Document ID: SEC-2016-0630-0001
Agency: sec
Document Type: Notice
Title: Self-Regulatory Organizations; Proposed Rule Changes: Financial Industry Regulatory Authority, Inc.
Posted Date: 2016-04-13T04:00Z

[Federal Register Volume 81, Number 71 (Wednesday, April 13, 2016)]
[Notices]
[Pages 21914-21916]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2016-08424]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-77551; File No. SR-FINRA-2016-007]

Self-Regulatory Organizations; Financial Industry Regulatory 
Authority, Inc.; Order Approving a Proposed Rule Change To Require 
Registration as Securities Traders of Associated Persons Primarily 
Responsible for the Design, Development, Significant Modification of 
Algorithmic Trading Strategies or Responsible for the Day-to-Day 
Supervision of Such Activities

April 7, 2016.

I. Introduction

    On February 11, 2016, the Financial Industry Regulatory Authority, 
Inc. (``FINRA'') filed with the Securities and Exchange Commission 
(``Commission''), pursuant to Section 19(b)(1) of the Securities 
Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 thereunder,\2\ a 
proposed rule change to amend NASD Rule 1032 (Categories of 
Representative Registration) to require registration as Securities 
Traders of associated persons primarily responsible for the design, 
development or significant modification of algorithmic trading 
strategies, or who are responsible for the day-to-day supervision or 
direction of such activities. The proposed rule change was published 
for comment in the Federal Register on February 24, 2016.\3\ The 
Commission received one comment on the proposal.\4\ This order approves 
the proposed rule change.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 77175 (February 18, 
2016), 81 FR 9235 (``Notice''). The Notice contains a detailed 
description of the proposal.
    \4\ See Letter from Michele Van Tassel, President, Association 
of Registration Management, to Marcia E. Asquith, Office of the 
Corporate Secretary, Financial Industry Regulatory Authority, dated 
March 15, 2016 (``ARM Letter'').
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II. Description of the Proposed Rule Change

    FINRA's rules generally require each person associated with a 
member included within the definition of a representative to register 
with FINRA as a Securities Trader if, with respect to transactions in 
equity, preferred or convertible debt securities effected otherwise 
than on a securities exchange, such person is engaged in proprietary 
trading, the execution of transactions on an agency basis, or the 
direct supervision of such activities.\5\ FINRA proposes to expand the 
registration requirement so that associated persons who are (i) 
primarily responsible for the design, development or significant 
modification \6\ of algorithmic trading strategies, or (ii) responsible 
for the day-to-day supervision or direction of such activities, be 
required to register as Securities Traders with FINRA.\7\
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    \5\ NASD Rule 1032(f).
    \6\ FINRA notes that a ``significant modification'' to an 
algorithmic trading strategy generally would be any change to the 
code of the algorithm that affects the logic and functioning of the 
trading strategy employed by the algorithm. Therefore, for example, 
a data feed/data vendor change generally would not be considered a 
``significant modification,'' whereas a change to a benchmark (such 
as an index) used by the strategy generally would be considered a 
``significant modification.'' See Notice, supra note 3, at 9237 n. 
5.
    \7\ Id. at 9237. FINRA notes, for example, while an equity 
trader involved in the design of an algorithmic trading strategy 
would currently be required to register pursuant to NASD Rule 
1032(f), the developer with which the trader collaborates to create 
an algorithmic trading strategy, however, may not be. Id.
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    For purposes of the proposal, FINRA defines an ``algorithmic 
trading strategy'' as an automated system that generates or routes 
orders or order-related messages--such as routes or cancellations--but 
does not include an automated system that solely routes orders received 
in their entirety to a market center. The proposed registration 
requirement applies to orders and order related messages whether 
ultimately routed or sent to be routed to an exchange or over the 
counter.\8\ An order router alone would not constitute an algorithmic 
trading strategy. However, an order router that performs any additional 
functions would be considered an algorithmic trading strategy.\9\ An 
algorithm that solely

[[Page 21915]]

