August 20, 2019

August 20, 2019

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August 19, 2019

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REGULATORS, QUANT UP! New Rules from FINRA, SEC and CFTC Target Automated Algorithmic Trading

On February 11, 2016, the Financial Industry Regulatory Authority (“FINRA”) filed a proposed rule with the Securities and Exchange Commission (“SEC”) that would require individuals who “design, develop or significantly modify algorithmic trading strategies” (or “ATS”) as well as individuals responsible for the “day-to-day supervision or direction of the development process,” to pass a qualification exam and register with FINRA as securities traders. During the comment period, FINRA clarified that the rule would not apply to every person who touches or is otherwise involved in the design of a trading system, but that it would be up to each firm to determine who is primarily responsible for the design of the ATS system.  The rule defines ATS as “any program that generates and routes (or sends for routing) orders (and order-related messages, such as cancellations) in securities on an automated basis” and identifies eight typical programs that it would consider an ATS.  (FINRA Reg. Notice 15-06.)  The rule was prompted by FINRA’s concern that programmers be properly educated in securities regulations in order to avoid inaccurate orders, inadequate risk management controls, and other problematic conduct. Commentators criticized the proposal as having a “potential chilling effect” by “discouraging well-qualified developers from participating in the design, development or modification of algorithmic trading strategies, and even from affiliating with FINRA member firms.”

In similar moves, both the SEC and the Commodity Futures Trading Commission (“CFTC”) have proposed rules that would impact trading firms, clearing members and exchanges that utilize ATS. In November 2015, the CFTC proposed Regulation Automated Trading or Regulation AT (CFTC PR7283-15 (11/24/15)), under which these entities would have to put in place pre-trade risk controls, establish standards for how they develop, test, and monitor their ATS, make annual reports to their designated contract markets attesting to their pre-trade compliance controls, and register with the CFTC if they haven’t already.  Furthermore, the CFTC also plans to require automated trading firms to keep their trading software’s source code available for inspection.

On February 19th, the SEC disclosed that it too is developing an ATS “record keeping” proposal. According to John Roeser, an associate director in the SEC’s trading and markets division, later this year, the staff will recommend the Commission consider the new rule, which is designed to “improve regulatory oversight over algorithmic trading by enhancements of record keeping of broker-dealers.” Roeser acknowledged that firms have a proprietary interest in the ATS information, but insisted that “it is essential those records be available to the commission to inform market oversight” and help it conduct investigations.  Though the SEC has not identified what specific information would be affected by the new rule, it is almost certain to include the firm’s ATS code.

Regulators are clearly fixing their sights on ATS. In addition to requiring ATS programmers to register with FINRA, firms that engage in ATS are also likely to face requests from regulators to inspect their proprietary and confidential ATS programming code.  These are not insubstantial burdens, and firms will have to consider and decide how best to implement and respond to these new requirements.

Copyright © 2019, Sheppard Mullin Richter & Hampton LLP.

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About this Author

Sarah Aberg Government Contracts Attorney Sheppard Mullin Law Firm New York
Associate

Sarah Aberg is an associate in the Government Contracts, Investigations & International Trade Practice Group in the firm's New York office.

Areas of Practice

Ms. Aberg’s practice encompasses securities regulation, compliance, and litigation as well as internal investigations and white-collar defense. She frequently represents broker-dealers and associated individuals who are the focus of SEC, FINRA, and other regulatory investigations. She has conducted numerous internal investigations into a wide...

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