SEC Approves FINRA Rule Amendment Affecting Algorithmic Trading Strategies

On April 7, 2016, the U.S. Securities and Exchange Commission ("SEC") approved certain amendments to NASD Rule 1032(f) (the "Amended Rule"), which may require certain associated persons of Financial Industry Regulatory Authority ("FINRA") members, who are involved in algorithmic trading activities to: (i) register as Securities Traders; (ii) pass certain qualification exams; and (iii) be subject to continuing education requirements. More specifically, the Amended Rule will apply to associated persons of FINRA member firms is such persons are: a. primarily responsible for the design, development or significant modification of algorithmic trading strategies; or b. responsible for the day-to-day supervision or direction of such activities.

The Amended Rule defines an "algorithmic trading strategy" as an automated system that generates or routes orders or order-related messages such as routes or cancellations. The Amended Rule also expressly excludes from this definition any automated systems that solely route orders received in their entirety to a market center and, additionally, provides certain examples of those strategies that fall both within and outside of the definition.

Implications of the FINRA Rule

The purpose of the new Amended Rule is to provide FINRA with additional data regarding algorithmic trading activities, so that it can reduce or prevent certain "problematic conduct" often associated with algorithmic trading activity, such as failure to verify 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.

Although the obligatory registration and required education of individuals involved in algorithmic trading may very well promote both transparency and accountability over such activity, the Amended Rule does create some practical issues. For example, the application of what exactly will be considered an 'algorithmic trading strategy' under the Amended Rule and who exactly is subject to its requirements will vary on a case-by-case basis and create some confusion. Moreover, these requirements will likely impose additional compliance-related burdens on member firms involved in algorithmic trading activities, such as the expense of one or more additional registrations, updating their written supervisory procedures, the need for internal training, the possibility of reconfiguring certain staff members and their responsibilities (e.g., many firms may need to choose between training their program developers to be more compliance-proficient or readjusting the duties and qualifications of their compliance staff to be more knowledgeable about designing, administering and monitoring algorithmic trading programs), as well as the implementation of certain monitoring tools and other controls with regard to firm-wide algorithmic trading activity. Although the Amended Rule has a direct impact on broker-dealers, technically, investment advisers (including those that manage and advise private funds) are beyond the direct reach of the Amended Rule (unless such advisors are dually registered as both an investment adviser and a broker-dealer). However, such advisers should not disregard this rule, as it will likely serve as a "best practice" for those advisers involved in algorithmic trading, as the SEC and FINRA continue their increased focus on algorithmic trading strategies, systems and controls and the various risks they present.

FINRA must publish the final Amended Rule by June 6, 2016, and the Amended Rule will take effect no sooner than 180 days after such publication, but no later than 300 days following Commission approval (i.e., February 1, 2017). We anticipate that FINRA will provide additional and more detailed guidance in connection with the implementation of the registration requirement.

The SEC's release of the Amended Rule can be found here: https://www.gpo.gov/fdsys/pkg/FR-2016-04-13/pdf/2016-08424.pdf

If you have questions regarding the Amended Rule or would like to discuss this Alert, please contact John T. Araneo at 212.573.8158 or Lance Friedler at 212.573.8030.

Cheryl Spratt