Document ID: SEC-2014-1065-0001
Agency: sec
Document Type: Notice
Title: Self-Regulatory Organizations; Proposed Rule Changes: Financial Industry Regulatory Authority, Inc.
Posted Date: 2014-06-26T04:00Z

[Federal Register Volume 79, Number 123 (Thursday, June 26, 2014)]
[Notices]
[Pages 36357-36361]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2014-14942]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-72444; File No. SR-FINRA-2014-025]

Self-Regulatory Organizations; Financial Industry Regulatory 
Authority, Inc.; Notice of Filing of a Proposed Rule Change To Adopt a 
Supplemental Schedule for Inventory Positions Pursuant to FINRA Rule 
4524 (Supplemental FOCUS Information)

June 20, 2014.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'' or ``SEA'') \1\ and Rule 19b-4

[[Page 36358]]

thereunder,\2\ notice is hereby given that on June 16, 2014, the 
Financial Industry Regulatory Authority, Inc. (``FINRA'') filed with 
the Securities and Exchange Commission (``SEC'' or ``Commission'') the 
proposed rule change as described in Items I, II, and III below, which 
Items have been substantially prepared by FINRA. The Commission is 
publishing this notice to solicit comments on the proposed rule change 
from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    FINRA is proposing to adopt a supplemental schedule for inventory 
positions pursuant to FINRA Rule 4524 (Supplemental FOCUS Information).
    The text of the proposed rule change is available on FINRA's Web 
site at http://www.finra.org, at the principal office of FINRA, and at 
the Commission's Public Reference Room.

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, FINRA included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. FINRA has prepared summaries, set forth in Items II.A., 
II.B., and II.C. below, of the most significant aspects of such 
statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

