FINRA and NASDAQ Fine Company for Alleged Supervisory and Trade Violations
FINRA and Nasdaq censured a firm and fined it $675,000 for supervisory violations in connection with its handling of a client's redemption activity and trading of leveraged exchange-traded funds ("ETFs"). Its mishandling of the client led to the chronic failure to deliver on shares of several ETFs over a two-year period.
The FINRA Department of Market Regulation's investigation revealed extensive failures to deliver on shares of 14 leveraged and inverse-leveraged ETFs by the firm – which served as the clearing firm and authorized participant for the client broker-dealer – that resulted from the client broker-dealer's redemption activity and trading of such ETF shares on the secondary market from January 1, 2010 through March 16, 2012.
During the review period, the client broker-dealer submitted orders to the firm repeatedly in order to redeem ETF shares on the primary market, and sold ETF shares repeatedly in the open secondary market. These transactions resulted in failures to deliver substantial numbers of shares of ETFs by the firm, which allocated the failures to the client broker-dealer. Although the client broker-dealer took action to close out the failures on T+6, typically through creating ETF shares by submitting creation orders through the firm, the client broker-dealer reestablished the fail position by redeeming or selling shares of the ETF through or with the assistance of the firm on the next trading day.
The client broker-dealer engaged in this cyclical pattern of fail-to-deliver activity in order to maximize the number of days it remained short in the securities, and to take advantage of the inherent financial benefits of being short versus long in the ETF shares. As such, the client broker-dealer was not entitled to utilize the T+6 closeout timeframes for bona fide market-making activities under Rule 204 of Regulation SHO.
FINRA's action against the firm asserts that the firm was or should have been aware that the client broker-dealer routinely submitted naked redemption orders contrary to the firm's obligations as an authorized participant in the trading of the ETFs.