Each year, the Financial Industry Regulatory Authority (“FINRA”) publishes its Annual Regulatory and Examination Priorities Letter to highlight issues of importance to FINRA’s regulatory programmes. 5 January 2016 saw the release of the FINRA 2016 Regulatory and Examination Priorities letter. The 2016 letter identifies new areas of focus as well as areas of recurring concern. FINRA first identifies and addresses three broad issues – Culture, Conflicts of Interest and Ethics; Supervision, Risk Management and Controls; and Liquidity – and then discusses more specific topics later in the letter.
Culture, Conflicts of Interest and Ethics
FINRA defines “firm culture” as a set of explicit and implicit norms, practices and expected behaviours that influence how a firm’s executives, supervisors and employees make and implement decisions in the course of conducting a firm’s business. In 2016, FINRA intends to formalise its assessment of firm culture to understand how it affects compliance and risk management practices at firms. FINRA identifies five indicators it will look to assess firm culture:
- whether control functions are valued within the organisation;
- whether policy or control breaches are tolerated;
- whether the organisation proactively seeks to identify risk and compliance events;
- whether supervisors are effective role models of firm culture; and
- whether sub-cultures (e.g. at a branch level, a trading desk or an investment banking department) that may not conform to overall corporate culture are identified and addressed.
Supervision, Risk Management and Controls
In the Supervision, Risk Management and Controls category, FINRA will focus on four areas where it has observed repeated concerns.
- Management of Conflict of Interest;
- Outsourcing; and
- Anti-Money Laundering.
Under each category FINRA has further divided the areas of focus into sub-categories. Below is a brief synopsis of each category and sub-category.
Management of Conflict of Interest
FINRA plans to complete its ongoing targeted examination launched in late 2015 regarding incentive structures and conflicts of interest in connection with firms’ retail brokerage business.
FINRA also took this opportunity to remind firms that FINRA recently filed with the United States Securities and Exchange Commission (“SEC”) proposed Rule 2273 which would require firms to deliver education communications in connection with firm recruitment practices.
Investment Banking and Research Business Lines
FINRA plans to assess whether firms’ research analysts are inappropriately involved in their investment banking activities and whether investment backing personnel exercise undue influence on analysts.
FINRA will continue its interest in firms’ controls to identify, minimise and mitigate information leakage within or outside of a firm.
FINRA will focus on assessing firms’ supervision, control and validation of traders’ pricing of illiquid, level 3 assets to ensure that positions are fairly valued.
It should be no surprise that FINRA remains focused on firms’ cybersecurity preparedness. FINRA states it will review firms’ approaches to cybersecurity risk management and, depending on a firm’s business and risk profile, will examine one or more of the following topics:
- Risks assessment;
- Technical controls;
- Incident response:
- Vendor management;
- Data loss prevention; and
- Staff training.
FINRA also plans to examine firms’ abilities to protect the confidentiality, integrity and availability of sensitive customer and other information, including compliance with SEC Regulation S-P, and high-frequency trading and proprietary trading firms’ ability to protect their systems from unauthorized access.
FINRA intends to examine firms’ technology governance and change management practices.
Data Quality and Governance
FINRA proposes to examine firms’ data governance, quality controls and reporting practices to ensure the accuracy, completeness, consistency and timeliness of data reported to firm management and to firms’ surveillance and supervisory systems.
FINRA will review firms’ due diligence and risk assessment of providers of outsourced services and their supervision of those services.
Suspicious Activity Monitoring
FINRA has made its priority to assess the adequacy of firms’ monitoring of high-risk customer accounts and transactions. FINRA further warns firms that, when monitoring customer money movement activity, firms should ensure that the business purpose of high risk transactions is understood to enable the firm to know about the customer and the customer’s anticipated activity.
FINRA remains focused on the high-risk activity involving microcap securities reminding firms to review deposits of microcap securities and implement processes and procedures for customer trading in microcap securities with a focus on suspicious activity and manipulative trading.
FINRA highlights one area under Liquidity – firm funding. FINRA indicates it has long taken an interest in firm funding because firms’ failures to manage liquidity have contributed to both individual firm failures and systemic crises. Therefore, FINRA intends to review firms’ practices in managing funding and liquidity risk. FINRA also highlights its intent to review firms’ contingency funding plans with regard to their business model.
