FINRA Starting Sweep on ATS Practices
February 13, 2013
The Financial Industry Regulatory Authority is about to pay visits to a wide range of alternative trading systems, in an attempt to make sure they are properly handling customers' orders.
The independent regulator of brokers, which shares oversight of alternative trading systems with the Securities and Exchange Commission, has made ATS operations one of its top priorities in 2013, according to John Malitzis, executive vice president of market regulation at the agency. [IMGCAP(1)]
The examiner will conduct an initial sweep of about 15 of the systems, which are typically set up to help match buyers and sellers of large quantities of stocks who want to trade anonymously. These can include crossing networks, such as ITG's Posit or Goldman Sachs' Sigma X, which match trades without first routing orders to a public exchange; block-trading venues such as Liquidnet or the BIDS ATS; and electronic communications networks, which display public quotes, such as LavaFlow, operated by Citigroup, or Light Pool, operated by Credit Suisse.
The systems that allow anonymous trading off public exchanges are typically called dark pools. The largest of these is Crossfinder, also operated by Credit Suisse.
"They're going to be looking at the usual suspects," said James J. Angel, a market structure expert and visiting associate professor at the Wharton School of the University of Pennsylvania.
Dark pools accounted for 13.3 percent of all equities trading in 2012, according to Rosenblatt Securities. In January, 2.4 billion shares of stock were traded off exchanges, according to NYSE Euronext, accounting for 36.7 percent of all trading.
"We are looking at the use of indications of interest, whether the firm trades as principal or riskless principal within the ATS, and whether and how this is disclosed to ATS subscribers. We are also looking at the method by which the ATS generates compensation, how customer errors are handled, and whether and how affiliates of the ATS interact with order flow," Malitzis said.
Indications of interest, or IOIs, are nonbinding offers to buy or sell securities, communicated within alternative trading systems. Riskless principal is a characteristic of a trade in which a member who has received a customer order immediately executes an identical order in the marketplace, while taking on the role of principal, in order to fill the customer order.
"There's been a lot of concern," Angel said, about "when is an IOI an IOI and when is it really an order."
If an IOI is an order, he noted, then the quote must be reported to the Order Audit Trail System managed and operated by FINRA.
A widespread set of fines for OATS violations could be "just the thing for the FINRA budget," Angel said.
Also on the priorities list for review are how the systems handle errors, how confidential information on customers' orders get handled and whether any interaction occurs between an ATS and any affiliated organizations.
Last fall, the SEC fined the LeveL ATS $800,000 for failing to properly safeguard customer information. In that case, the smart order router of LeveL's technology provider, the Lava Trading unit of Citigroup, kept in its memory information about LeveL subscribers' unexecuted orders. The router then used that information to make routing decisions for the benefit of its own order-routing business.
In a 2011 case, Pipeline Trading Systems paid $1 million after the SEC found that at times, more than 97 percent of orders in its alternative trading system were being filled by a trading operation affiliated with the firm.
It's taken FINRA roughly a year and a half to see if other ATS's "have a Pipeline problem," Angel said.
Many dark pools, such as Crossfinder and Sigma X, are owned by broker-dealers-which they have, however, disclosed. Pipeline failed to disclose to its customers that the vast majority of orders were filled by Milstream Strategy Group, an affiliated trading operation. The SEC also found that Pipeline failed to disclose the compensation formula.
FINRA has not said which specific routing or disclosure practices at ATSs will be examined. But it plans to look at how orders are routed, how order types are disclosed and how confidential customer order information is protected, according to its 2013 annual priorities letter, published in January.
FINRA does not disclose which dark pools or trading systems will be included in a sweep, which will be conducted as part of the operations of its Trading and Market Making Examination Program (TMMS).
As noted in the priorities letter, the program takes a "risk-based" approach to deciding what market practices and participants to review.
The risk criteria, in FINRA's ongoing "cycle" program of examinations, can include the volume of trading on a given system, any complaints received and the system's disciplinary history.
The way sweeps can work, Malitzis said, is that if FINRA finds there are issues that need wider examination, then it could broaden its review.
In such a case, the authority can broaden a TMMS sweep by looking at additional areas and firms, as well as including the review as part of its regular cycle of examinations of broker-dealers under its regulatory purview.
"More than likely, we will look at those issues as we go through the cycle in the following year," he said.
In 2010, FINRA conducted reviews of algorithmic trading and so-called "information barriers," between different profit-seeking parts of brokerage firms. After that, the SEC typically issues a report on weaknesses that have been identified and pushes firms to "make whatever adjustments they need to make" to fix the problems.
The TMMS program will also be conducting a sweep that will look at how well brokers have set up internal controls that protect customers against front-running. That is a sweep involving FINRA Rule 5320, known as the customer order protection rule.
The rule prohibits trading by brokers ahead of "held" customer orders covered by the rule, as protected orders. A FINRA member is prohibited from trading a security on the same side of the market for its own account at a price that would satisfy a protected order, unless it immediately thereafter executes the customer order up to the size and at the same or better price at which it traded for its own account.
That sweep likely will look at large brokers, but whether that might include bulge bracket firms such as Goldman Sachs, Morgan Stanley or J.P. Morgan is not known.