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Comments FINRA is issuing this Notice to remind member firms of their obligations during extreme market conditions with respect to handling customer orders, maintaining appropriate margin requirements and effectively managing their liquidity. Questions
concerning the best execution guidance discussed in this Notice should be directed to: Questions concerning the margin guidance discussed in this Notice should be directed to: Questions concerning the liquidity management guidance discussed in this Notice should be directed to: Member firms should maintain strong procedures, thoughtfully crafted in advance, to reasonably ensure they can continue to provide investors access to the securities markets during times of extreme market volatility, as in the past several months. These procedures include order handling procedures designed to maintain best execution for customers; margin procedures to prevent a
firm from becoming overextended from lending in support of customer trades; and liquidity management practices to ensure the firm is able to continue to provide customers with access to the markets despite abnormal liquidity demands. The foundation of the securities industry is fair dealing with customers. Fair dealing is a core principle that underlies many FINRA rules, and FINRA guidance repeatedly has emphasized the importance of preserving fair customer treatment, even during
times of market stress. In light of recent market events, including the extreme volatility of certain stocks’ trading prices, FINRA is reminding member firms that the duty of best execution requires the fair, consistent and reasonable treatment of customer orders at all times. Further, it is important that customers are informed about member firms’ order handling procedures, particularly during volatile market periods, and FINRA is reminding firms of prior guidance that addresses the kinds of
disclosures firms should consider making in connection with their fair dealing obligations. In addition, FINRA is reminding member firms that the recent extreme price volatility and trading volume of certain stocks has the potential to expose firms and investors to rapid and severe losses, particularly when such securities may have been purchased using margin or sold short. Member firms are reminded to consider the need for additional margin consistent with Rule 4210. Relatedly,
FINRA also is providing guidance on sound liquidity practices that firms can use to meet their obligations to maintain reasonable funding and liquidity risk management. FINRA’s ongoing surveillance and examination programs will continue to review member firms’ compliance with these obligations. Best execution is a critical investor protection
requirement embodied in long-standing SEC policy and interpretations under the antifraud provisions of the federal securities laws and in FINRA’s order handling rules.1 Under Rule 5310 (Best Execution and Interpositioning), member firms must exercise “reasonable diligence” to ascertain the best market for a security and buy or sell in that market so that the resultant price to the customer is as favorable as possible under prevailing market conditions. Among other things, Rule 5310
requires member firms to make every effort to execute marketable customer orders that they receive fully and promptly.2 Rule 5310 applies whether member firms act as agent or execute transactions on a principal basis,3 and it covers transactions for or with a customer or a customer of another broker-dealer.4 As FINRA has explained, this means that best execution obligations apply to member firms that receive customer orders from another member firm for
purposes of order handling and execution, which includes wholesale market makers in addition to member firms that receive orders directly from customers.5 FINRA recognizes that evaluating a member firm’s satisfaction of its duty of best execution necessarily requires a “facts and circumstances” analysis and that market conditions are an important factor in best execution determinations.6 However, as FINRA reiterated recently, member firms are not relieved of their
best execution obligations in volatile market conditions.7 Accordingly, FINRA has consistently stated that any order handling procedures—or changes to order handling procedures—that a member firm implements during volatile or extreme market conditions must remain consistent with the duty of best execution by providing for the fair, consistent and reasonable treatment of customer orders.8 Member firms are not obligated to receive or accept orders from customers where
the firms believe that the associated compliance or legal risks are unacceptable,9 and there may be situations where firms determine they must change their order handling procedures to restrict the entry or acceptance of customer orders to limit the firm’s exposure to extraordinary market risk. However, firms must implement any such changes on fair, consistent and reasonable terms.10 In addition, in situations where member firms receive marketable customer orders, the firms
are obligated to handle such orders promptly in accordance with Rule 5310.01.11 In furtherance of these obligations, FINRA has stated that firms should consider establishing and implementing procedures that are designed to preserve the continued execution of customers’ orders in a manner that is consistent with the firm’s best execution obligations while also recognizing and limiting the exposure of the firm to extraordinary market risk.12 Furthermore, FINRA has
stated that modifications to order handling procedures, or the activation of procedures designed to respond to extreme market conditions, may be implemented only when warranted by market conditions and that member firms should document the basis for activating any modified procedures.13 Frequent activation of modified order handling procedures because a firm has failed to maintain adequate system capacity to handle exceptional loads may raise best execution concerns.14
