FINRA 2018 Regulatory and Examination Priorities

Bovill

FINRA has released the annual Regulatory and Examination Priorities which highlights the primary areas of focus for the coming year. The report encompasses both new and ongoing areas of focus, and corresponds to some of the themes and best practices in the first public summary of the Examination Findings Report. This report was designed as a compliance guide for brokerages after examining nearly half of their broker-dealer members. FINRA also announced additional changes to improve the examination program to implement a risk-based framework designed to better align examination resources to the risk profile of member firms. These measures will add or strengthen information sharing with firms during examinations, improve processes for making examination information requests, and enhance training of examiners.

The major areas of focus in 2018 are fraud and high-risk firms and brokers, which is a continuation of work previously done, operational and financial risks – including technology governance and cybersecurity – and market regulation.

Fraud

FINRA will continue to closely monitor for insider trading, issuer fraud and Ponzi-type schemes that harm investors and damage the integrity of the market. There will also be increased focus on microcap pump-and-dump schemes, particularly as it relates to protecting elderly investors. FINRA’s new Rule 2165 and amendments to FINRA Rule 4512 provide Firms tools to protect senior investors from microcap pump-and-dump schemes, and have highlighted that Firms need to file a Suspicious Activity Report (SAR) for illicit activity involving the exploitation of senior investors.

High-risk firms and brokers

Along with Fraud, FINRA will also continue identifying high-risk firms and individual brokers to mitigate risk to investors, specifically those who are unsophisticated or senior. The focus will be on the recommendations for complex products that may fall outside of an investment objective.

Business continuity planning

FINRA Rule 4370 requires firms to maintain plans that are reasonably designed to enable them to meet their existing obligations to customers in an emergency or business disruption. FINRA will review firms’ BCPs with a focus on their implementation of the plan (under what circumstances firms activate their BCPs and how this is done, how they classify systems as mission-critical or secondary, how they accomplish data backup and recovery, and where applicable, how firms coordinate with their affiliates and vendors during a business continuity situation).

Customer protection and verification of assets and liabilities

FINRA will examine the accuracy of firms’ net capital and reserve computations under Securities Exchange Act (SEA) Rules 15c3-1 and 15c3-3. This will also include a review of processes for verifying customer assets and proprietary assets and liabilities in those financial records, as well as validate whether firms have implemented adequate controls and supervision to protect customer assets and assess their compliance with the specific requirements of the Rule.

Technology governance

Because some firms have experienced significant customer service and regulatory problems caused by the implementation of new systems, FINRA intends on reviewing firms’ information and technology change management policies and procedures to ensure strong controls are maintained while implementing any changes to the IT infrastructure to prevent disruptions.

Cybersecurity

FINRA raised concerns in the Examination Findings Report around cybersecurity, and will continue to prioritize this in 2018 as a significant threat and will monitor firms’ preparedness and controls in place to protect sensitive information.

Anti-money laundering (AML)

FINRA also raised concerns in the Examination Findings Report and will continue to identify concerns related to the adequacy of:

  1. Firms’ policies and procedures to detect and report suspicious transactions
  2. Resources for AML monitoring
  3. Independent testing required under FINRA Rule 3310(c).

Liquidity risk

FINRA will evaluate whether a firm’s liquidity planning is appropriate for the firm’s business and customers, and whether it includes scenarios that are consistent with its collateral resources and client activity.

Short sales

FINRA will examine firms’ policies and procedures for establishing and monitoring the rates charged to customers for short sales and test whether firms are calculating rates consistent with procedures.

Suitability

FINRA identified worrisome selling practices surrounding complex products such as unit investment trusts (UITs) and leveraged and inverse exchange trade funds (ETFs) in the Examination Findings Report and therefore will continue to assess the adequacy of firms’ controls to meet their suitability obligations. This includes reviewing how firms identify products that are subject to new product vetting, the vetting process itself, and the supervisory systems and controls firms put in place to ensure personnel are appropriately educated and trained on the sale and supervision of the product and that recommendations are suitable.

Initial Coin Offerings (ICOs) and Cryptocurrencies

FINRA will monitor cryptocurrencies, ensuring that firms have adequate supervisory, compliance and operational infrastructure under federal securities laws and FINRA rules should the assets be deemed as a security or where registered firms and representatives effect transactions.

