Document ID: SEC-2014-0757-0001
Agency: sec
Document Type: Notice
Title: Self-Regulatory Organizations; Proposed Rule Changes: Financial Industry Regulatory Authority, Inc.
Posted Date: 2014-05-07T04:00Z

[Federal Register Volume 79, Number 88 (Wednesday, May 7, 2014)]
[Notices]
[Pages 26293-26297]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2014-10384]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-72067; File No. SR-FINRA-2013-036]

Self-Regulatory Organizations; Financial Industry Regulatory 
Authority, Inc.; Order Approving Proposed Rule Change, as Modified by 
Amendment No. 1, Relating to Self-Trades and FINRA Rule 5210 
(Publication of Transactions and Quotations) May 1, 2014.

I. Introduction

    On August 15, 2013, the Financial Industry Regulatory Authority, 
Inc. (``FINRA'') filed with the Securities and Exchange Commission (the 
``Commission'') pursuant to Section 19(b)(1) of the Securities Exchange 
Act of 1934 (the ``Act'') \1\ and Rule 19b-4 thereunder,\2\ a proposed 
rule change to add Supplementary Material .02 to FINRA Rule 5210 
(Publication of Transactions and Quotations) to emphasize that wash 
sale transactions are generally non-bona fide transactions and that 
members have an obligation to have policies and procedures in place to 
review their trading activity for, and prevent, wash sale transactions. 
The proposed rule change was published for comment in the Federal 
Register on September 4, 2013.\3\ The Commission

[[Page 26294]]

received five comment letters on the proposed rule change.\4\ On 
October 4, 2013, the Commission extended the time period for Commission 
action to December 3, 2013.\5\ On December 2, 2013, FINRA submitted a 
response to the comment letters \6\ and filed Amendment No. 1 to the 
proposed rule change. On December 3, 2013, the Commission published for 
comment both Amendment No. 1 and an order instituting proceedings under 
Section 19(b)(2)(B) of the Act \7\ to determine whether to approve or 
disapprove the proposed rule change, as modified by Amendment No. 1.\8\ 
The Commission received three comment letters on the Notice of Filing 
of Amendment No. 1 and Order Instituting Proceedings.\9\ On February 
24, 2014, FINRA submitted a response to the comment letters.\10\ This 
order approves the proposed rule change, as modified by Amendment No. 
1.
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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. 70276 (August 28, 
2013), 78 FR 54502 (``Notice'').
    \4\ See letter from Anonymous to Elizabeth M. Murphy, Secretary, 
Commission, dated September 9, 2013 (``Anonymous Letter''); letter 
from William A. Jacobson, Clinical Professor of Law, and Director, 
Cornell Securities Law Clinic, and Jimin Lee, Cornell University Law 
School, to Elizabeth M. Murphy, Secretary, Commission, dated 
September 25, 2013 (``Cornell Letter''); letter from Stuart J. 
Kaswell, Executive Vice President, Managing Director and General 
Counsel, Managed Funds Association, to Elizabeth M. Murphy, 
Secretary, Commission, dated September 25, 2013 (``MFA Letter''); 
letter from Manisha Kimmel, Executive Director, Financial Industry 
Forum, to Elizabeth M. Murphy, Secretary, Commission, dated 
September 25, 2013 (``FIF Letter''); and letter from Theodore R. 
Lazo, Managing Director and Associate General Counsel, Securities 
Industry and Financial Markets Association, to Elizabeth M. Murphy, 
Secretary, Commission, dated October 4, 2013 (``SIFMA Letter''). For 
a discussion of these comment letters, see Notice of Filing of 
Amendment No. 1 and Order Instituting Proceedings, infra note 8, at 
73902-73903.
    \5\ See Securities Exchange Act Release No. 70613 (October 4, 
2013), 78 FR 62784 (October 22, 2013).
    \6\ See letter from Brant K. Brown, Associate General Counsel, 
FINRA, to Elizabeth M. Murphy, Secretary, Commission, dated December 
2, 2013 (``FINRA Response 1'').
    \7\ 15 U.S.C. 78s(b)(2)(B).
    \8\ See Securities Exchange Act Release No. 70966 (December 3, 
2013), 78 FR 73900 (December 9, 2013) (``Notice of Filing of 
Amendment No. 1 and Order Instituting Proceedings'').
    \9\ See letter from Manisha Kimmel, Executive Director, 
Financial Industry Forum, to Elizabeth M. Murphy, Secretary, 
Commission, dated December 23, 2013 (``FIF Letter 2''); letter from 
Mary Ann Burns, Chief Operating Officer, Futures Industry 
Association, to Elizabeth M. Murphy, Secretary, Commission, dated 
January 6, 2014 (``FIA PTG Letter''); and letter from Theodore R. 
Lazo, Managing Director and Associate General Counsel, Securities 
Industry and Financial Markets Association, to Elizabeth M. Murphy, 
Secretary, Commission, dated January 13, 2014 (`SIFMA Letter 2'').
    \10\ See letter from Brant K. Brown, Associate General Counsel, 
FINRA, to Elizabeth M. Murphy, Secretary, Commission, dated February 
24, 2014 (``FINRA Response 2'').
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II. Description of the Proposal, as Modified by Amendment No. 1

