Manipulative Trading - Effective Compliance Practices

The Financial Industry Regulatory Authority (FINRA) highlighted manipulative trading related to anti-money laundering (AML), fraud, and sanctions as its own standalone topic in its 2023 Report on FINRA’s Examination and Risk Monitoring Program¹ (Report). Recent regulatory rulemaking, enforcement actions, and examination programs indicate an increased attention to issues of impermissible trading practices and market manipulation.

While manipulative practices have always been a focus of both the U.S. Securities and Exchange Commission (SEC) and FINRA, there is a new focus on how firms set up formal governance surveillance for manipulation, with an emphasis on the process for choosing rules, setting thresholds, changing and/or tuning rules as necessary, and filing Suspicious Activity Reports. This focus also extends to the technology solutions (i.e., monitoring software or tools) used for surveillance.

Relevant Regulations and Enforcement Trends

FINRA and the SEC rules prohibit firms and broker-dealers from engaging in improper trading practices, including manipulative trading (e.g., momentum ignition, layering, front running).²

FINRA Supervision Rule 3110³ requires the firms to supervise their associated persons’ trading activities and the firms’ supervisory procedures to include a securities transactions process reasonably designed to identify trades that may violate the Exchange Act, SEC rules, or FINRA rules prohibiting insider trading and manipulative and deceptive devices. FINRA Rule 3310 requires registered broker-dealers in securities to have a reasonable program to comply with the Bank Secrecy Act⁴ and to file suspicious activity reports. These rules are the primary requirements for how firms should design their monitoring and surveillance programs.

In its Strategic Plan for FY 2022 through FY 2026,⁵ the SEC indicates the protection of the investing public against fraud, manipulation, and misconduct is one of its three major goals that advance the SEC’s mission. The Enforcement Results for FY22 press release⁶ published by the SEC devotes a separate section to the Market Abuse actions describing the abusive trading cases brought in fiscal year 2022, including cases against senior executives at issuers⁷ and service providers⁸, as well as cases originating from the SEC Enforcement Division’s Market Abuse Unit’s use of data analytics that detect suspicious trading patterns. 

The 2023 SEC and FINRA enforcement actions charging market manipulation are picking up and indicate a strong intent of the regulators to prioritize manipulative trading enforcement for the current year. 

In particular, one of the recent SEC enforcement cases involved charges against a crypto-asset executive and his wholly owned companies for fraudulently manipulating the secondary market “through extensive wash trading.”⁹ Similarly, a number of FINRA’s recent disciplinary actions included settlements imposing fines for not establishing and maintaining a supervisory system, including written supervisory procedures regarding surveilling for potentially manipulative trading, such as pre-arranged trading, wash trading, and marking the close¹⁰. Another FINRA supervisory filing concerned a failure to establish, document, and maintain a risk management controls system and conduct supervisory reviews of the firm’s “electronic trading customers’ trading activity for any type of potentially manipulative trading, including layering, spoofing, wash sales, or marking the close or open.”¹¹

FINRA Exam Findings

FINRA’s examination efforts illustrate the following factors that contribute to insufficient market abuse surveillance:

Inadequate Written Supervisory Procedures (WSPs) — FINRA indicates that the firms failed to identify specific steps and individuals responsible for monitoring for manipulative conduct and escalating any detected conduct. FINRA takes this opportunity to stress that trade surveillance procedures are in scope of the firms’ WSPs reviewed by FINRA under its Membership and Registration Rules¹².  The Report further points out that the firms should regularly assess whether changes in their business model or customer base require changes in supervisory controls to detect possible manipulation.

Non-Specific Surveillance Thresholds — The Report calls out the firms’ failure to design and establish surveillance controls to capture manipulative trading, including thresholds designed to capture the appropriate market class and/or type of securities, or include both customer and proprietary trading, and setting up thresholds that are too low or too high to identify meaningful activity. Specifically, the Report implicitly requires more formal governance of the firm’s surveillance system. It indicates that when establishing or testing their surveillance controls, the firms should take into consideration their business, client base, and structure; test the changes prior to implementing, and monitor them for any unanticipated impact; document the changes and the rationale for such changes. 