FINRA has noted the importance of operational readiness in relation to best execution and believes that appropriate planning and testing should help firms avoid or mitigate the need to implement procedure changes in the first instance. Accordingly, to avoid excessive or unwarranted activation of modified order handling procedures, FINRA has reminded firms that they need to take steps to prevent their operational systems from being overwhelmed by periodic spikes in systems message traffic due to
high volume.15 Prior FINRA guidance also has addressed member firms informing customers through meaningful disclosures about their order handling procedures during extreme market conditions. To the extent that a member firm implements different order handling procedures during extreme market conditions, FINRA has stated that the firm should disclose to its customers in advance
the differences in the procedures from normal market conditions and the circumstances in which the firm may generally activate the procedures.16 Appropriate meaningful disclosures may help inform whether a firm acted fairly, consistently and reasonably. Importantly, however, FINRA has emphasized that a firm cannot rely on disclosures alone to justify deficient order handling procedures. Specifically, FINRA has stated that the disclosure of alternative order handling procedures
that are unfair or otherwise inconsistent with a member firm’s best execution obligations would neither correct the deficiencies with such procedures nor absolve the firm of potential best execution violations.17 For example, contractual terms, such as a disclosure in a customer account agreement that states a firm may, in its sole discretion, prohibit or restrict trading without notice, do not relieve a firm of its obligation to handle orders in a manner that is fair, consistent and
reasonable. In addition, FINRA has stated that firms should consider particular disclosures to enhance customers’ knowledge and understanding of how member firms’ order handling procedures operate, especially during volatile market conditions. For example, in Regulatory Notice 99-11, FINRA discussed several issues that member firms should consider disclosing to customers,18 along with
any additional disclosures that may be appropriate, including about: Separately, in Regulatory Notice 16-19,19 FINRA discussed the risks of stop orders20 in
volatile markets and that member firms and registered representatives should inform customers that: Similarly, SEC staff guidance has stated that broker-dealers should use every reasonable effort to notify customers about operational difficulties, communicate promptly with customers about volatile market conditions and put mechanisms in place to explain to customers how their orders will be handled.21 As the SEC staff discussed in this guidance,
broker-dealers at a minimum should make web page postings promptly to inform customers of trading halts and to explain how pending or new orders will be handled, and broker-dealers that handle orders online should have mechanisms in place to provide this information directly in response to customers that try to enter orders while trading is halted.22 Margin and LiquidityMargin RequirementsFINRA Rule 4210(c) sets forth maintenance margin requirements for accounts other than portfolio margin accounts. For any long equity security in a Regulation T margin account, the maintenance margin requirement is generally 25 percent of the current market value,23 and for any short equity security, the maintenance margin requirement is generally 30 percent of the current market value.24 In a portfolio margin account as detailed in Rule 4210(g), the current maintenance margin requirement for both long and short eligible equity securities is generally based on a minimum stress range of plus and minus 15 percent.25 Member firms should monitor the need for additional margin consistent with Rule 4210(d) in conditions of extreme price volatility. Member firms must have procedures to formulate their own “house” margin requirements and where appropriate institute higher margin requirements than are required by Rule 4210 for individual securities or customer accounts.26 Further, Rule 4210(f)(1) requires substantial additional margin in all cases where the securities carried in long or short positions are subject to unusually rapid or violent changes in value.27 In determining appropriate “house” maintenance margin requirements, member firms should take into account volatility as well as concentrated positions in a single customer account and across all customer accounts as well as the daily volume and market capitalization of each security. Member firms should also consider the total dollar amount of credit to be extended to any one customer or on any one security.28 Increased maintenance margin requirements on specific securities or customers can help to ensure that the equity in each customer account is sufficient to cover any large swings in the price of a security, which protects both the member firm and customers by reducing the likelihood that the member firm will have to liquidate assets in the customer's account to cover a margin deficiency.29 In a portfolio margin account, volatile and concentrated positions should be subjected to heightened review and daily monitoring, subjected to higher margin requirements where appropriate and included in exception reporting to senior management.30 Liquidity ManagementIn view of the recent volatility in the markets, FINRA reminds firms about their need to have effective liquidity management practices.31 Failure to adequately manage liquidity has in the past limited firms’ ability to conduct normal business operations, and contributed to both individual firm