generates trading ideas or investment allocations--including an 
automated investment service that constructs portfolio 
recommendations--but that is not equipped to automatically generate 
orders and order-related messages to effectuate such trading ideas into 
the market--whether independently or via a linked router--would not 
constitute an algorithmic trading strategy.
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    \8\ Id.
    \9\ See Notice, supra note 3, at 9236-37.
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    The associated persons covered by the expanded registration 
requirement must pass the requisite qualification examination and be 
subject to the same continuing education requirements that are 
applicable to individual Securities Traders. FINRA believes that 
problematic conduct stemming from algorithmic trading strategies--such 
as failure to check for order accuracy, inappropriate levels of 
messaging traffic, wash sales, failure to mark orders as ``short'' or 
perform proper short sale ``locates,'' and inadequate risk management 
controls--could be reduced or prevented, in part, through improved 
education regarding securities regulations for the specified 
individuals involved in the algorithm design and development 
process.\10\
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    \10\ See Notice, supra note 3, at 9236.
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    The proposal is intended to ensure the registration of one or more 
associated persons that possesses knowledge of, and responsibility for, 
both the design of the intended trading strategy and the technological 
implementation of the strategy, sufficient to evaluate whether the 
resulting product is designed to achieve regulatory compliance in 
addition to business objectives.\11\ For example, a lead developer who 
liaises with a head trader regarding the head trader's desired 
algorithmic trading strategy and is primarily responsible for the 
supervision of the development of the algorithm to meet such objectives 
must be registered under the proposal as the associated person 
primarily responsible for the development of the algorithmic trading 
strategy and supervising or directing the team of developers.\12\ 
Individuals under the lead developer's supervision would not be 
required to register under the proposal if they are not primarily 
responsible for the development of the algorithmic trading strategy or 
are not responsible for the day-to-day supervision or direction of 
others on the team.\13\ Under this scenario, the person on the business 
side that is primarily responsible for the design of the algorithmic 
trading strategy, as communicated to the lead developer, also would be 
required to register. In the event of a significant modification to the 
algorithm, members, likewise, must ensure that the associated person 
primarily responsible for the significant modification (or the 
associated person supervising or directing such activity), is 
registered as a Securities Trader.\14\
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    \11\ See Notice, supra note 3, at 9237. FINRA states the 
registration requirement is not intended to apply to every 
associated person that touches or otherwise is involved in the 
design or development of a trading algorithm. For example, if a sole 
associated person determines the design of the trading strategy 
employed by an algorithm, writes the code to effectuate such 
strategy, and executes or directs the modification of such code 
going forward, then that person alone would be required to register 
as a Securities Trader under the proposal. Id.
    \12\ Id.
    \13\ FINRA notes that a junior developer on the lead developer's 
team presumably is not ``primarily'' responsible for the design, 
development or significant modification of an algorithmic trading 
strategy and, therefore, would not be required to register under the 
proposal. Id. By limiting the registration requirements to those 
persons primarily responsible for the design, development or 
significant modification of algorithmic trading strategies or 
responsible for the day-to-day supervision or direction of such 
activities FINRA aims to ensure that the member has identified the 
individuals primarily responsible for covered activities, and for 
the day-to-day supervision and direction of covered activities, and 
equip them with a basic level of familiarity with the regulatory 
obligations of the firm employing the algorithm. Id. FINRA expects 
that the competency of these associated persons will inform the 
behaviors of those acting under their supervision or at their 
direction. Id.
    \14\ Id.
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    FINRA notes that FINRA Rule 3110(a)(2) generally requires that all 
registered persons be designated to an appropriately registered 
principal or principals with authority to carry out the supervisory 
responsibilities of the member for each type of business in which it 
engages for which registration as a broker-dealer is required. With the 
addition of algorithmic trading activities to the Securities Trader 
registration category, members will be required to designate developers 
to a registered principal for Rule 3110(a)(2) purposes.\15\ In such 
instances, members may ``assign'' a lead algorithm developer (or other 
non-trader) engaging in covered activities to one or more other 
registered persons of the member that supervise trading activities 
outside such developer's or other non-trader's usual reporting 
line.\16\ Accordingly, the proposal may not necessarily trigger 
registration requirements for the current supervisor of algorithm 
design or development personnel if that supervisor is not responsible 
for the day-to-day supervision or direction of the specific activities 
covered by this proposal. However, the firm must designate an 
appropriately registered person to be responsible for supervising the 
algorithmic trading strategy activities.\17\
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    \15\ See Notice, supra note 3, at 9238.
    \16\ FINRA notes that the adequacy of a member's supervisory 
structure must be evaluated on an individual firm basis, and that 
members are afforded a degree of flexibility in arranging for the 
appropriate supervision of a lead developer (or other non-trader) 
that engages in covered activities. See Notice, supra note 3, at 
9238.
    \17\ Id.
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    FINRA notes that a member employing an algorithm is responsible for 
the algorithm's activities whether the algorithm is designed or 
developed in-house or by a third-party.\18\ Thus, in all cases, robust 
supervisory procedures, both before and after deployment of an 
algorithmic trading strategy, are a key component in protecting against 
problematic behavior stemming from algorithmic trading. In addition, 
associated persons responsible for monitoring or reviewing the 
performance of an algorithmic trading strategy must be registered 
pursuant to NASD Rule 1032(f); a member's trading activity must always 
be supervised by an appropriately registered person.\19\ Therefore, 
even where a firm purchases an algorithm off-the-shelf and does not 
significantly modify the algorithm, the associated person responsible 
for monitoring or reviewing the performance of the algorithm must be 
registered pursuant to NASD Rule 1032(f).\20\
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    \18\ Id. FINRA also notes that an algorithmic trading strategy 
employed by a member may not have originated in-house and, 
therefore, may not have been designed or built by the member's 
associated persons. In cases where the design and development of an 
algorithmic trading strategy was performed solely by a third-party, 
the proposed registration requirement would not apply to the member 
with regard to the design or development of such algorithm. However, 
FINRA notes that, to the extent associated persons were involved in 
the design or development, or are able to significantly modify the 
algorithmic trading strategy in-house, such persons must be 
registered as Securities Traders. In addition, members also may 
engage a third-party to custom-build an algorithmic trading strategy 
for the member. In such cases, the associated person responsible for 
directing the third-party in the design, development or significant 
modification of the algorithmic trading strategy also would be 
included within the scope of this proposal and must be registered as 
a Securities Trader. Similarly, after the member has launched the 
externally built algorithm, any significant modification by the 
member to such algorithm must be performed by a registered 
Securities Trader. Id.
    \19\ Id.
    \20\ Id.
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III. Comment Letter