Use of margin

FINRA will examine whether firms and registered representatives adequately disclose the risk of margin loans and whether firms maintain controls reasonably designed to prevent excessive margin trading.

Securities backed lines of credit

FINRA will assess the adequacy of disclosures firms provide customers regarding the potential risks associated with SBLOCs, including the potential impact of a market downturn, the potential tax implications if pledged securities are liquidated and the potential impact of an increase in interest rates.

Manipulation

FINRA will continue to make enhancements to the surveillance program used to detect any new threats, which includes the addition of machine learning techniques.

Best execution

FINRA found that some firms failed to implement and conduct an adequate, regular and rigorous review of the quality of the executions of their customers’ orders in the Examination Findings Report and therefore is expanding the equity best execution surveillance program to assess the degree to which firms provide price improvement when routing customer orders for execution or when executing internalized customer orders. FINRA will also review how broker-dealers manage the conflict of interest that exists between their duty of best execution and their own financial interests.

Regulation SHO

FINRA raised concerns in the Examination Findings Report that firms were overly reliant on third party order management systems and automated systems to meet Reg SHO requirements and has indicated an increased focus on evaluating firms compliance with Rule 201 of Reg SHO.

Fixed income data integrity

FINRA developed a suite of data integrity surveillance patterns to monitor firms’ transaction reporting in Treasury securities in anticipation of the launch of treasury securities reporting to TRACE. The patterns identify instances of late reporting, failing to report inter-dealer trades, misreporting of inter-dealer trades and inaccurate execution time reporting.

Options

FINRA developed a surveillance pattern to detect potential front running in correlated options to detect where a market participant may engage in transactions in one product while having knowledge of a pending transaction in a correlated product prior to the public dissemination of the terms of the order. FINRA will also focus on options “marking the close” activity where orders are being sent immediately prior to the close that impact the final national best bid or offer (NBBO) to benefit positions held by that account or accounts with which they are acting in concert.

Market access

FINRA will continue to review broker-dealers’ compliance with SEA Rule 15c3-5 (the Market Access Rule), which requires that broker-dealers establish reasonable pre-trade financial controls, among other things after identifying a number of firms who fell short in this area in the Examination Findings Report.

Alternative trading system surveillance

FINRA will review alternative trading systems’ supervisory systems in the context of reviews opened as a result of surveillance alerts related to potential manipulative activity occurring on or through an alternative trading system.

New Rules and Amendments to Existing Ones

  • FINRA Rule 2165 (Financial Exploitation of Specified Adults) permits members to place temporary holds on disbursements of funds or securities from the accounts of specified customers where there is a reasonable belief of financial exploitation of these customers. This rule becomes effective February 5, 2018.
  • Amendments to FINRA Rule 4512 (Customer Account Information) – An amendment to FINRA Rule 4512 requires members to make reasonable efforts to obtain the name of and contact information for a trusted contact person for a non-institutional customer’s account. The amendment will become effective February 5, 2018.
  • The Financial Crimes Enforcement Network’s (FinCEN) Customer Due Diligence Rule (CDD Rule) – This new rule identifies four components of customer due diligence: (1) customer identification and verification; (2) beneficial ownership identification and verification; (3) understanding the nature and purpose of customer relationships; and (4) ongoing monitoring for reporting suspicious transactions and, on a risk basis, maintaining and updating customer information. The rule becomes effective May 11, 2018.
  • Amendments to FINRA Rule 2232 (Customer Confirmations) – The amended FINRA Rule 2232 requires a member to disclose the amount of mark-up or mark-down it applies to trades with retail customers in corporate or agency debt securities if the member also executes offsetting principal trades in the same security on the same trading day. The amended rule also requires members to disclose two additional items on all retail customer confirmations for corporate and agency debt security trades. The amendment becomes effective May 14, 2018.
  • Margin Requirements for Covered Agency Transactions (Amendments to FINRA Rule 4210) – FINRA’s new margin requirements for Covered Agency Transactions are scheduled to become effective on June 25, 2018.
  • Consolidated FINRA Registration Rules – The consolidated FINRA registration rules (FINRA Rules 1210 through 1240) will become effective October 1, 2018. The complete restructuring of the representative-level qualification program has been designed bring consistency and uniformity to the qualification and registration requirements and introduces the Security Industry Essentials Exam, which removes any overlap of the content between exams.
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