1. Purpose
    Pursuant to SEA Rule 17a-5,\3\ most firms are required to file with 
FINRA reports concerning their financial and operational status using 
the Financial and Operational Combined Uniform Single (FOCUS) 
Report.\4\ In general, firms with a FOCUS filing requirement must 
either file a FOCUS Report Part II if they clear transactions or carry 
customer accounts \5\ or file a FOCUS Report Part IIA if they do 
not.\6\ Firms that are government securities broker-dealers registered 
under Section 15C of the Act \7\ do not file a FOCUS Report and instead 
are required to file reports concerning their financial and operational 
status using the Report on Finances and Operations of Government 
Securities Brokers and Dealers (FOGS Report).\8\ These firms are 
required to file a FOGS Report Part I and either a FOGS Report Part II 
if they clear transactions or carry customer accounts or FOGS Report 
Part IIA if they do not.\9\
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    \3\ 17 CFR 240.17a-5.
    \4\ SEC Form X-17A-5.
    \5\ Firms that calculate net capital using Appendix E to SEA 
Rule 15c3-1 file FOCUS Report Part II CSE, rather than FOCUS Report 
Part II.
    \6\ 17 CFR 240.17a-5.
    \7\ 15 U.S.C. 78o-5.
    \8\ Department of the Treasury Form G-405.
    \9\ 17 CFR 405.2; 17 CFR 240.17a-5.
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    FINRA Rule 4524 (Supplemental FOCUS Information) requires each 
firm, as FINRA shall designate, to file such additional financial or 
operational schedules or reports as FINRA may deem necessary or 
appropriate for the protection of investors or in the public interest 
as a supplement to the FOCUS Report.\10\ Pursuant to FINRA Rule 4524, 
FINRA is proposing the adoption of a supplemental schedule to the FOCUS 
Report Part II, FOCUS Report Part IIA and the FOGS Report Part I that 
would provide more detailed information of inventory positions held by 
firms. The proposed Supplemental Inventory Schedule (``SIS'') would be 
due 20 business days after the end of a firm's FOCUS or FOGS reporting 
period.\11\
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    \10\ The reference to FOCUS reports under FINRA Rule 4524 
includes FOGS Reports required to be filed by government securities 
broker-dealers registered under Section 15C of the Act in lieu of 
FOCUS Reports.
    \11\ Firms that file FOCUS Report Part II CSE would not be 
subject to the proposed SIS. As part of FOCUS Report Part II CSE, 
the Aggregate Securities and OTC Derivative Positions schedule 
requires firms to provide information that is similar to the 
proposed SIS.
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    The proposal requires the SIS to be filed by firms that are 
required to file FOCUS Report Part II, FOCUS Report Part IIA or FOGS 
Report Part I with inventory positions as of the end of the FOCUS or 
FOGS reporting period with two exceptions. The first exception is for 
firms that have a minimum net capital or liquid capital requirement 
\12\ of less than $100,000. Such firms are not allowed to engage in 
dealer activities and are limited to 10 proprietary transactions per 
year. Further, such firms are not permitted to self-clear or carry 
customer accounts. The second exception is for firms that have 
inventory positions consisting only of money market mutual funds. Money 
market mutual funds limit their investments to short-term, high-quality 
debt securities and are permitted to sell and redeem shares at a stable 
price, typically at $1.00 per share, without regard to small variations 
in the value of the funds' underlying securities.\13\ A firm with 
inventory positions consisting only of money market mutual funds would 
need to affirmatively indicate through functionality on the eFOCUS 
system that no SIS filing is required for the reporting period. FINRA 
believes that firms that meet either of these two criteria pose 
significantly less risk to customers and other market participants. 
These exceptions will not only minimize the burden on firms, but also 
will allow FINRA to focus its resources where the risk is most 
concerning.
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    \12\ Firms that file the FOCUS Report must comply with a minimum 
net capital requirement, while firms that file the FOGS Report must 
comply with a minimum liquid capital requirement.
    \13\ See Securities Act Release No. 9408 (June 5, 2013), 78 FR 
36834, 36835 (June 19, 2013) (Proposed Rule: Money Market Fund 
Reform; Amendments to Form PF).
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    The proposed SIS is intended to capture more details of a firm's 
long and short inventory positions than what is captured on the FOCUS 
Report Part II, FOCUS Report Part IIA and FOGS Report Part I. For 
example, FOCUS Report Part II, FOCUS Report Part IIA and FOGS Report 
Part I require total inventory of securities sold short to be reported 
in aggregate (Item 1620), providing no information on the types of 
securities sold short by firms. In addition, FOGS Report Part I 
requires that all long inventory be reported in aggregate (Item 850). 
Further, on FOCUS Report Part II and IIA, long inventory is reported in 
categories that aggregate securities with different market risk 
profiles (e.g., the Corporate Obligations category on the FOCUS Report 
Part II (Item 400) and Debt Securities category on the FOCUS Report 
Part IIA (Item 419) include single name corporate bonds, private-label 
mortgage-backed securities and foreign issuer debt obligations). The 
proposed SIS would enhance FINRA's ongoing surveillance monitoring of 
firms' financial condition by providing greater transparency into the 
market risk posed by a firm's inventory positions and the potential 
impact to a firm's net capital or liquid capital, as well as related 
funding and liquidity needs. In addition, the information provided by 
the proposed SIS would enable FINRA staff to perform more targeted 
examinations of firms' market risk exposure.
    The proposed rule change will be effective upon Commission 
approval. FINRA will announce the implementation date of the proposed 
supplemental schedule in a Regulatory Notice to be published no later 
than 60 days following Commission approval. The due date for the first 
proposed schedule will be no later than 90 days following Commission 
approval of the proposed rule change.

[[Page 36359]]