    FINRA proposes to add Supplementary Material .02 to FINRA Rule 5210 
to address members' obligations with respect to certain securities 
transactions that result from the unintentional interaction of orders 
originating from the same firm (now referred to by FINRA as ``self-
trades''), that involve no change in the beneficial ownership of the 
security.\11\ The proposed rule change requires FINRA members to have 
policies and procedures in place that are reasonably designed to review 
their trading activity for, and prevent, a pattern or practice of self-
trades resulting from orders originating from a single algorithm or 
trading desk, or from related algorithms or trading desks. 
Additionally, the proposed rule change states that transactions 
resulting from orders that originate from unrelated algorithms or from 
separate and distinct trading strategies within the same firm would 
generally be considered bona fide self-trades.\12\ The proposed rule 
change also establishes a presumption that algorithms or trading 
strategies within the most discrete unit of an effective system of 
internal controls at a member firm are related.
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    \11\ Securities transactions that do not result in a change of 
beneficial ownership of the securities and that are undertaken for 
the purpose of creating or inducing a false or misleading appearance 
of activity in the securities are already prohibited by existing 
securities laws and FINRA rules. See note 14, infra.
    The Commission notes that the original proposal addressed wash 
sale transactions. Subsequently, FINRA filed Amendment No. 1, which 
clarified that the focus of the proposal was self-trades, rather 
than wash sale transactions.
    \12\ Transactions that originate from unrelated algorithms or 
from separate or distinct trading strategies, trading desks, or 
aggregation units that are frequent or numerous may raise a 
presumption that such transactions were undertaken with the intent 
that they cross and may, therefore, be intended as manipulative or 
fraudulent. See Notice, supra note 3, at 54503.
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    The proposed rule change is intended to address self-trades that 
occur as a result of orders sent by a single algorithm or the 
interaction of multiple, related algorithms operated by a single firm. 
In a number of instances, FINRA has found that these types of 
transactions can account for a material percentage (e.g., over 5%) of 
the consolidated trading volume in a security on a particular day, 
which can distort the market information that is publicly available for 
that security. In FINRA's view, even if not purposeful, these 
transactions can create the misimpression of active trading in a 
security that could adversely affect the price discovery process. 
Furthermore, FINRA believes that, in these instances, firms will 
continue to allow this type of trading to occur rather than incur the 
costs necessary to prevent it, even though the trading activity may 
result in instances where significant misinformation is disseminated to 
the market. The proposed rule change requires members to adopt 
reasonable policies and procedures to prohibit such activity and would 
not, therefore, apply to isolated self-trades resulting from orders 
originating from a single algorithm or trading desk, or from related 
algorithms or trading desks, provided the firm's policies and 
procedures were reasonably designed.\13\
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    \13\ The proposed rule change would not change member firms' 
existing obligations under NASD Rule 3010 and FINRA Rule 2010 with 
respect to wash sales. See Notice, supra note 3, at 54503.
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    FINRA rules and the federal securities laws explicitly prohibit 
transactions in securities that do not result in a change of beneficial 
ownership of the securities when there is a fraudulent or manipulative 
purpose behind the trading activity.\14\ In addition, FINRA Rule 5210 
provides that no member may cause to be published or circulated any 
report of a securities transaction unless the member knows or has 
reason to believe that the transaction was a bona fide transaction. 
Supplementary Material .01 states that ``[i]t shall be deemed 
inconsistent with Rules 2010 (Standards of Commercial Honor and 
Principles of Trade), 2020 (Use of Manipulative, Deceptive or Other 
Fraudulent Devices) and 5210 (Publication of Transactions and 
Quotations) for a member to publish or circulate or cause to be 
published or circulated, by any means whatsoever, any report of any 
securities transaction or of any purchase or sale of any security 
unless such member knows or has reason to believe that such transaction 
was a bona fide transaction, purchase or sale.'' Thus, each FINRA 
member has an existing obligation to know, or have a basis to believe, 
that transactions in which it participates are bona fide.
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    \14\ See, e.g., 15 U.S.C. 78i(a)(1); FINRA Rule 6140(b).
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III. Discussion and Commission Findings

