Any brokerage firm that hires brokers with a pattern of misconduct and complaints against them at prior jobs could be facing more intense scrutiny during their regulatory examinations.
Today, the Financial Industry Regulatory Authority (FINRA), issued its list of regulatory and examination priorities for 2014. The regulatory body examines the industry's nearly 4,200 securities firms for compliance with the rules.
This year, Wall Street’s watchdog is targeting a small number of risky brokers that have a pattern of complaints or disclosures for sales practice abuses. In 2014, FINRA will expand the so-called High Risk Broker program, which it launched in 2013, and create a dedicated enforcement team to prosecute such cases, according to letter.
Firms that hire these high-risk brokers will be expected to show what they’ve done to monitor and prevent recurrences of misconduct in the future. Examiners will review the firm’s due diligence they conducted in the hiring process, and the adequacy of supervision of higher risk brokers — including whether brokers have been placed under heightened supervision — based on the patterns of past conduct. FINRA said examiners would also look at these brokers’ client accounts.
Also, FINRA is honing in on the potential risks presented by brokers that worked at firms “expelled from the security industry, who may bring unethical or illegal practices to the new firm,” stated the letter. The regulator is using sophisticated analytics, known as the Broker Migration Model, to identify and monitor brokers who move from a firm that has been expelled or has a serious disciplinary history at another regulated firm.
Cracking Down on Complex Products
Suitability is also a top priority for FINRA when it comes to recommendations made to retail investors for complex products, which may be challenging to understand due to ineffective disclosure practices, said the regulatory in its letter. With the proliferation of complex products (i.e., leveraged ETFs, REITs, frontier funds, interest rate sensitive FINRA will focus its examination on the manner in which firms disclose material risks to investors and the policies and procedures surrounding those disclosures. In the current economic environment, FINRA is concerned about an “unanticipated, rapid or uncontrolled shift in the interest rate environment” due to monetary policy, which could have adverse impact on fixed income products and possibly a negative effect on equity markets. FINRA cited its concerns about complex structured products, such as leveraged ETFs, frontier funds which invest in emerging markets, long-duration bond funds and ETFs and municipal securities.
A retail investor that has a portfolio concentrated in long duration instruments such as bond funds or high-yield securities, for someone who has near-term liquidity needs, would raise red flags.
FINRA also singled out frontier funds, which the Wall Street Journal story noted are“ funds that focus on regions that aren't yet considered emerging markets, ranging from Argentina and Bangladesh to Nigeria and Vietnam.”
Cybersecurity remains a priority for FINRA as well in 2014 since this is an ongoing issue for the securities industry. “In recent years, many of the nation’s largest financial institutions were targeted for disruptions through a range of different attacks,” stated FINRA in its examinations and priorities letter. Noting that the frequency and sophistication of these attacks seems to be increasing, FINRA said it continues to be concerned about the integrity of firm’s infrastructure and the safety and security of sensitive customer data.
FINRA is again keeping tabs on algorithmic trading and trading systems, referring to a number of malfunctions in recent years that led to substantial market disruptions. “These malfunctions raise concern about firms’ ability to develop, implement and effectively supervise these systems,” wrote FINRA in its letter. The regulator will continue to assess whether firm’s testing and controls related to high frequency trading (HFT) and other algorithmic trading strategies and trading systems are adequate in light of the Market Access Rule and supervisory obligations. “Firms subject to review should be prepared to address whether they conduct separate, independent and robust pre-implementation testing of algorithms and trading systems and whether the firm’s legal, compliance and operations staff are reviewing the design and development of the firm’s algorithms and trading systems for compliance with legal requirements,” stated FINRA in its letter. Examiners will ask firms if they actively monitor and surveil algorithms and trading systems after they are placed into production or after they have made changes. Firms will also need to explain their approach to “kill switches” as well as procedures for responding to catastrophic events.
Other concerns on FINRA’s watch list include anti-money laundering, crowdfunding portals, insider-trading, funding and liquidity risk and microcap fraud.
Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio