasonable basis and customer-specific
suitability analyses, as well as how firms supervise communications
with the public and meet their AML requirements using such
platforms. FINRA will also focus on how firms address the risks
presented when providing offering documents to the public through
online platforms. FINRA's stated reason that this is a priority
is the assertion by some member firms that they are not selling or
recommending securities when involved with online distribution
platforms despite what FINRA described as "evidence to the
contrary, including handling customer accounts and funds or
receiving transaction-based compensation."
Fixed Income Mark-Up Disclosure
FINRA will review firms' compliance with their mark-up or
mark-down disclosure obligations on fixed income transactions with
customers pursuant to amendments to FINRA Rule 2232 (Customer Confirmations) and MSRB Rule G-15, which became effective on May
14, 2018. FINRA will also review any changes in firms' behavior
that might be undertaken to avoid their mark-up and mark-down
disclosure obligations.
Regulatory Technology
FINRA will engage with firms to understand how they are using
RegTech tools and addressing related risks, challenges or
regulatory concerns, including those related to supervision and
governance systems, third-party vendor management, safeguarding
customer data and cybersecurity.
Sales Practice Risks
Suitability
Suitability remains one of FINRA's top priorities. Specific
areas of focus include:
- Deficient quantitative suitability determinations or related supervisory controls;
- Overconcentration in illiquid securities, such as variable annuities, non-traded alternative investments and securities sold through private placements;
- Recommendations to purchase share classes that are not in line with the customer's investment time horizon or hold for a period that is inconsistent with the security's performance characteristics (which could include, for example, a recommendation to purchase and hold a security that is intended for short-term trading or to engage in short-term trading in products designed primarily for long-term holding);
- Whether firms are meeting their suitability obligations and risk disclosure obligations when recommending complex exchange-traded products; and
- How firms are supervising transactions with retail investors in securities products that package leveraged loans (e.g., collateralized loan obligations).
Outside Business Activities and Private Securities
Transactions
FINRA is particularly concerned about fundraising activities for
entities that the associated persons control or in which they have
an interest. As such, FINRA will continue to assess firms'
controls related to associated persons' activities raising
funds from their customers away from their firm and outside of
their supervision.
Operational Risks
Supervision of Digital Assets Business
Firms are encouraged to notify FINRA if they plan to engage in
activities involving digital assets, even where a membership
application is not required. FINRA will review firms'
activities related to digital assets and assess how firms determine
whether a particular digital asset is a security and whether firms
have implemented adequate controls and supervision over compliance
with rules related to the marketing, sale, execution, control,
clearance, recordkeeping and valuation of digital assets, as well
as AML/Bank Secrecy Act rules and regulations.
Customer Due Diligence and Suspicious Activity
Reviews
In connection with FinCEN's Customer Due Diligence (CDD) rule,
which became effective on May 11, 2018, FINRA will focus on the
data integrity of suspicious activity monitoring systems, as well
as decisions associated with changes to those systems. The CDD rule
requires that firms identify beneficial owners of legal entity
customers, understand the nature and purpose of their accounts,
conduct ongoing monitoring of customer accounts to report and
identify suspicious activities and update customer information on a
risk basis.
Market Risks
Best Execution
FINRA is concerned about firms failing to use reasonable diligence
to assure customer order flow is directed to the best market given
the size and types of transactions. In this regard, FINRA will
review the following:
- Firms' best execution decision-making where the firm routed all or substantially all customer orders to a small number of wholesale market makers from which they received payment for order flow or an affiliated broker-dealer or an alternative trading system (ATS) in which the firm had a financial interest;
- How firms check additional venues for potential price improvement; and
- How firms quantify the benefits to customers from firms' receipt of order routing inducements and how firms manage the conflict of interest between their duty of best execution and any inducements or benefits they receive from the routing or internalization of customer orders.
Market Manipulation
FINRA will focus on manipulative trading in correlated ETFs,
including those that track common, broad market indices, as well
as, potential manipulation across correlated options products (e.g.
options on broad market indices and options on ETFs overlying the
same indices).
Financial Risks
Credit Risk
FINRA will review firms' policies and procedures for
identifying, measuring and managing credit risk, including risk
exposures that may not be readily apparent (e.g., under clearing
arrangements, prime brokerage arrangements, "give up"
arrangements, sponsored access arrangements or principal letters).
FINRA will also assess the extent to which firms identify and
address all relevant risks when they extend credit to their
customers and counterparties, including an examination of
firms' compliance with FINRA Rule 4210(f)(1) (Margin Requirements),
which requires substantial additional margin on long and short
positions in securities that are subject to "unusually rapid
or violent changes in value, or do not have an active market on a
national securities exchange, or where the amount carried is such
that the position(s) cannot be liquidated promptly."
Funding and Liquidity
FINRA will continue to evaluate firms' liquidity planning and
will focus on the following:
- Whether firms update their stress test assumptions in light of changes in the marketplace;
- Contingency plans for disruptions of, or reductions in funding available from, the government securities repo market;
- Adequacy of firms' liquidity pools;
- Firm's review of the reasonableness of stress test assumptions on a regular basis in light of all of their business activities and arrangements, including any arrangements where firms become responsible for transactions that their customers and correspondents execute "away" from them.
For further information, you can find the entire report here.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.