Algorithmic trading has occupied an increasingly prominent role on Wall Street. The "flash crash" in 2010 and its aftermath began to pique the interest of the regulators, as was apparent from the 2014 speech of Mary Jo White, wherein she expressed that the SEC had an interest in "assessing the extent to which specific elements of the computer-driven trading environment may be working against investors rather than for them."1 Since that time, a number of potentially manipulative activities such as "spoofing"2 have caught the eye of regulators and resulted in a call for increased oversight by FINRA and the SEC. While the very same regulators cite the benefits of algorithmic trading, such as the reduction of manual errors and reduced transaction costs,3 the rise of algorithmic trading as a substantial portion of activity on U.S. markets has heightened the concern over the need for increased supervision and regulatory oversight.
In March of last year, FINRA published Regulatory Notice 15-09, "Equity Trading Initiatives: Supervision and Control Practices for Algorithmic Trading Strategies," wherein FINRA provided guidance on effective supervision and control practices for firms that employ algorithmic trading strategies. In that release, it cited FINRA Rule 5210, which addressed "spoofing" and other manipulative trading strategies. The SRO also cited in that Release to SEC Rules 15c3-5,4 Regulation NMS,5 and Regulation SHO6 in laying out supervision methodologies and guidelines for risk assessment and compliance monitoring.
Given the above, it was foreseeable that FINRA would file a request with the SEC to require associated persons to register as "securities traders." In their request, they identified those primarily responsible for the design, development, or significant modification of algorithmic trading strategies (and supervision or direction of such activities) as individuals who should register as "securities traders." FINRA's request came on February 11 of this year, and the SEC approved this request on April 7, 2016.7
The new requirement imposes not only registration requirements for algorithmic traders, developers, or supervisors, but also the further requirement that they pass an examination and be subject to the same continuing education requirements that are applicable to individual securities traders. FINRA and the SEC believe that the new requirements and oversight may reduce the incidence of abuse in this area.
An "algorithmic trading strategy" as defined by FINRA generally requires two components: 1) an automated system that generates or routes order-related messages, such as route orders or cancellations, and 2) the ability to execute such a strategy. Just the strategy alone or just the order route alone would not constitute the strategy.8
Although the registration requirement, finally released in June of this year, has clearly provoked interest, perhaps the more daunting requirement is the five-point supervision program released by FINRA as part of an expanded supervision requirement under Rule 3110. That five-point supervisory program requires:9
- General Risk Assessment and Response
- Software Code Development and Implementation
- Software Testing and System Validation
- Trading Systems
- Compliance
Guidance regarding these requirements will be addressed in upcoming issues of the Fund Forum.
[1] See Mary Jo White, Chair, Commission, "Enhancing our Equity Market Structure," Speech at the Sandler, O'Neill & Partners, L.P. Global Exchange and Brokerage Conference (June 5, 2014).
[2] "Spoofing" is the manipulative act of bidding or offering with the intent to cancel before execution. This activity was addressed in the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, Title VII, Part II, Section 747. See also 7 U.S.C. 6c(a), Section 4(c)(a)(5).
[3] See Mary Jo White at "Enhancing our Equity Market Structure," Speech at the Sandler, O'Neill & Partners, L.P. Global Exchange and Brokerage Conference (June 5, 2014).
[4] SEA Rule 15c3-5 requires brokers and dealers with market access, or registrants who provide customers with market access, to establish and document a system of risk management and supervisory procedures that are reasonably designed to manage the "financial and regulatory risks related to market access."
[5] Although multifaceted, Rule NMS, among other things, requires broker-dealers, trading centers, and others to "establish, maintain and enforce written policies and procedures reasonably designed to prevent the execution of trades at inferior prices to protected quotations."
[6] Regulation SHO, through a number of requirements, establishes a set of regulations regarding a firm's ability to sell securities short.
[7] See SEC Release No. 34–77551; File No. SR–FINRA–2016–007.
[8] See SEC Release, February 18, 2016, Securities Exchange Act Release No. 77175 (February 18, 2016), 81 FR 9235 at 9237.
[9] See Algorithmic Trading, FINRA.