AML again a top priority for broker-dealer exams, FINRA says

January 17, 2013

By Stuart Gittleman, Compliance Complete

(Additional reporting by Suzanne Barlyn of Reuters)

NEW YORK, Jan. 17 (Thomson Reuters Accelus) – Anti-money laundering compliance will again be a focus of Financial Industry Regulatory Authority examinations this year, particularly at broker-dealers with higher-risk business models due to their clients, products and service mix, or locations.

HSBC’s $1.9 billion fine last month highlighted, among other things, the potential AML risks associated with foreign affiliates and the business they transact through their U.S. financial institution affiliates, FINRA said in its 2013 annual regulatory and examination priorities letter

The letter was issued on Friday. Among other focuses of the letter were algorithmic trading, speculative microcap securities and business development companies, a type of private equity vehicle that can be hard to exit.

AML was also a key focus area in last year’s FINRA priorities letter. Among other topics covered by this year’s

FINRA this year noted a rise in foreign currency conversion transactions in which foreign financial institutions buy U.S.-denominated bonds, generally issued by foreign governments, with local currency, and transfer the bonds to a U.S. firm that sells them and transfers the proceeds offshore. U.S. firms involved in these deals must perform due diligence and adequately review the transactions for potential suspicious activity, FINRA warned. AML risks are continually changing and firms must adapt their programs accordingly, it said.

FINRA also tweaks its AML and other exam priorities throughout the year to adapt to changing and emerging risks, and a particular firm’s exam will focus on the risks attendant to its business, the letter added.

Better due diligence will help protect against the risks to customers and firms of high-risk, speculative microcap and low-priced over-the-counter securities that are being touted to investors looking to recover from their credit crisis-related losses or to escape the low yield environment. FINRA urged firms to review their policies and procedures to ensure compliance in activities related to these securities, including:

  • heightened supervision of employees who maintain direct or indirect outside business activities associated with microcap and OTC issuers;
  • heightened supervision of traders involved in trading these securities;
  • ensuring that any research the firm produces for these issuers is accurate and balanced, and appropriately discloses the securities’ risks to investors;
  • monitoring customer accounts liquidating these securities to ensure, among other things, that the firm is not facilitating, enabling or participating in an unregistered distribution;
  • heightened supervision of activities where an affiliate of the firm is the transfer agent for the securities;
  • implementing AML responsibilities that require monitoring for suspicious activity and filing Suspicious Activity Reports where warranted; and,
  • monitoring broker solicitations of customers to trade these securities to ensure that any recommendations are balanced and the securities are suitable for the specific customer in accordance with FINRA’s amended suitability rule, 2111.

Following these suggestions will also help firms comply with FINRA’s enhanced know-your-customer rule, 2090.

Other key operational and market integrity priorities include assessing whether firms:

  • using high frequency trading strategies and other trading algorithms test these strategies pre- and post-launch to ensure that they do not result in abusive trading such as “momentum-ignition strategies” ion which one trader tries to lure others into trading at artificially high or low prices;
  • use options mini-manipulation strategies in which traders try to manipulate the price of underlying equities, typically through HFT, to either close out their options positions at favorable prices or establish new positions at advantageous prices.

FINRA warned it has changed its cross-product surveillance reviews to capture recently identified ploys and will continue to devote substantial resources to detecting, and bringing enforcement actions over, such conduct.

FINRA’s focus on business development corporations (BDCs) marks a change from last year. BDCs pay generous dividend yields, sometimes as high as 11 percent, and are typically publicly traded. But FINRA said it was concerned about an “increasing issuance” of BDC funds that are not publicly traded.

The nontraded funds pose liquidity risks to investors, who may only be able to exit from the investment by waiting for the BDC to repurchase shares. Investors, in that case, may have to sell at a deep discount from what they initially paid, according to FINRA.

BDCs typically target mid-size companies that have capital constraints or are underfunded.

FINRA said it is conducting a sweep exam to help determine the significance of options origin mis-coding across the industry, focusing on situations in which firms are improperly coding firm or broker orders as customer orders, thus impacting priority, the options audit trail and paying exchange fees. The options surveillance and exam teams are also looking at whether firms are deliberately trying to circumvent the professional customer designation and thus maintain order priority status, along with reduced exchange fees.

FINRA has found weaknesses in large options position reporting and continues to review situations where firms either misreport positions or do not report positions as required by exchange rules. FINRA has identified position-aggregation errors, in-concert reporting errors, reliance on flawed vendor programs and the non-reporting of positions that are clearly within the scope of what the rules require be reported, and urged firms to review the Options Clearing Corporation’s frequently asked questions to remediate any deficiencies.

FINRA also said it remains focused on fixed income trading issues such as best execution, inter-positioning and fair pricing, and continues to be concerned about fair and reasonable markups, particularly in products such as collateralized mortgage obligations and mortgage-backed securities. FINRA warned that it has developed automated surveillance patterns to spot areas of potentially problematic behavior such as wash sales, marking the close and trading ahead.

The letter comes at a time when industry changes and regulatory developments such as the registration of private fund advisers have put many people into the chief compliance officer role without having gone through a FINRA exam before.

“It generally could be 30 days” between when an exam team makes a document request to a firm and when the team begins an on-site visit, “but it depends on a variety of factors including the size of the firm and its regulatory history,” Nancy Condon, FINRA vice president of media relations, told Compliance Complete.

“The exam could also be conducted with no advance notice at all,” Condon added.

Depending on its business model, a firm can be examined for its business conduct and sales practices, its financial and operational issues, or both.

“If the same firm will be examined for both areas in the same year we have the teams conduct what we call ‘collaborative exams’ to make it less burdensome,” Condon said.

FINRA noted two areas where the exams may be supplemented by targeted investigations: algorithmic trading, and cyber-security and data protection. Consistent with the Securities and Exchange Commission’s market access rule, 15c3-5 under the Securities Exchange Act of 1934 and other supervisory obligations, FINRA will assess whether firms have adequate testing and controls over HFT and other algo strategies and trading systems. The reviews may include whether a firm:

  • conducts separate, independent and “robust” pre-implementation testing of algos and trading systems;
  • ensures that its legal, compliance and operations staff appropriately perform their respective roles in the design and development of the firm’s algos and trading systems;
  • actively monitors algos and trading systems once they are placed into production, including procedures and controls to detect potential trading abuses such as wash sales, marking, layering and momentum-ignition strategies; and
  • controls changes made after an algo and trading system is placed into production.

FINRA said it will also focus on whether brokers have firm-wide disconnect or “kill” switches and procedures for responding to widespread system malfunctions.

Also, the frequency and intensity of cyber-threats such as denial of service attacks and data security breaches raise concerns of an industry-wide vulnerability to disruption and unauthorized access to customer account information. As a result, FINRA said it will evaluate the integrity of firms’ policies, procedures and controls to protect sensitive customer data.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus ( Compliance Complete ( provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges. Follow Accelus compliance news on Twitter at:


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