Combating Disruptive Electronic Trading: Expedited Cease and Desist Proceedings by FINRA

The Financial Industry Regulatory Authority, Inc. (“FINRA”) recently filed an immediately effective proposal with the Securities and Exchange Commission (“SEC”) to adopt new rules aimed at certain abusive forms of electronic trading.  The proposed rules prohibit two specific types of disruptive quoting and trading activity, and permit FINRA to bring expedited cease and desist proceedings against violations, even if there is no showing of improper intent.  The proposal was published by the SEC on November 21, and will become operative on December 15 (see SR-FINRA-2016-043, available here).

The new rules point up FINRA’s increasing concerns with the continued presence of abuses in the electronic trading markets.  FINRA already actively conducts cross-market surveillance for trading abuses, and provides its members with “report cards” aimed at helping firms identify and halt improper activity.  Now, the new rules effectively permit FINRA to find that certain trading patters are per se disruptive.  Broker-dealer firms that engage in or permit high-frequency trading strategies will wish to assess their current monitoring and supervisory practices in order to ensure compliance with the new rules.  FINRA will expect its members to assess any “report cards” that they have received in connection with their compliance review.

The new prohibitions will be added as Supplementary Material to FINRA Rule 5210.  They forbid FINRA members from engaging in or “facilitating” the following two types of disruptive quoting and trading activity on electronic markets (commonly known as “layering” and “spoofing”):

  1. A frequent pattern in which (a) a party enters multiple limit orders on one side of the market at various price levels (the “Displayed Orders”), (b) following the entry of the Displayed Orders, the level of supply and demand for the security changes, (c) the party enters one or more orders on the opposite side of the market of the Displayed Orders (the “Contra-Side Orders”) that are subsequently executed, and (d) following the execution of the Contra-Side Orders, the party cancels the Displayed Orders.
  2. A frequent pattern in which (a) a party narrows the spread for a security by placing an order inside the national best bid and national best offer (“NBBO”), and (b) the party then executes an order on the opposite side of the market that executes against another market participant that joined the new inside market established by the order described in clause (a).

FINRA has made clear that no intent is necessary for a violation.  The prohibition also extends to persons acting in concert with others to effect the prohibited activity.  The order of events would not control whether or not a violation occurs.  The rules would not be limited to activity conducted on a single market venue, but would apply to activity conducted across trading platforms.

FINRA recognizes that standard enforcement proceedings can take lengthy periods of time, while cases involving manipulating trading can inflict ongoing, substantial harm.  Therefore, the new rules will also permit FINRA to issue a Permanent Cease and Desist Order (“PCDO”) against any FINRA member that (a) violates the new rules, or (b) provides market access to a client engaged in the violative activity.  All related proceedings, including hearings, would be conducted on an expedited basis.

The new rules are based on similar measures previously adopted by the BATS Exchange.  The fact that self-regulatory organizations are adopting expedited procedures to combat specific types of abusive electronic trading practices indicates how seriously regulators are taking these matters.  Nonetheless, it is not clear how FINRA intends to determine when a “frequent pattern” of disruptive trading exists, especially when many high-frequency traders and others frequently place and cancel orders on both sides of the market.  Broker-dealers that engage in proprietary high frequency trading, and that provide market access to high frequency traders, must be aware of the new rules, assess whether strategies could be deemed disruptive by regulators (including by reviewing any report cards from FINRA), and implement appropriate compliance measures in order to avoid sudden disciplinary actions.

Additional contributors to this post:

Andrew J. Shipe, andrew.shipe@aporter.com, http://www.arnoldporter.com/en/people/s/shipe-andrew-joseph

Daniel Waldman, dan.waldman@aporter.com http://www.arnoldporter.com/en/people/w/waldman-daniel

Daniel M. Hawke, daniel.hawke@aporter.com http://www.arnoldporter.com/en/people/h/hawke-daniel-m

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