SEC Approves FINRA-Proposed Rule Regarding Self-Trades (with Lofchie Comment)
FINRA announced that the SEC approved amendments to FINRA Rule 5210("Publication of Transactions and Quotations") to limit "self-trading."
The new rule change would, among other things, add Supplementary Material .02 to FINRA Rule 5210 to address members' obligations with respect to certain securities transactions that result from the unintentional interaction of orders originating from the same firm, known as "self-trades," that involve no change in the beneficial ownership of the security.
The rule amendments establish a distinction between two types of transactions in which the same person acts as both buyer and seller. The term "wash sales," which has long been used to describe these transactions is limited to situations where the buyer/seller has a bad intent, most commonly to manipulate price or to show false trading volume. A new term, "self-trade" is used to describe transactions where a person unknowingly acts as both buyer and seller due to the interaction between different trading algorithms, but without any ill intent.
Under this new regulatory scheme, wash sales will continue to be treated as fraudulent, and as such, are subject to the same provisions in the federal securities laws and the FINRA Rule.
As to self-trades, the rule change requires FINRA members to have policies and procedures in place that are "reasonably designed" to review their trading activity for, and prevent, a pattern of self-trades originating from a single algorithm or trading desk, or from related algorithms or trading desks. According to the FINRA Rule, "Algorithms or trading strategies within the most discrete unit of an effective system of internal controls at a member firm are presumed to be related."
The new rule change also states that transactions resulting from orders that originate from unrelated algorithms or from separate and distinct trading strategies within the same firm would generally be considered bona fide self-trades, and thus not generally subject to disciplinary action. However, in the SEC order approving the rule amendment, the SEC noted that "FINRA reiterates its position that, although self-trades between unrelated trading desks or algorithms are generally bona fide, frequent self-trades may raise concerns that they are intentional or undertaken with manipulative or fraudulent intent." In short, firms should not become too comfortable that they will not be subject to disciplinary action if their trading algorithms result in a large volume of bona fide self-trades that could be limited by a reasonable improvement in procedures.
FINRA will announce the effective date for this change to Rule 5210 in a future Regulatory Notice.
Lofchie Comment: This rule change is a reasonable attempt by FINRA to balance two competing policy considerations. The first relates to false reporting of a market transaction that results from a self-trade (that it is false does not imply that it is either intentionally false or of material harm). The second policy consideration relates to the consequences of the first, that is, completely stopping all such false reports would require such changes in firms' trading methodologies that the injury would far outweigh the benefit.While FINRA came to a reasonable balance, firms should be mindful that the downside of the FINRA approach is that it is inherently ambiguous, and enforcement decisions will, except perhaps in extreme cases, be judgment calls. Against that background of uncertainty, firms should attempt to determine the degree to which they self-trade, how much of this self-trading is from the same or related desks and algorithms, and how much of it can be prevented, whether it results from related or separate desks. The greater the effort the firm undertakes (firms should document their efforts in this regard), the more it protects itself from any possible disciplinary action.Interestingly, because this is a FINRA rule, it applies only to FINRA firms (SEC-registered broker-dealers). Of course, broker-dealers are not the only entities that employ trading algorithms. Accordingly, other types of firms should consider how the rule might affect them were it to become applicable to them.
See: FINRA Rule Proposal; SEC Order of Approval; FINRA Announcement.Related news: SEC Extends Review Period for FINRA Wash Sale Transactions Amendments (with Lofchie Comment) (March 3, 2014) FINRA Files Amendment to Proposed Rule Change Relating to Wash Sale Transaction, Self-Trades and FINRA Rule 5210 (December 4, 2013) FINRA Proposed Rule on Wash Sale Transactions (with Lofchie Comment) (August 16, 2013) MFA Comment Letter on Unintentional Wash Sales (September 26, 2013).