2. Statutory Basis
    FINRA believes that the proposed rule change is consistent with the 
provisions of Section 15A(b)(6) of the Act,\14\ which requires, among 
other things, that FINRA rules must 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. FINRA believes that the proposed rule change is 
consistent with the provisions of the Act noted above in that the 
proposed SIS will provide FINRA with greater insights into the types of 
securities held in inventory by firms and the related market risk 
associated with such inventory positions. In addition, the proposed SIS 
would enable FINRA staff to assess the related impact on firms' 
liquidity and funding needs. The information provided on the proposed 
SIS would be used by FINRA to monitor firms' financial condition and 
perform more targeted examinations of firms' market risk exposure. The 
proposed rule change also is consistent with Section 712(b)(3)(B) of 
the Dodd-Frank Wall Street Reform and Consumer Protection Act \15\ in 
that it is necessary to enable FINRA to more effectively examine for 
compliance with, and enforce, its rules on capital adequacy.
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    \14\ 15 U.S.C. 78o-3(b)(6).
    \15\ Public Law 111-203, 124 Stat. 1376 (2010).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    FINRA does not believe that the proposed rule change will result in 
any burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act. FINRA believes that the 
economic and operational impact associated with completion of the 
proposed SIS would be minimal because the required information should 
be readily available to firms, as it is necessary for purposes of 
computing the haircut deductions required under SEA Rule 15c3-1.\16\ 
However, FINRA recognizes that there may be an initial one-time cost to 
map inventory positions to the line items on the proposed SIS. FINRA 
believes that any burden imposed by the proposed SIS would be 
outweighed by the benefit to firms in allowing the staff to better 
understand a firm's market risk, which will lead to more focused 
reviews during examinations. In addition, the proposal is narrowly 
tailored to capture those firms that pose the most risk to customers 
and other market participants. Firms with inventory positions as of the 
end of the FOCUS or FOGS reporting period will not have to file the 
proposed SIS if they: (1) Have a minimum net capital or liquid capital 
requirement of less than $100,000; or (2) have inventory positions 
consisting only of money market mutual funds. Based on FOCUS Report 
data, as of June 30, 2013, FINRA estimates that 2,830 out of 4,327 
firms (65 percent) have a minimum net capital or liquid capital 
requirement of less than $100,000.
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    \16\ 17 CFR 240.15c3-1.
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    As discussed in Item II.C. below, FINRA initially considered 
exempting from the SIS filing requirement those firms that had 
inventory positions consisting only of U.S. Treasury securities or 
money market mutual funds. However, three commenters questioned the 
U.S. Treasury exemption, noting among other factors the market risk 
posed by certain U.S. Treasury securities and the risks posed by 
concentrations in those securities. Alternatively, these commenters 
suggested exemptions based on a firm's level of excess capital and 
leverage, for short-term instruments and for small broker-dealers. In 
response to commenters' suggestions, FINRA is not proposing an 
exemption for U.S. Treasury securities. However, FINRA is proposing at 
this time to exempt from the SIS filing requirement those firms that 
have a minimum net capital or liquid capital requirement of less than 
$100,000. FINRA believes that exempting such firms should serve to 
reduce the compliance burdens for many small firms while also ensuring 
that FINRA receives the SIS data from those firms that pose higher risk 
to customers and other market participants.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants, or Others

    The proposed rule change was published for comment in Regulatory 
Notice 13-05 (January 2013) (the ``Notice''). Four comments were 
received in response to the Notice. \17\ Below is a summary of the 
comments and FINRA's responses.
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    \17\ See Letter from Pat Nelson, dated January 31, 2013 
(``Nelson''); letter from Jim Nelson, dated February 7, 2013 (``Jim 
Nelson''); letter from Wendie L Wachtel, CCO, Wachtel & Co Inc, to 
Marcia E Asquith, Corporate Secretary, FINRA, dated February 12, 
2013 (``Wachtel''); and letter from Howard Spindel, Senior Managing 
Director, and Cassondra E. Joseph, Managing Director, Integrated 
Management Solutions USA LLC, dated February 25, 2013 (``IMS'').
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1. Exemption for U.S. Treasury Securities
    In the Notice, FINRA specifically requested comment on whether 
firms that have inventory positions consisting only of U.S. Treasury 
securities should be exempt from the filing requirement. One commenter 
believed that no securities, including U.S. Treasury securities, should 
be excluded from review as all securities pose certain risks especially 
if they are concentrated.\18\ As discussed further below, one commenter 
believed that the exemption is a poor match with regulatory 
objectives.\19\ Another commenter disagreed with the exemption and 
questioned ``why FINRA would exempt from reporting a firm with a 
portfolio of longer-term, low coupon U.S. Government bonds that would 
be significantly more sensitive to market risk than many other debt 
instruments especially investment-grade ones of much shorter 
durations.''\20\ The commenter believed that there should be an 
exemption for firms that invest their excess cash in short-term 
instruments such as money market mutual funds, short-term funds and 
high-grade debt instruments maturing in the short term.\21\
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    \18\ Nelson.
    \19\ Wachtel.
    \20\ IMS.
    \21\ IMS.
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    FINRA has considered these comments and agrees that a firm that has 
inventory positions consisting only of U.S. Treasury securities should 
be required to file the proposed SIS. FINRA, however, proposes to 
exempt from the filing requirement those firms that: (1) Have a minimum 
net capital or liquid capital requirement of less than $100,000; or (2) 
have inventory positions consisting only of money market mutual funds. 
In response to the comment for a short-term instrument exemption, FINRA 
notes that the proposal exempts firms with inventory positions 
consisting only of money market mutual funds. However, FINRA believes 
that firms with inventory positions in short-term funds or high-grade 
debt instruments maturing in the short term should not be exempted from 
the proposed SIS as those positions are subject to greater market risk. 
For example, the credit crisis showed that short-term debt instruments 
(e.g., auction rate securities) can suffer material losses, 
irrespective of their investment grade ratings.
2. Exemption for Firms Based on Net Capital or Liquid Capital 
Requirement
    In the Notice, FINRA specifically requested comment on whether 
there is a category of firms that should not be required to file the 
proposed SIS based upon a de minimis amount of inventory

