By: Chris Montagnino, Directory of Regulatory Affairs, Eventus
Two recent enforcement actions serve as reminders of the importance of having appropriate supervision and monitoring relating to short sales. In each matter, the firm incurred violations of SEC Regulation SHO (“Reg SHO”) and paid a six figure fine as a result of the missteps. SEC Rule 203(b)(1) of Regulation SHO generally prohibits a broker-dealer from accepting a short sale order in any equity security, or effecting a short sale order in an equity security for the broker-dealer’s own account, unless the broker-dealer has: 1) borrowed the security; 2) entered into a bona-fide arrangement to borrow the security (locates); or 3) has reasonable grounds to believe that the security can be borrowed so that it can be delivered on the delivery date, and has documented compliance with the requirement. In each of the cases discussed below, the firms failed to properly locate securities for certain short sales which led to the regulatory actions and eventual fines.
In one matter, the broker-dealer operated a separate, single dealer platform (“SDP”) where it transacted principally with other broker-dealers. Within the SDP, the firm posted non-binding indications of interest which included the side and size of the interest, but no prices. Other broker-dealers routed immediate-or-cancel orders into the SDP and the execution system determined whether or not to trade with such orders. For any short sales executed by the firm principally within the SDP, the firm did not obtain locates for such transactions. The firm incorrectly relied on the bona-fide market making exemption from Regulation SHO which allows for short selling without obtaining locates for firms engaged in such activity. The SEC determined that the firm was not engaged in bona-fide market making as it did not maintain quotes at or near the market given that the IOIs were not binding and did not contain prices. Thus, all principal short sales executed through the SDP from 2017-2020 violated Regulation SHO as they were executed without first obtaining a locate.
Another firm experienced locate issues when it inadvertently configured its delivery versus-payment (DVP) client accounts to allow short sale orders entered into the firm’s order management systems to route for execution without obtaining locates. As a result, the firm failed to obtain locates for thousands of orders over a three year period from 2016 through 2019. The firm’s Reg SHO violations were compounded by associated supervisory deficiencies noted by FINRA. The firm’s supervisory system required that a review for locate information be performed but it inadvertently failed to include a locate review for short sale orders by the firm’s DVP accounts. The firm conducted a supervisory review of locates for custodial accounts, but it incorrectly excluded short sales orders that were accepted for execution but did not execute.
ViP: In addition to the array of procedures for potential market manipulation and insider trading that are standard offerings for any trade surveillance provider, Validus provides additional coverage for rule-based monitoring. This includes the requirements of Regulation SHO such as order marking and locates. Other rule-based monitoring covers trade-throughs and intermarket sweep orders under Regulation NMS as well as market making-related requirements such as Manning and Limit Order Display. With regard to short sales, Validus incorporates the firm’s positions files, easy-to-borrow list and locates file, supplementing the order/trade records, to allow for a thorough analysis of compliance with Reg SHO.
Additionally, when utilizing Validus clients also have access to our team of industry experts who perform a thorough inventory of firm systems during onboarding to ensure all applicable activity is accounted for. Our regulatory team can also provide guidance as to the appropriate supervisory procedures which can be developed to complement the systemic monitoring within the platform.
Eventus is a leading global provider of multi-asset class trade surveillance and market risk solutions. Its powerful, award-winning Validus platform is easy to deploy, customize and operate across equities, options, futures, foreign exchange (FX), fixed income and digital asset markets. Validus is proven in the most complex, high-volume and real-time environments of tier-1 banks, broker-dealers, futures commission merchants (FCMs), proprietary trading groups, market centers, buy-side institutions, energy and commodity trading firms, and regulators. The company’s rapidly growing client base relies on Validus and Eventus’ responsive support and product development teams to overcome its most pressing regulatory challenges. For more, visit www.eventus.com.