This week on Gary DeWaal’s Bridging the Week, algorithmic trading gets most of the headlines because of a proposed rule change by FINRA in the United States, guidance issued by ASIC in Australia, and an all broker dealer review in China. Also reviewed this Week on Bridging the Week are:
1. A CFTC Interpretation on Retail Commodity Transactions;
2. FATCA Reporting Begins;
3. PCAOB Issues a Very Disturbing Report on Audits of US Broker Dealer Capital and Reserve Calculation Computations, among other things,
There again were no major regulatory developments this week worldwide impacting the financial services industry. However, there still were some interesting matters around the globe.
One theme reverberated in numerous locations however – algorithmic trading.
FINRA: Proposed Wash Sale Rule
In the United States, the Financial Regulatory Industry Authority (FINRA) submitted to the US Securities and Exchange Commission (SEC) a proposed rule change that identifies what types of trading activity by algorithmic programs within the same organization that may constitute wash sales. This proposed rule change incorporates many of the same themes of a proposed Market Regulation Advisory Notice submitted by the Chicago Mercantile Exchange (CME) to the US Commodity Futures Trading Commission (CFTC) on July 9 that also interprets conduct that may constitute wash transactions.
According to the FINRA proposal:
- all members must have policies and procedures in place that are reasonably designed to review their trading activity for, and prevent wash sale transactions;
- transactions that originate from unrelated algorithms within the same firm generally will not be considered wash sales even if they do not result in a change of beneficial ownership unless the transactions are undertaken for fraudulent or manipulative purposes; and
- transactions within the most discrete unit at a member firm – for example at individual trading desks – will be considered related and thus, potentially wash sales.
For FINRA, wash sales are “transactions in a security that involve no change in the beneficial ownership of the security.”
In announcing its propose rule amendment, FINRA indicated that it is not seeking to eradicate non-purposeful, isolated wash sale transactions. Rather, it is seeking to stop only those firms that engage “…in a pattern or practice of effecting wash sale transactions that result in a material percentage of trading volume in a particular security.”
FINRA will announce the effective date of its new rule if the SEC approves it by no later than 60 days following such approval. The CME proposed Advisory Notice is proposed to be effective September 9.
(A separate article on the CME proposed Advisory Notice on wash sales is on this website; check out: http://www.garydewaalandassociates.com/compliance-weeds-cme-issues-new-guidance-regarding-wash-trades/)
ASIC: Market Integrity Guidance
Down under in Australia, the Australian Securities and Investments Commission (ASIC) also published Guidance on ASIC’s Market Integrity Rules for Risk Management and Other Requirements.
In general this guidance sets forth obligations of market participants related to risk management for house accounts, supervisory policies and procedures, and minimum requirements for foreign market participants that have come about because of amendments to related ASIC rules that took effect during May 2013.
Among other things, this guidance discusses the requirement that market participants trading for their house account set and document appropriate limits (including volume per order limits, aggregate loss limits, aggregate net session limits and maximum price change limits) and other requirements related to terminal connections. Market participants permitting principal traders to access terminals also have obligations to set and document pre-determined limits too.
China: Review of all Brokers Algorithmic Programs
In China, the China Securities Regulatory Commission announced in a formal press release that it would be conducting a review of the risk controls surrounding the algorithmic trading systems of all brokers in China. This followed the well-publicized malfunctioning algorithmic program of Chinese broker Everbright Securities on August 16 that caused a temporary 5.96% spike of the Shanghai Securities Exchange composite index on that date.
CFTC: Retail Commodity Transactions
Back in the United States, the CFTC on August 23 issued an Interpretation regarding Retail Commodity Transactions that was first proposed in December 2011.
Under amendments to the Commodity Exchange Act as a result of Dodd Frank, certain retail commodity transactions are subject to certain provisions of the law. However, generally transactions that result in actual delivery within 28 days are exempted from these provisions.
According to the CFTC’s new Interpretation, in determining whether actual delivery has occurred within 28 days, the Commission will use a so-called “functional approach” and consider “…how the agreement, contract, or transaction is marketed, managed, and performed, instead of relying solely on language used by the parties” in the relevant written document.
Customers may cancel proposed deliveries on occasion under the CFTC’s Interpretation, however such cancellations must be on limited occasions only and customers can’t enter into a subsequent transaction within three business days of a cancellation.
- FATCA. Remember the Foreign Account Tax Compliance Act or “FATCA” – that’s the US program to help ensure greater tax compliance among US taxpayers with foreign accounts and assets? Basically, FATCA requires foreign financial intermediaries to enter into an information reporting agreement with the US Internal Revenue Service, or with the IRS approval, their local revenue authority, or require 30% of payments to such FFI’s to be withheld on US source interest, dividends, rents, salaries or gross proceeds from the sale of US assets. As of August 19, FFIs were able to provisionally begin registering on through the IRS FATCA Registration website, although no registration will be considered final until January 1, 2014. All FFIs must register by April 25, 2014 to avoid penalties and withholdings must begin July 1, 2014.
- PCAOB Review – Audits and Auditors of BDs Deficient: The Public Company Accounting Oversight Board (“PCAOB”) last week issued its second report on the progress of the interim inspection program related to audits of brokers and dealers. For this report, the PCAOB inspected 43 audit firms and reviewed portions of 60 audits of SEC registered broker dealers. The result? Deficiencies were found in all the audit firms and 57 out of the 60 audits. Scarier still, deficiencies in 1/3 of the audits were found specifically in audit procedures related to (a) capital and customer reserve calculation supporting schedules (this is the equivalent of CFTC required segregation computations), (b) the basis for an exemption claimed by certain broker dealers to comply with the SEC’s Customer Protection Rule, or (c) the accountant’s supplemental report on material inadequacies. Many audit firms also failed to satisfy independence requirements. The SEC recently approved rules to enhance the audit process around broker dealers and the CFTC has similar rules pending regarding the audit of future commission merchants.
- FINRA sues Morgan Stanley. Last week FINRA filed and settled an enforcement action involving Morgan Stanley related to the Firm’s alleged failure at various times from January 2008 through September 2011to purchase or sell certain corporate, agency, and municipal bonds to customers at prices that were not fair and reasonable – namely did not reflect so called “best execution.” For this Morgan Stanley paid a fine of US$ 1 Million and paid restitution of almost US$ 200,000.
Finally, the end of the fiscal year is approaching soon for many US registrants that will subsequently be required to file shortly afterwards their first full annual compliance report certified by their CEO or CCO. An article will be posted on this website during the first week of September regarding what firms practically should be doing now before their fiscal year ends to prepare themselves for this report preparation. Check it out. You want to avoid those last minutes battles between Chief Compliance officers and senior management – if you can!
For more, see:
ASIC Guidance on Market Integrity Rules for Risk Management:
CFTC Interpretation regarding Retail Commodity Transactions:
CME Proposed Market Regulation Advisory Notice (Wash Sales):
CSRC Notification on Irregularities in the Proprietary Business of Everbright Securities.
FINRA Proposed Rule Change (Wash Sales):
FINRA AWC re: Morgan Stanley:
PCAOB Second Interim Report related to Audits of Broker Dealers:
The information contained in this memorandum is not legal advice. For legal advice, please consult with your attorney. The information in this memorandum is derived from sources believed to be reliable as of August 23, 2013, but no representation or warranty is made regarding the accuracy of any statement.
Because of the Labor Day holiday in the United States, the next issue of Bridging the Week will be issued Tuesday, September 3, 2013.