    The Commission received one comment letter that supports the 
proposal.\21\ The commenter states ``ARM understands the need to 
address the increased significance of algorithmic trading strategies, 
and therefore

[[Page 21916]]

supports the FINRA proposal.'' However, the commenter requested 
additional information regarding the definition of ``algorithmic 
trading'' and requested that FINRA provide adequate time for member 
firms to identify the personnel who must register pursuant to the 
proposal.\22\ The Commission notes that FINRA will announce the 
effective date of the proposed rule change in a Regulatory Notice to be 
published no later than 60 days following Commission approval, and the 
effective date will be no sooner than 180 days following publication of 
the Regulatory Notice but no later than 300 days following Commission 
approval.\23\ The Commission also notes that FINRA gave a list of 
examples of what would be included in the definition of an algorithmic 
trading strategy.\24\ FINRA further notes that what is considered an 
``algorithmic trading strategy'' may evolve as new trading strategies 
are designed and developed.\25\ The Commission also expects that FINRA 
will provide more detailed guidance in connection with the 
implementation of the registration requirement.
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    \21\ See ARM Letter, supra note 4.
    \22\ Id.
    \23\ See Notice, supra note 3, at 9238.
    \24\ See Notice, supra note 3, at 9236.
    \25\ Id.
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IV. Discussion and Findings

    After carefully considering the proposed rule change and the 
comment submitted the Commission finds that the proposed rule change is 
consistent with the requirements of the Act and the rules and 
regulations thereunder applicable to a national securities 
association.\26\ In particular, the Commission finds that the proposed 
rule change is consistent with Section 15A(b)(6) of the Act,\27\ which 
requires, among other things, that FINRA rules be designed to prevent 
fraudulent and manipulative acts and practices, to promote just and 
equitable principles of trade, and, in general, to protect investors 
and the public interest. In addition, the Commission finds that the 
proposed rule change is consistent with Section 15A(g)(3)(A) of the Act 
which authorizes FINRA to examine and verify the qualifications of an 
applicant to become a member, and the natural persons associated with 
such an applicant, in accordance with procedures established by FINRA's 
rules.\28\ The proposed rule change requires associated persons 
primarily responsible for the design, development or significant 
modification of an algorithmic trading strategy or responsible for the 
day-to-day supervision or direction of such activities to register and 
meet a minimum standard of knowledge regarding the securities rules and 
regulations applicable to the member employing the algorithmic trading 
strategy. The Commission notes that this minimum standard of knowledge 
is identical to the standard of knowledge currently applicable to 
traditional securities traders. The Commission believes that improved 
education of firm personnel may reduce the problematic market conduct 
and manipulative trading activities identified by FINRA.\29\
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    \26\ In approving this proposed rule change, the Commission has 
considered the proposed rule change's impact on efficiency, 
competition, and capital formation. See 15 U.S.C. 78c(f).
    \27\ 15 U.S.C. 78o-3(b)(6).
    \28\ 15 U.S.C. 78o-3(g)(3)(A).
    \29\ See Notice, supra note 3, at 9238-39.
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V. Conclusion

    It is therefore ordered pursuant to Section 19(b)(2) of the Act 
\30\ that the proposed rule change (SR-FINRA-2016-007), be and hereby 
is approved.
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    \30\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\31\
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    \31\ 17 CFR 200.30-3(a)(12).
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Robert W. Errett,
Deputy Secretary.
[FR Doc. 2016-08424 Filed 4-12-16; 8:45 am]
 BILLING CODE 8011-01-P