[[Page 36360]]

positions. One commenter believed there should be a de minimis cutoff 
and stated that FINRA should ``not place undue burdens on the small 
broker dealer community.'' \22\ The commenter suggested that 
``reporting should only be required by firms that pose a systemic risk 
to the financial markets.''\23\ One commenter believed that an 
exemption should be focused on a firm's level of excess capital and 
leverage.\24\ FINRA has considered these comments and proposes that 
firms with inventory positions that have a net capital or liquid 
capital requirement of less than $100,000 would not need to file the 
proposed SIS. These firms are prohibited from engaging in dealer 
activities, self-clearing or carrying customer accounts and, as such 
pose less risk to the financial markets than firms with higher net 
capital or liquid capital requirements. FINRA disagrees with the 
commenters that reporting should only be required by firms that pose 
systemic risk or that an exemption should be focused on a firm's level 
of excess capital and leverage. Systemic risk is not the focus of the 
proposed SIS; rather, the proposal is intended to protect customers and 
other market participants who could be at risk if the firm's financial 
condition deteriorates. As such, requiring only firms that pose 
systemic risk to report to FINRA would hinder the staff's ability to 
identify and monitor the market, funding and liquidity risk of other 
firms whose inventory positions and dealer activities could result in 
harm to customers and other market participants. In addition, an 
exemption based on a firm's high excess net capital or liquid capital 
without regard to the type of inventory positions held would exempt a 
number of firms that hold significant levels of complex securities in 
inventory and self-clear, carry customer accounts or engage in dealer 
activities. Further, an exemption based on leverage would exempt those 
firms that have a low leverage ratio without regard to other risk 
factors, such as a high concentration in a particular category of less 
liquid securities (e.g., high yield debt, private label collateralized 
mortgage obligations).
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    \22\ Jim Nelson and Nelson.
    \23\ Nelson.
    \24\ Wachtel.
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3. Economic Impact
    In the Notice, FINRA specifically requested comment on the economic 
impact of the proposed SIS. Two commenters believed that the proposed 
SIS would place an unjustified burden on firms.\25\ One of these 
commenters stated that even though firms already have the requested 
inventory information, the data will have to be put in the required 
format.\26\ The commenter suggested that FINRA should ask a firm for a 
copy of its inventory and then input the data.\27\ One commenter 
believed that there would be significant cost with no benefit and the 
proposed SIS would increase the effort of monthly filing by 15%.\28\ 
Further, the commenter requested that any new requirements be 
incorporated into the original FOCUS form rather than requiring 
separate schedules that entail burdensome duplication and 
reconciliations.\29\ However, one commenter agreed that firms currently 
compile inventory information as it is needed to compute haircut 
deductions when calculating net capital and stated that the proposed 
SIS is not nearly as burdensome as receiving questions from FINRA 
examiners or coordinators seeking to drill down into figures that are 
provided by the FOCUS Report.\30\
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    \25\ Jim Nelson and Nelson.
    \26\ Nelson.
    \27\ Nelson.
    \28\ Wachtel.
    \29\ Wachtel.
    \30\ IMS.
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    Consistent with the discussion above, FINRA believes that the 
economic impact associated with completion of the proposed SIS would be 
minimal because the required information should be readily available to 
firms, as it is necessary for purposes of computing the haircut 
deductions required under SEA Rule 15c3-1.\31\ Moreover, FINRA believes 
the proposed SIS is an effective and timely way to obtain detail of the 
inventory positions held by firms. FINRA notes it consulted with its 
advisory committees to help inform this view. In regard to the comment 
that the proposed SIS would increase the effort of monthly filing by 
15%, FINRA notes that the commenter did not provide any evidence, basis 
or context to support the assertion, and therefore FINRA is uncertain 
as to its reliability. With respect to incorporating new requirements 
into the original FOCUS form, Form X-17A-5, FINRA notes that it is an 
SEC form, and any changes to it must be proposed and adopted by the 
SEC. However, FINRA would support updates to Form X-17A-5 by the SEC 
that would incorporate this more detailed reporting, and, if such 
updates were made, FINRA staff would seek to reduce accordingly the 
requirement for firms to file the proposed SIS.
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    \31\ 17 CFR 240.15c3-1.
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4. Instructions and Recommended Changes
    One commenter was concerned that there were no instructions 
provided for the proposed SIS and that key definitions such as 
``arbitrage'' and ``no ready market'' are not defined.\32\ In addition, 
the commenter believed that the term ``Investments'' is particularly 
confusing in the category for ``Investments with no ready market'' and 
suggested that ``Securities'' should be used.\33\ In addition, the 
commenter believed that asking for a beginning date on the proposed SIS 
is meaningless information.\34\ Furthermore, the commenter stated that 
the proposed SIS ignores financings such as repurchase agreements and 
loans, does not contain a line for securities lending, does not itemize 
derivatives by market bias and does not request a breakdown of the 
types of commodities actually being held.\35\
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    \32\ IMS.
    \33\ IMS.
    \34\ IMS.
    \35\ IMS.
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    In response to the commenter, FINRA has developed instructions for 
the proposed SIS. The instructions include guidance, clarifications and 
definitions with respect to specific line items that FINRA believes 
should ameliorate the commenter's concern. In addition, FINRA has 
amended the proposed SIS to state ``[s]ecurities with no ready market'' 
on line 13, instead of ``[i]nvestments with no ready market,'' to 
alleviate confusion and has removed the line item for a beginning 
period date. With regard to capturing information about repurchase 
agreements and securities lending, FINRA notes that the proposed SIS is 
an inventory schedule and, as such, is not intended to capture 
financing transactions. In response to the comment about itemizing 
derivatives exposures by market bias, FINRA has expanded the 
``Derivatives including Options'' on line 11 to distinguish between 
centrally cleared derivatives and other derivatives and to require a 
limited breakdown of information for the two categories. In addition, 
FINRA notes that additional derivatives information is captured on the 
Derivatives and Other Off-Balance Sheet Schedule. Finally, in response 
to the request for a breakdown of the types of commodities actually 
being held, FINRA believes, at this time, that the proposed SIS 
captures the information that is needed to enable FINRA staff to