    The Commission has carefully considered the proposal, the comments 
submitted, and FINRA's response to the comments, and believes that 
FINRA has responded adequately to the concerns raised by the commenters 
and by the Commission in the Order Instituting Proceedings. For the 
reasons discussed below, the Commission finds that the proposal is 
consistent with the

[[Page 26295]]

requirements of the Act and the rules and regulations thereunder 
applicable to a national securities association.\15\ In particular, the 
Commission finds that the proposed rule change is consistent with the 
provisions of Section 15A(b)(6) of the Act,\16\ which requires, among 
other things, that FINRA's 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. The proposal requires firms to adopt policies and 
procedures reasonably designed to prevent a pattern or practice of 
certain types of self-trades, which could create the misimpression of 
active trading and adversely affect the price discovery process. Thus, 
the proposed rule change is designed to improve the quality of 
transaction information that is disseminated to the public.
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    \15\ In approving the proposed rule change, the Commission has 
considered the proposed rule's impact on efficiency, competition and 
capital formation. See 15 U.S.C. 78c(f).
    \16\ 15 U.S.C. 78o-3(b)(6).
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    As noted above, the Commission received three comment letters in 
response to the Notice of Filing of Amendment No. 1 and Order 
Instituting Proceedings \17\ and FINRA responded to the comments.\18\ 
Two comment letters supported the approval of the proposed rule change, 
as amended.\19\ The third comment letter is generally supportive, but 
requests modifications to the proposal.\20\
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    \17\ See FIF Letter 2; FIA PTG Letter; SIFMA Letter 2, supra 
note 9. For a discussion of the comment letters received by the 
Commission in response to the Notice, see Notice of Filing of 
Amendment No. 1 and Order Instituting Proceedings, supra note 8, at 
73902-73903.
    \18\ See FINRA Response 2, supra note 10.
    \19\ See FIF Letter 2; SIFMA Letter 2, supra note 9.
    \20\ See FIA PTG Letter, supra note 9.
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    Two commenters support FINRA's amendment to focus the proposed rule 
change on ``self-trades,'' rather than ``wash sales.'' \21\ One 
commenter supports FINRA's replacement of the term ``wash sale'' with 
``self-trade,'' explaining that, unlike wash sale transactions, self-
trades can be inadvertent and bona fide.\22\ The commenter believes 
that this change in terminology recognizes that automated trading can 
result in coincidental self-trades from independently initiated orders 
that lack the requisite fraudulent or manipulative intent to be 
classified as ``wash sales.'' \23\ The other commenter also supports 
the distinction and states that the proposed rule better addresses the 
concern raised in the original proposal--that self-trades can distort 
market information regarding a security--by creating an obligation for 
broker-dealers to avoid transactions that unintentionally result in no 
change in beneficial ownership and do not involve manipulative or 
fraudulent intent.\24\
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    \21\ See FIA PTG Letter, supra note 9, at 2; SIFMA Letter 2, 
supra note 9, at 1.
    \22\ See FIA PTG Letter, supra note 9, at 2.
    \23\ Id.
    \24\ See SIFMA Letter 2, supra note 9, at 1-2.
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    Because the proposal is intended to address the unintentional 
interaction of orders originating from the same firm that involve no 
change in the beneficial ownership of the security and can lead to the 
dissemination of misinformation to the marketplace and the public, the 
Commission believes that modifying the focus of the proposed rule from 
``wash sales'' to ``self-trades'' appropriately tailors the scope of 
the proposed rule and addresses potential confusion.
    Two commenters support FINRA's requirement that members have 
policies and procedures in place to review their trading activity for, 
