By by Brian T. Daly, Julian Rainero, David S. Sieradzki, William J. Barbera and Derek N. Lacarrubba of Schulte Roth & Zabel LLP
On April 7, 2016, the Securities and Exchange Commission approved the Financial Industry Regulatory Authority’s proposed amendments[1] to NASD rule 1032 (Categories of Representative Registration).[2] These amendments will require FINRA members to register associated persons who are primarily responsible for the design, development or significant modification of “algorithmic trading strategies” (or for the day-to-day supervision or direction of such activities) as “Securities Traders.”
Background
Historically, associated persons of FINRA members who are involved solely in the design, development or significant modification of “algorithmic trading strategies” have not been subject to FINRA’s registration requirements. As a result of the lack of any individual licensing obligation, these algorithmic trading personnel: (1) have not been required to pass any examinations; (2) have not been subject to continuing education requirements; and (3) have — in many ways — been “under the radar” when it came to FINRA’s examination and inspection program.
FINRA now believes that requiring the registration of certain algorithmic trading personnel could help reduce or prevent problematic conduct caused by the widespread use of algorithmic trading strategies. In February 2016, FINRA proposed a new rule that would require the registration (as Securities Traders[6]) of “associated persons that possess knowledge of, and responsibility for, both the design of the intended trading strategy (e.g., the arbitrage strategy) and the technological implementation of such strategy (e.g., coding)” and to make those associated persons subject to FINRA’s continuing education requirements applicable to Securities Traders.[7]
On April 7, 2016, the SEC approved this proposal and the new rule is expected to become effective following FINRA’s publication of a Regulatory Notice relating to the revised rule.
Implications for Investment Advisers
The new rule (NASD rule 1032(f)) is only applicable to registered broker-dealers and has no direct effect on investment advisers (unless the adviser is dually registered as a broker-dealer). However, systematic and other quantitative managers should review the Adopting Release and RN 15–09, as regulators may well look to them as being instructive in determining best practices for investment advisers.[8]
RN 15-09, in particular, lists five categories of (and 30 specific) “Suggested Effective Practices for Firms Engaging in Algorithmic Strategies” that all systematic and quantitative managers should consider reviewing and, where applicable, incorporating into their quality control processes. These five suggested practices are:
1. General Risk Assessment and Response: Undertaking a “holistic review of [a firm’s] trading activity” and implementing cross-disciplinary committees to continually assess the risks associated with individual algorithmic strategies;
2. Software/Code Development and Implementation: Implementing policies and processes that focus on the development, testing and implementation of algorithmic strategies, rather than just post-production reviews;
3. Software Testing and System Validation: Developing and implementing policies and procedures around the actual testing of algorithmic strategies, including modification to existing strategies;
4. Trading Systems: Implementing policies and procedures providing for the post-implementation review of an algorithmic strategy’s trading activity; and
5. Compliance: Ensuring effective communication between compliance staff and algorithmic strategy development staff.
New NASD rule 1032(f) can also be useful to legal and compliance personnel as a construct for supervisory authority and responsibility. Given the SEC examination focus on quantitative funds, systematic managers should use this FINRA guidance as an opportunity to evaluate and update their business and compliance processes.
Effective Date
FINRA must announce the effective date of the proposed rule change in a Regulatory Notice published no later than 60 days from April 7, 2016, and the effective date will be no sooner than 180 days following publication of the Regulatory Notice but no later than 300 days following SEC approval.
If you have any questions concerning this Alert, please contact your attorney at Schulte Roth & Zabel or one of the authors.
1] See File No. SR-FINRA-2016-007.
[2] See Exchange Act Release No. 34-77551 (Apr. 7, 2016), 81 Fed. Reg. 21914 (Apr. 13, 2016) (the “Adopting Release”).
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[6] The pre-requisite to registration as a Securities Trader is successfully passing the Series 57 (Securities Trader) examination.
[7] See Exchange Act Release No. 34-77175 (Feb. 18, 2016), 81 Fed. Reg. 9235 (Feb. 24, 2016) (the “Proposing Release”).
[8] See, e.g., the CFTC’s broad survey of U.S. and non-U.S. industry best practices and regulatory requirements in the Regulation AT proposing release (80 FR at 78834).
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