Important Regulatory Developments for Proprietary Trading Firms and Broker-Dealers Using Algorithmic Trading Strategies

01 April 2015 Legal News: Securities Enforcement & Litigation Publication
Author(s): J. Craig Long Kathryn M. Trkla

Legal News: Securities Enforcement & Litigation

SEC Proposes Rule Extending FINRA Registration Membership to Currently Exempted Proprietary Trading Firms


On March 25, 2015, the U.S. Securities and Exchange Commission (SEC) voted unanimously to issue a proposed rule amendment that would significantly narrow the existing exemption that permits many proprietary-trading broker-dealers to operate without being a member of the Financial Industry Regulatory Authority (FINRA).

Section 15(b)(8) of the Securities Exchange Act of 1934 requires a registered broker-dealer to belong to a registered national securities association, i.e., FINRA, unless it is a member of a national securities exchange and trades securities only on that exchange. SEC Rule 15b9-1 currently expands the statutory exemption from FINRA membership for broker-dealers that 1) are members of a national securities exchange; 2) carry no customer accounts; and 3) have “annual gross income” of less than $1,000 from over-the-counter securities transactions (which the SEC calls the “de minimis allowance”). A broker-dealer does not have to count income derived from off-exchange transactions for the firm’s own account with or through another broker-dealer towards the de minimis allowance. The proposed rulemaking would eliminate the de minimis allowance, which the SEC says has been used in a way that departs significantly from the original regulatory intent underlying Rule 15b-9, including, in particular, by firms that employ what are commonly labeled “high frequency trading strategies.”

The de minimis allowance would be replaced by a requirement that for the exception from FINRA regulation to apply, a broker-dealer must, in addition to being a member of a national securities and carrying no customer accounts, effect no off-exchange securities transactions whatsoever except in two cases: 1) Where the dealer conducts trading on a physical exchange floor, but engages in off-exchange transactions for the dealer’s own account with or through another registered broker dealer where those transactions are solely for the purpose of hedging the risks of the dealer’s floor-based activities; or 2) Where the broker-dealer’s only off-exchange transactions result from orders that are routed by the exchange of which the broker-dealer is a member in order to prevent trade throughs as required by SEC Regulation NMS Rule 611.

The effect of the proposed rule change, if adopted, will be to require proprietary trading firms that are not FINRA members, and that trade on dark pools or other alternative trading systems, to join FINRA.

Joining FINRA can be expected to introduce some additional compliance obligations and corresponding costs for previously exempted firms. This is particularly true given FINRA’s recently stated commitment to develop a series of initiatives relating to equity market structure and automated trading activities, exemplified most recently by the FINRA notice described in the next section of this alert.

The proposed rule amendment to Rule 15b9-1 has not yet been published in the Federal Register. Once it is, a 60-day public comment period will be open and industry participants and the public at large will be able to weigh-in on the SEC’s proposal. See SEC Release No. 34-74581.

FINRA Seeks Comment on Proposed Registration of the Principal Developers and Supervisors of Algorithmic Trading Strategies


In late March, FINRA issued Regulatory Notice No. 15-06 (the Notice), requesting comment on a proposal that would require the registration of associated persons (APs) who are involved in the design, development, or significant modification of algorithmic trading strategies. Noting certain recent examples in which algorithmic trading strategies resulted in problematic conduct, including improper trading activities and possible securities law violations, the Notice explains FINRA’s belief that requiring the registration of APs primarily responsible for or supervising or directing those primarily responsible for the design, development, or significant modification of algorithmic trading strategies would better educate individuals involved in the algorithm development process regarding trading rules and securities laws, and prevent future violations.

The Notice proposes to define “algorithmic trading strategies” to mean “any program that generates and routes (or sends for routing) orders (and order-related messages, such as cancellations) in securities on an automated basis.” An order router alone would not constitute an algorithmic trading strategy.

FINRA also explains that it does not intend to require the registration of all technology personnel who play a role in the deployment of an algorithmic trading strategy. For this reason, the proposed focus is on those who are principally responsible for or who supervise or direct on a day-to-day basis those who are principally responsible for the design, development, or significant modification of the algorithmic trading strategies. Junior developers and others who solely write code to implement design or modification instructions, and supervisors of lead developers not involved in day-to-day supervision or direction of the development process, are among those who would not be required to register. Where a member engages a third party to build an algorithmic trading strategy, the AP directing the third-party in designing and developing the algorithmic trading strategy would be required to register.

The Notice also proposes that covered associated persons would be required, in addition to passing the examination and becoming registered, to meet continuing education requirements every three years (pursuant to FINRA Rule 1250).

The Notice seeks comment from members on its proposed definition of the scope of these categories and on other related issues. Comments must be received by May 18, 2015.

Legal News Alert is part of our ongoing commitment to providing up-to-the-minute information about pressing concerns or industry issues affecting our clients and our colleagues. If you have any questions about this update or would like to discuss this topic further, please contact your Foley attorney or the following:

J. Craig Long
Chicago, Illinois

Kathryn M. Trkla
Chicago, Illinois

William J. Katt, Jr.
Chicago, Illinois

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