and prevent, a pattern or practice of self-trades resulting from orders 
originating from a single algorithm or trading desk, or related 
algorithms or trading desks.\25\ One commenter states, ``Amendment No. 
1 strikes the right balance of addressing a pattern and [sic] practice 
of self-trading while acknowledging the implementation issues inherent 
in preventing every self-trade.'' \26\ This commenter believes that the 
pattern or practice standard addresses the problem outlined in the 
proposal of self-trades that distort the market information that is 
publicly available for a security.\27\ The other commenter believes 
that the pattern or practice standard would deter broker-dealers from 
permitting large numbers of self-trades from being publicly 
reported.\28\
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    \25\ See FIF Letter 2, supra note 9, at 1-2; SIFMA Letter 2, 
supra note 9, at 2. FIA PTG also supports FINRA's amended policies 
and procedures requirement, but believes the requirement needs to be 
clarified. See FIA PTG Letter, supra note 9, at 2, 7.
    \26\ See FIF Letter 2, supra note 9, at 1.
    \27\ See FIF Letter 2, at 2, supra note 9.
    \28\ See SIFMA Letter 2, supra note 9, at 2.
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    In its response, FINRA explains that the proposed supplementary 
material is primarily designed to address instances where self-trades 
account for a significant percent of volume in a security, which may 
affect price discovery.\29\ FINRA explains that its proposed policies 
and procedures requirement addresses its concern that self-trades by a 
single algorithm or trading desk, or related algorithms or trading 
desks, may not reflect genuine trading interest, especially when there 
is a pattern or practice of such trading behavior.\30\ FINRA believes 
that its proposal will allow FINRA to more effectively deter self-
trading that, while not involving fraudulent or manipulative intent, is 
disruptive to the marketplace.\31\
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    \29\ See FINRA Response 2, supra note 10, at 3.
    \30\ Id.
    \31\ Id.
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    Tailoring the limitation in the supplementary material to a pattern 
or practice of self-trades resulting from orders originating from a 
single algorithm or trading desk, or related algorithms or trading 
desks, would not prohibit isolated instances of self-trading, yet would 
address more systematic self-trading that could result in the 
dissemination of misleading trading information to the marketplace. The 
proposal would provide FINRA with an enforceable rule specifically 
targeting activity that rises to the level of a pattern or practice of 
such self-trading, and requires firms to have policies and procedures 
reasonably designed to review their trading activity for, and prevent, 
the same. The Commission encourages FINRA to surveil the efficacy of 
these policies and procedures in reducing the volume of self-trading, 
and to consider further refinement of the rule if warranted.
    One commenter requests that FINRA clarify its distinction between 
bona fide and non-bona fide self-trades.\32\ This commenter notes that 
the proposed rule states that self-trades that result from orders 
originating from unrelated algorithms or separate and distinct trading 
strategies within the same firm are generally bona fide, but that FINRA 
also stated in the Notice that such transactions, if frequent or 
regular, may raise a presumption of manipulative or fraudulent 
intent.\33\ The commenter requests clarification of FINRA's views on 
frequent self-trades resulting from unrelated trading strategies, and 
asserts that it would be ``inappropriate and inaccurate to infer their 
relatedness or the intent to self-trade based solely on a volume 
threshold.'' \34\ Instead, the commenter recommends that FINRA adopt a 
wash sale approach described by the Chicago Mercantile Exchange Group 
(``CME'') in a recent CME Market Regulation Advisory Notice to 
determine whether trades between unrelated algorithms are bona 
fide.\35\ The commenter explains that the CME Market Regulation 
Advisory Notice states that orders entered by an independent trader in 
good faith for the purpose of executing bona fide