failures and, when widespread, systemic crises. Controlling liquidity risk is critical to investor protection by ensuring investors’ access to their assets and ability to trade, even in times of stress. Liquidity practices have been an ongoing focus of FINRA’s financial supervision programs. FINRA has issued several Notices addressing this area. Regulatory Notice 10-57 outlined several steps that firms should consider in managing liquidity and funding risks.32 Regulatory Notice 15-33provided guidance based upon a review of policies and practices at several firms related to managing liquidity needs in a stressed environment. Additionally, it detailed specific stress criteria that FINRA used to examine firms during the reviews of liquidity risk.33 Many firms have found the guidance helpful when implementing their own liquidity risk management frameworks and related stress tests. In addition, many firms have used or adapted FINRA’s published observations on stressed assumptions and considerations when modeling liquidity stress. Additionally, strict compliance with the SEC’s Net Capital Rule34 and Customer Protection Rule35 is an additional safeguard for firms, especially during challenging market conditions. The SEC’s Net Capital Rule is designed to ensure that a broker-dealer always has sufficient liquid assets to promptly satisfy the claims of customers and creditors if the broker-dealer goes out of business. Moreover, the SEC’s Customer Protection Rule protects customer funds and securities held by a broker-dealer by generally prohibiting the broker-dealer from using those funds and securities to support its proprietary trading activities. Compliance with these SEC financial responsibility rules together with strong funding and liquidity risk management practices help to ensure that member firms can continue to meet all their obligations. Given market volatility and events over the past year, member firms should take a proactive approach to meeting their obligations for strong funding and liquidity risk management practices. Such practices enable firms to meet their obligations to counterparties, central counterparties (CCPs) and customers, including by providing reasonable customer access to the markets even during times of stress. While the specific policies and procedures will vary depending upon the business profile of the firm, firms should take account of the following areas given recent market events: 1. Central Counter Party MarginClearing broker-dealers are members of one or more CCPs, such as the National Securities Clearing Corporation, the Fixed Income Clearing Corporation or the Options Clearing Corporation, with clearing fund and margin requirements that are calculated on a periodic basis. During times of market volatility, these requirements can spike suddenly and significantly, requiring a clearing broker-dealer to deposit significantly more margin with the CCP. Member firms facing the potential for rapid changes and concentration in order volume should expect commensurate changes in CCP requirements. It is important for a member firm to model potential CCP requirement spikes, and to assess whether it has adequate funding available to meet those spikes. Member firms should consider the following in making such assessments:
Member firms should include these points and any other relevant considerations in planning for the impact that their clearing and customer activities have on their liquidity position. 2. Mismatch in margining during market volatilityTemporary CCP, counterparty and customer margin mismatches can occur in periods of extreme market volatility, causing stress to a firm’s liquidity position. Member firms should plan to have sufficient liquidity to withstand this mismatch. For example:
ConclusionWhile FINRA recognizes the challenges that member firms may face during extreme market volatility, particularly when conditions change quickly, firms nevertheless should be prepared to provide customers ongoing access to the securities markets. To this end, firms must be prepared to handle customer orders fairly, consistently, and reasonably at all times. Member firms should have effective procedures in place to ensure they are fulfilling their best execution obligations during extreme market conditions, and disclosures to customers explaining how their orders will be handled in both normal and volatile market conditions. Finally, member firms should be prepared to adjust margin requirements during periods of extreme price volatility and take a proactive approach to meeting their obligations for strong funding and liquidity management practices during adverse periods. Endnotes
What is an executing broker?Key Takeaways. An executing broker is a broker that processes a buy or sell order on behalf of a client, usually at a hedge fund. Executing brokers are usually middlemen who are housed under a prime brokerage service, which offers a one-stop-shop service for large active traders.
Who regulates brokerFINRA Regulates Broker-Dealers, Capital Acquisition Brokers, and Funding Portals. A Broker Dealer is in the business of buying or selling securities on behalf of its customers or its own account or both. A Capital Acquisition Broker is a Broker Dealer subject to a narrower rule book.
What are broker/dealer operations?Broker-dealers fulfill several important functions in the financial industry. These include providing investment advice to customers, supplying liquidity through market-making activities, facilitating trading activities, publishing investment research, and raising capital for companies.
What does a clearing broker do?A clearing broker is a member of an exchange that acts as a liaison between an investor and a clearing corporation. A clearing broker helps to ensure that the trade is settled appropriately and the transaction is successful.
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