Additionally, FINRA will specifically focus on the adequacy of high-frequency trading (“HFT”) firms’ liquidity planning and controls.
Other Areas of Focus in 2016
The other areas of focus FINRA identifies are:
- Suitability and Concentration – FINRA will focus on firms’ policies and procedures that govern monitoring for excessive concentrations, as well as suitability determinations for recommended transactions or investment strategies.
- Seniors and Vulnerable Investors – FINRA states it will make the treatment of senior and vulnerable investors a priority in 2016, specifically suitability and concentration concerns and recommendations regarding higher-cost products that may drive unsuitable recommendations and affect product performance to the detriment of the investor.
- Sales Charge Discounts and Waivers – FINRA will continue its focus on firms’ failures to provide appropriate volume discounts or sales charge waivers for products. FINRA continues this focus from 2015.
- 529 College Savings Plans (“529 Plans”).
- Private Placements, the JOBS Act and Public Offerings – FINRA will focus on private placements suitability, disclosure and due diligence in 2016. FINRA will further continue to evaluate firms’ compliance with respect to their communications, including general solicitation advertisements and materials posted on the Internet. FINRA will subject Non-Traded Real Estate Investment Trusts (“REITs”) and Direct Participation Programs to rigorous review. Finally, FINRA stated its intent to review whether firms have processes in place to ensure that investors are treated fairly, that firms are complying with fair pricing obligations and that they are conducting bona fide public offerings, specifically as they relate to new bond offerings.
- Outside Business Activities (“OBA”) – FINRA will evaluate firms’ procedures to review OBAs as required by FINRA Rule 3270.
Financial and Operational Control
- Market-Maker Net Capital Exemptions – FINRA will focus on whether firms have properly claimed the exemption under, and operated consistent with, the net capital rule and whether firms are engaged in bona fide market-making and permissible hedging transitions pursuant to the net capital rule.
- Exchange-Traded Funds – FINRA will review broker-dealers’ role as Authorized Participants (“APs”) in the ETF creation process and the processes firms use to measure and monitor the impact of overnight counterparty credit risk.
- Fixed Income Prime Brokerage – A 2016 focus will be on settlement practices for fixed income trades to understand how the operational and credit risks are managed when large trades are executed away from the prime broker. FINRA says it will explore industry practice with respect to disaffirming trades and the legal documentation that supports the settlement process as well as financing practices for fixed income where extensive leverage is offered.
- Internal Audit – FINRA will focus on the organisation and governance of the Internal Audit function.
- Client Onboarding – FINRA intends to focus on firms’ policies and controls related to onboarding clients and correspondents, specifically how they assess credit, liquidity and operational risks associated with onboarding new clients.
- Transmittal of Customer Funds – FINRA plans to assess whether firms implement adequate supervisory controls to test and verify systems to prevent improper transmittal of customer funds.
- Vendor Display Rule.
- Market Access – FINRA will examine how firms use FINRA’s new monthly report card to take steps to identify and address the potential misconduct.
- Fixed Income – FINRA will continue to review fixed income order handling, markups and related controls. Other areas of focus will include wash sales, marking the close and trading ahead as well as Alternative Trading Systems (“ATSs”).
- Regulation SHO – FINRA will examine firms’ compliance with SEC Regulation SHO.
Cross-Market and Cross-Product Manipulation – FINRA will focus on coordinated equity and options market activity designed to create momentary, artificial prices intended to affect the settlement prices of related products.
- Audit Trail Integrity – FINRA will focus on identifying potential audit trail issues not typically detected through routine compliance sweeps including late reporting of securities and errors in the equity audit trail.
FINRA provides the first line of oversight for broker-dealers and, through its comprehensive regulatory programmes, regulates both the firms and professionals that sell securities in the United States and the U.S. securities markets. FINRA touches virtually every aspect of the securities business – from registering industry participants to examining securities firms; writing rules and enforcing those rules and the federal securities laws; informing and educating the investing public; providing trade reporting and other industry utilities; and administering the largest dispute resolution forum for investors, firms and individual brokers.
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