[[Page 26296]]

transactions, that are not prearranged and are entered without 
knowledge of the other trader's order, will not violate the CME's 
prohibition on wash trades.\36\ Similarly, another commenter requests 
that FINRA issue a Regulatory Notice that states that self-trades 
resulting from orders originating from unrelated algorithms would not 
be deemed related based solely on the fact that the unrelated 
algorithms were being used by traders on the same trading desk.\37\
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    \32\ See FIA PTG Letter, supra note 9, at 3-4.
    \33\ Id.
    \34\ Id. at 4.
    \35\ Id.
    \36\ Id. In its comment letter, FIF noted that it believes that 
FINRA's pattern and practices standard is consistent with the 
guidance provided in the CME Market Regulation Advisory Notice. See 
FIF Letter 2, supra note 9, at 2.
    \37\ See FIF Letter 2, supra note 9, at 2.
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    In its response, FINRA reiterates its position that, although self-
trades between unrelated trading desks or algorithms are generally bona 
fide, frequent self-trades may raise concerns that they are intentional 
or undertaken with manipulative or fraudulent intent.\38\ FINRA also 
distinguishes its proposal's goals from those addressed by the CME 
Market Regulation Advisory Notice.\39\ FINRA notes that its proposal is 
meant to address unintentional self-trading activity--not the 
regulation of wash sale transactions.\40\ Further, unlike the CME 
Market Regulation Advisory Notice, FINRA states that its proposal 
``imposes specific additional obligations on firms that engage in 
algorithmic activity or use multiple algorithms or trading desks as 
part of their trading activity.'' \41\ The proposal is intended to curb 
unintentional self-trades that result in the dissemination of 
misinformation to the public and negatively affect price discovery.
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    \38\ See FINRA Response 2, supra note 10, at 4.
    \39\ Id.
    \40\ Id.
    \41\ Id.
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    One commenter states that FINRA's amended proposal would continue 
to establish a rebuttable presumption that algorithms within discrete 
units of a firm's internal controls are related, regardless of comments 
that assert that ``discrete units of a firm's internal controls are 
established for reasons wholly separate from whether the trading 
strategies and algorithms within that unit are related.'' \42\ The 
commenter believes that the proposal causes confusion over whether the 
presumption can be overcome.\43\ The commenter requests that FINRA 
provide clear guidance on the standards that would rebut the 
presumption of relatedness.\44\ In its response, FINRA explains that 
the presumption is based on the fact that generally firms have the same 
people supervising algorithms or trading desks within a discrete unit, 
and that such algorithms or trading desks communicate with each 
other.\45\ FINRA states, however, that firms would be able to rebut 
this presumption if they can show, for example, that different 
personnel are responsible for supervising the algorithms or trading 
desks.\46\ The Commission believes that FINRA has taken a reasonable 
position with respect to this presumption and provided appropriate 
guidance with respect to how it might be rebutted.
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    \42\ See FIA PTG Letter, supra note 9, at 5.
    \43\ Id., at 6.
    \44\ Id.
    \45\ See FINRA Response 2, supra note 10, at 4.
    \46\ Id.
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    One commenter believes that the proposed rule lacks clarity 
regarding the types of self-trading for which firms would need to 
review, and prevent, patterns or practices.\47\ The commenter requested 
more specificity from FINRA about the amount of activity that would 
constitute a pattern or practice.\48\ In response to the commenter, 
FINRA states that it ``declines to establish a specific threshold below 
which a firm could continue to engage in unlimited self-trading.'' \49\ 
FINRA reiterates that isolated self-trades are generally bona fide, but 
that a practice of self-trading over time ``whether of material volume, 
regularity, or both,'' would indicate a pattern or practice.\50\ The 
Commission believes that the proposed rule change, as amended provides 
sufficient clarity to member firms, and notes that the concept of a 
pattern or practice is used in a number of FINRA rules.\51\
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    \47\ See FIA PTG Letter, supra note 9, at 7.
    \48\ Id.
    \49\ See FINRA Response 2, supra note 10, at 5.
    \50\ Id.
    \51\ See, e.g., FINRA Rule 6282, Supplementary Material .02(b).
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    In the Notice of Filing of Amendment No. 1 and Order Instituting 
Proceedings, the Commission expressed concern that the proposed rule, 
as amended, would continue to allow a significant number of self-trades 
to be publicly reported.\52\ Specifically, the Commission noted FINRA's 
statement in its filing that only those firms that engage in a pattern 
or practice of effecting self-trades that result in a material 
percentage of the trading volume in a particular security would 
generally violate the proposed rule, as well as FINRA's proposed 
requirement that its members have policies and procedures to prevent, 
specifically, a pattern or practice of self-trades from orders 
originating from a single or related algorithms or trading desks.\53\ 
The Commission stated that the proposed rule would appear to provide 
substantial flexibility regarding the required policies and procedures, 
such that a significant number of self-trades could continue to be 
publicly reported, as orders originating from ``unrelated'' algorithms 
or ``separate and distinct'' trading strategies would not be subject to 
the proposed rule, and because only self-trades amounting to a material 
percentage of a security's trading volume would constitute violative 
activity.\54\ The Commission also noted that FINRA provided little 
guidance on its interpretations of what would constitute ``unrelated'' 
algorithms or ``separate and distinct'' trading strategies.\55\
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    \52\ See Notice of Filing of Amendment No. 1 and Order 
Instituting Proceedings, supra note 8, at 73904.
    \53\ Id.
    \54\ Id.
    \55\ Id.
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    In its response, FINRA explained that the proposed rule is designed 
to strike a balance between recognizing that self-trades may reflect 
genuine trading interest and therefore be bona fide, and imposing an 
obligation on firms to prevent a pattern or practice of self-trading 
that rises to the level of disruptive activity. While self-trades may 
be unintentional, if the number of self-trades by a firm constitutes a 
material percentage of the volume in a security, it could have a 
negative effect on the price discovery process.\56\ FINRA explained 
that the proposed rule would allow it to better pursue self-trading 
violations because the proposed rule specifically addresses self-
trades, allowing FINRA to charge a firm with a violation of the 
proposed rule for such conduct, in addition to a supervisory violation, 
and establishing a new requirement for firms to monitor and prevent 
self-trading activity from a single algorithm or trading desk, or 
related algorithms or trading desks.\57\
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    \56\ See FINRA Response 2, supra note 10, at 2-3.
    \57\ Id.
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    In response to the concern about a lack of guidance on the types of 
self-trades that would violate the proposed rule, FINRA stated its 
understanding that discrete units within a firm's system of internal 
controls typically do not coordinate their trading strategies or 
objectives with other discrete units of internal controls, but that 
multiple algorithms or trading desks within a discrete unit are 
permitted to communicate or are under the supervision of the same 
personnel and thus, are presumed to be related.\58\ FINRA stated that 
the proposed rule permits firms to rebut this presumption, suggesting 
that a firm could demonstrate