[[Page 36361]]

assess the related market risk and impact on firms' liquidity and 
funding needs arising from inventory holdings.
5. Alternatives to Proposed SIS
    One commenter offered an alternative to the proposed SIS.\36\ The 
commenter suggested that ``FINRA should offer firms the ability to 
report the dollar amounts to which each haircut category applies.'' 
\37\ The commenter believed that ``[t]he haircut category is so much 
more relevant than the issuer type or even whether the haircut is on a 
long or short position.'' \38\ FINRA disagrees with the commenter and 
believes that for purposes of understanding market risk associated with 
firms' inventory positions, issuer type is more appropriate than 
haircut category. For example, an equity security has different market 
risk than certain high-yield bonds; however, both types of securities 
can be in the same haircut category. Therefore, FINRA believes that 
obtaining information regarding the actual makeup of a firm's inventory 
positions is best achieved through the proposed SIS.
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    \36\ IMS.
    \37\ IMS.
    \38\ IMS.
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III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within 45 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the self-regulatory organization consents, the Commission will:
    (A) By order approve or disapprove such proposed rule change; or
    (B) institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act. Comments may be submitted by any of 
the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml); or
     Send an email to rule-comments@sec.gov. Please include 
File Number SR-FINRA-2014-025 on the subject line.

Paper Comments

     Send paper comments to Secretary, Securities and Exchange 
Commission, 100 F Street NE., Washington, DC 20549-1090.

All submissions should refer to File Number SR-FINRA-2014-025. This 
file number should be included on the subject line if email is used. To 
help the Commission process and review your comments more efficiently, 
please use only one method. The Commission will post all comments on 
the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml). Copies of the submission, all subsequent amendments, all 
written statements with respect to the proposed rule change that are 
filed with the Commission, and all written communications relating to 
the proposed rule change between the Commission and any person, other 
than those that may be withheld from the public in accordance with the 
provisions of 5 U.S.C. 552, will be available for Web site viewing and 
printing in the Commission's Public Reference Room, 100 F Street NE., 
Washington, DC 20549, on official business days between the hours of 10 
a.m. and 3 p.m.
    Copies of such filing also will be available for inspection and 
copying at the principal office of FINRA. All comments received will be 
posted without change; the Commission does not edit personal 
identifying information from submissions. You should submit only 
information that you wish to make available publicly. All submissions 
should refer to File Number SR-FINRA-2014-025 and should be submitted 
on or before July 17, 2014.

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\39\
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    \39\ 17 CFR 200.30-3(a)(12).
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Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2014-14942 Filed 6-25-14; 8:45 am]
BILLING CODE 8011-01-P