Surveillance Deficiencies — It is not surprising that a lack of systems governance can lead to inadequate monitoring. FINRA found that the firms did not adequately monitor customer activity for patterns of potential manipulation (e.g., failing to monitor for order entries and trading activity across multiple customers, multiple days, or both; or for trading that appears to lack legitimate economic sense). Additionally, firms did not review surveillance exception reports and document the review findings and failed to consider non-surveillance sources for red flags (e.g., inquiries from regulators or service providers).

Effective Compliance Practices

The Report shares several recommendations to improve practices in the manipulative trading area and maximize efficient trade surveillance in firms, including:

Manipulative Schemes — Maintaining and reviewing customer and proprietary data to detect manipulative trading schemes (e.g., momentum ignition, layering, front-running, trading ahead, spoofing, wash sales, prearranged trading), including those that involve cross-product as well as correlated securities.

Multiple Platform and Product Monitoring — Monitoring activity occurring across multiple platforms that also may involve related financial instruments or multiple correlated products, such as stocks, exchange-traded products, and options.

Algorithmic Trading — As algorithmic trading strategies, including high-frequency trading strategies, have grown more widespread in U.S. securities markets, along with the potential for these strategies to adversely impact market and firm stability¹³,  FINRA encourages members to review its Regulatory Notice 15-09¹⁴ (Guidance on Effective Supervision and Control Practices for Firms Engaging in Algorithmic Trading Strategies) to inform their surveillance programs of the following effective practices:

General Risk Assessment and Response The firms should undertake a holistic review of their trading activity and consider implementing a cross-disciplinary committee to assess and react to the evolving risks associated with algorithmic strategies.

Software/Code Development and Implementation FINRA highlights that firms' supervisory efforts should be focused on every stage in the process of developing algorithmic strategies and not be limited to reviewing trading activity by algorithmic strategies only after they have been put into production. Firms should also focus efforts on the development of algorithmic strategies and on how those strategies are tested and implemented. Examples of effective practices include deploying, where feasible, new algorithmic strategies in a pilot phase of limited size, increasing only as results are confirmed.

Software testing and System Validation Testing of algorithmic strategies prior to being put into production is an essential component of effective policies and procedures. One of the examples of effective practices includes conducting testing to confirm that core code components operate as intended and do not produce unintended consequences.

Trading Systems Firms should develop their policies and procedures to include review of trading activity after an algorithmic strategy is in place or has been changed. FINRA recommends that firms consider implementing controls, monitors, alerts, and reconciliation processes that would enable the firm to quickly identify whether an algorithm is experiencing unintended results that may indicate a failure at the firm or in the market.

Compliance FINRA points out that ensuring that there is effective communication between compliance staff and the staff responsible for algorithmic strategy development is a key element of effective policies and procedures. Effective compliance practices in this area include: 

1. Developing compliance monitoring tools that are broad enough in scope to include activity that may result from the interaction of multiple algorithms (e.g., wash sales, self-trades, manipulation)
2. Periodically evaluating and updating compliance tools and training supervisory and compliance staff related to the firm's policies and procedures regarding algorithmic strategies
3. Implementing controls, monitoring tools, and alerts to address the operation and financial risks of algorithmic strategies and aggregate firm activity, and periodically evaluating the supervisory framework in light of the current market conditions
   
   

How Guidehouse Can Help

Firms and broker-dealers play a key role in safeguarding the financial system from trading manipulation and market abuse. Guidehouse is well-equipped to assist clients reviewing their compliance practices and WSPs and revising policies and procedures as necessary to address topics covered in the Report and potentially minimize the risk of enforcement action, including:

• Performing Bank Secrecy Act (BSA)/AML risk assessments, independent testing, and control reviews
• Transaction monitoring system review and validation, including coverage assessments, software testing, algorithmic strategy development, threshold parameters tuning, and new code deployment
• AML/financial crime program enhancements, including implementing updates to operations, policies, procedures, controls, and monitoring technology supporting the firm’s program
• Developing and delivering targeted and firmwide BSA/AML/Office of Foreign Assets Control trainings
• Vendor sourcing and governance
• Staff augmentation and outsourced managed services

Co-authored by Natalia Prokofyev and Nate Perry.