[[Page 26297]]

that ``related'' algorithms or trading desks are in fact independent or 
are subject to supervision or management by separate personnel.\59\ 
FINRA declined to specify a volume of trading that would constitute a 
``pattern or practice'' for purposes of the proposed rule, explaining 
that it preferred not to ``establish a specific threshold below which a 
firm could continue to engage in unlimited self-trading,'' \60\ but 
urged firms to examine their self-trading for volume and frequency, 
which could indicate a pattern or practice.\61\
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    \58\ Id. at 4.
    \59\ Id.
    \60\ Id. at 5.
    \61\ Id.
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    Finally, FINRA noted that wash sales will continue to be subject to 
the same provisions in the federal securities laws and FINRA rules.\62\ 
The Commission believes that FINRA has sufficiently addressed the 
Commission's concerns. For the reasons discussed above, the Commission 
finds that the proposed rule change is consistent with the Act.
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    \62\ See FINRA Response 2, supra note 10, at 3.
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IV. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\63\ that the proposed rule change (SR-FINRA-2013-036), as modified 
by Amendment No. 1, be, and hereby is, approved.
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    \63\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\64\
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    \64\ 17 CFR 200.30-3(a)(12).
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Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2014-10384 Filed 5-6-14; 8:45 am]
BILLING CODE 8011-01-P