On the heels of the recently volatile trading period fueled by trading in so-called “meme” stocks egged on by social media, FINRA has issued a detailed Regulatory Notice 21-12 on March 24, 2021 addressing broker-dealer conduct in such turbulent times. The Notice reinforces the broker-dealers’ responsibility to ensure expanded capacity to handle periodic spikes in message traffic and trading activity. The Notice also details that disclosures in customer account agreements will not relieve a firm of its best execution obligations for handling customer orders.
Best Execution
The Best Execution portion of the Notice reiterates guidance from NASD Notices to Member 99-11 and 99-12 which noted that broker-dealers’ procedures for handling customer orders “must be fair, consistent, and reasonable during volatile market conditions and otherwise,” with particular attention to handling of marketable orders during periods of volatility and extreme conditions. Under FINRA Rule 5310, broker-dealers must execute market and marketable limit orders promptly, and a delay in executing such orders due to an influx of orders or market volatility is not consistent with a broker-dealer’s best execution obligations.
Plainly stated, FINRA prefers that brokers do not restrict customers from trading, regardless of market conditions, stating that “…procedures that are designed to preserve the continued execution of customer orders . . . while also recognizing and limiting the exposure of the firm to extraordinary market risk.” Customer agreements that allow a broker “in its sole discretion, [to] prohibit or restrict trading without notice” are seemingly frowned upon by FINRA. Frequently changing order handling procedures is another red flag, as is maintaining a system that could not handle increased trading volume or failing to maintain a reasonable funding and liquidity plan. In all, addressing increased clearing corporation deposit requirements, liquidity risk, or systems capacity issues should not be done by restricting trading. Rather, a broker-dealer’s procedures, systems and controls should reasonably address any developments without having to restrict client trading.
Although FINRA understands that procedures on order-handling practices during extreme or volatile market conditions may be different (or fully restrictive) than those of “normal” times, the Notice notes that such procedures “must implement such changes on fair, consistent and reasonable terms.” If BDs implement changes to order-handling practices, including order entry, such changes should be reasoned, pointed, and documented. Firms should consider:
Categories of clients that might be affected and seek to implement its change in the most fair, consistent, and reasonable manner.
If the concern is reducing risk at clearing corporations, the firm’s order-handling change should be designed to address only that risk, e.g. limiting new positions or positions that increase risk, rather than trading activity that reduces or closes risk positions.
If a change is driven by capacity concerns, the change should affect all customers fairly, rather than maintain access for selected categories of clients.
Disclosure for the change, the timeliness and reasoning thereof are material.
Customer Disclosures
As with Best Execution, the Disclosure section of the Notice reiterates older guidance that was first issued in the late 1990s when trading because more accessible through online channels and, as access to trading has become faster and more ubiquitous, that guidance has remained relevant. If broker-dealers implement different order-handling procedures in extreme market conditions, the Notice notes that it is imperative that customers be notified prior to such procedures kicking in and what type of market conditions would cause them to do so. Even basic disclosures, explaining the difference market, limit and stop orders should be described in the context of volatile markets and how each order type functions within such parameters and how each might be used by a customer. In this way, rather than mere disclosures, FINRA expects firm to provide customer education, especially customers with little or no experience.
Liquidity Management
Given the recent market volatility caused by a surge of retail investors in particular stocks, the Notice explicitly touts the importance of effective funding and liquidity management plans. Such plans must include modeling and stress testing of such potential scenarios. This emphasis is also not new, but the political focus that the surge of retail activity caused almost guarantees that FINRA will devote outsized resources in auditing the liquidity management plans of broker-dealers. Further detailed guidance on funding and liquidity management was provided by FINRA in Regulatory Notice 10-57 and Regulatory Notice 15-33.
The full detail of FINRA’s Regulatory Notice 21-12 issued on March 24, 2021 can be viewed here.