By: Chris Montagnino, Director of Regulatory Affairs
A US broker-dealer (the “Firm”) recently paid a fine of $75,000 and agreed to an undertaking in order to resolve a matter involving violations of the SEC’s Market Access Rule, 15c3-5. The Firm was noted to have had inadequate controls to address particular requirements of 15c3-5 concerning erroneous orders and failing to have a reasonable supervisory system in place for compliance with such requirements. As discussed in more detail below, the Firm failed to document the controls it did have in place, was not able to demonstrate the reasonableness of certain controls and, in other cases, lacked the requisite controls called for under 15c3-5. Perhaps most damaging to the Firm, it did not have monitoring in place to regularly test and document that the pre-trade controls which were in place were functioning correctly.
The order activity in question resulted in trade prices that were significantly below contemporaneous pricing for the securities. In one case, an order caused trades to occur below the 52-week low for the symbol. In all cases, the orders were placed either pre-open or post-close and the orders were not flagged or stopped by the Firm’s existing market access controls. However, the Firm did have controls that were active for pre and post-market activity. The issue concerned the reference point for the control which was the national best bid/offer (“NBBO”). The control would not stop or flag activity if the order price was within the boundaries of the NBBO at the time of order placement. The symbols at issue were illiquid and thus the spreads for those symbols widened extensively during the pre and post-market periods. So although the order prices were priced within the NBBO when placed, the resulting executions yielded prices that were significantly away from recent prices for the securities. The Firm filed Clearly Erroneous Execution requests for each of the instances which is presumably what garnered the attention of the regulators.
In addition to the issues regarding the particular orders, the Firm was cited for having an inadequate supervisory system as certain controls with regard to 15c3-5 were not reasonable. The Firm maintained soft blocks and hard blocks within their system to either alert users or block orders when an order was routed that was more than 5% or 10% away from the NBBO, respectively. As demonstrated by the erroneous orders discussed above, the price deviation controls were found to be ineffective during illiquid market conditions (such as the pre-and post-market) and were not reasonably designed to prevent the entry of erroneous orders. Further, the Firm did not perform a regular review or otherwise maintain any logs or records of instances where the Firm’s soft or hard block controls were triggered and did not memorialize the reason that the Firm’s soft block price controls were overridden by users of the Firm’s front end trading system.
ViP: At the heart of the SEC’s Rule 15c3-5 are the requirements to have pre-trade controls to prevent transactions leading to price dislocations and market disruptions. However, as this matter illustrates, having post-trade surveillance of such controls can serve as an effective supplement to the pre-trade controls and also serve to identify instances where such controls may be either malfunctioning or otherwise ineffective. As an example, in this case the regulator particularly took issue with the Firm’s lack of oversight around the soft and hard block controls in that there was no documentation or evidence of review when such controls were triggered. An order management system’s control process may not allow for such documentation whereas a post-trade surveillance system, designed with similar logic/parameters, could serve as an effective means to document the oversight of such controls. Further, the post-trade system could also be an effective safety net, potentially generating alerts for users at times when the pre-trade controls fail. A control may not function correctly and the Firm would theoretically never know unless the order truly resulted in a market dislocation. In real-time, the user is not manually checking to see if the controls malfunction, but the post-trade alert system can flag such items within 24 hours where they can be addressed before leading to further or more significant issues. This also satisfies the requirements within 15c3-5 to regularly test controls and document such testing. Moreover, since the post-trade monitoring does not impact real-time activity, the controls can be approached with different criteria or logic than the pre-trade controls. In this matter, had the Firm monitored for significant price deviations alone (not related to the NBBO), they may have identified where the existing control was lacking prior to incurring subsequent issues. Validus maintains extensive procedures to test both the financial and regulatory controls required as part of 15c3-5, including checks for duplicative and erroneous orders, which are an effective supplement to the pre-trade control framework and can potentially prevent a more damaging supervisory violation.
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.