1 “Report on FINRA’s Examination and Risk Monitoring Program | 2023 Report on FINRA’s Examination and Risk Monitoring Program,” 2023, https://www.finra.org/sites/default/files/2023-01/2023-report-finras-examination-risk-monitoring-program.pdf.
2 Relevant FINRA rules include rule 2020 (Use of Manipulative, Deceptive or Other Fraudulent Devices), 5210 (Publication of Transactions and Quotations), 5220 (Offers at Stated Prices), 5230 (Payments Involving Publications that Influence the Market Price of a Security), 5240 (Anti-Intimidation/Coordination), 5270 (Front Running of Block Transactions), 5290 (Order Entry and Execution Practices), and 6140 (Other Trading Practices).
3 “3110. Supervision | FINRA.org,” n.d., www.finra.org. https://www.finra.org/rules-guidance/rulebooks/finra-rules/3110.
4 “The Bank Secrecy Act | FinCEN.gov,” n.d., www.fincen.gov. https://www.fincen.gov/resources/statutes-and-regulations/bank-secrecy-act.
5 “Strategic Plan Protecting Investors Maintaining Fair, Orderly, and Efficient Markets Facilitating Capital Formation,” n.d., https://www.sec.gov/files/sec_strategic_plan_fy22-fy26.pdf.
6 “SEC.gov | SEC Announces Enforcement Results for FY22,” n.d., www.sec.gov. https://www.sec.gov/news/press-release/2022-206. 
7 “SEC.gov | SEC Charges Pharma CFO and Former Partner with Insider Trading,” n.d., www.sec.gov. https://www.sec.gov/news/press-release/2021-249. 
8 “SEC.gov | SEC Charges Partner at Global Consulting Firm with Insider Trading,” n.d., www.sec.gov. https://www.sec.gov/news/press-release/2021-230.
9  Sun, Justin, n.d., “United States District Court Southern District of New York SEC, Plaintiff, V.” https://www.sec.gov/files/litigation/complaints/2023/comp-pr2023-59.pdf.
10 FINRA Letter of Acceptance, Waiver, and Consent (AWC) No. 2017054852001, available at https://www.finra.org/sites/default/files/fda_documents/2017054852001 Blaylock Van%2C LLC CRD 145317 AWC va %282023-1675470007065%29.pdf; see also FINRA AWC No. 2018057188801, available at https://www.finra.org/sites/default/files/fda_documents/2018057188801 Regal Securities%2C Inc. CRD 7297 AWC vr %282023-1684369209943%29.pdf; see also FINRA AWC No. 2014039952901, available at https://www.finra.org/sites/default/files/fda_documents/2014039952901 ETRADE Securities LLC CRD 29106 AWC jlg %282022-1644538827782%29.pdf.
11 FINRA Letter of Acceptance, Waiver, and Consent No. 2017054491001, available at https://www.finra.org/sites/default/files/fda_documents/2017054491001 Wedbush Securities Inc. CRD 877 AWC gg %282023-1676766007705%29.pdf. 
12 “Written Supervisory Procedures Checklist for Broker-Dealers | FINRA.org,” n.d., www.finra.org. https://www.finra.org/compliance-tools/wsp-broker-dealers-checklist. 
13  “Algorithmic Trading | FINRA.org,” n.d., www.finra.org. https://www.finra.org/rules-guidance/key-topics/algorithmic-trading#overview. 
14 “Regulatory Notice 15-09 | FINRA.org,” n.d.. www.finra.org. https://www.finra.org/rules-guidance/notices/15-09.