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Brokers Should Audit Customer Algorithms, Finra Says

Oct. 19 (Bloomberg) -- Broker-dealers should increase oversight of customers who trade over their systems, with special focus on strategies known as algorithms, said Richard Ketchum of the Financial Industry Regulatory Authority.

The firms should consider conducting scenario analyses to gauge how algorithms will function under different conditions, said Ketchum, the chief executive officer of Washington-based Finra. Brokers should also engage in an auditing of algorithms to ensure they operate the way they’re supposed to work, he said. He spoke at a conference at Baruch College in New York.

“Broker-dealers have a responsibility to supervise activity that goes through them,” whether orders come over the phone or via algorithms, Ketchum told reporters at the conference. Finra oversees almost 4,700 U.S. brokers. “If they’re not asking questions regarding how the algos work in exceptional conditions, we’d have questions about how they’re doing their supervision.”

Regulators are looking for ways to protect investors in the wake of the May 6 plunge that temporarily erased $862 billion in equity value in about 20 minutes. A mutual fund company’s automated sale of futures contracts without regard to price and “hot potato” trading by computer-driven firms set off the rout, according to the Securities and Exchange Commission and Commodity Future Trading Commission report.

Sponsored Access

Broker-dealers are responsible for all trading that goes through their systems, whether flowing through their data pipes or through access to an exchange using their identification codes. Arrangements such as these are known as sponsored access. While brokers decide what type of oversight is necessary for their clients’ activities, they’re responsible for ensuring that rules aren’t breached. Exchanges and the SEC are in the process of imposing additional requirements.

A lesson of May 6 is that brokers and securities industry professionals could see how “volume operated under pressure,” Ketchum said. Trading in volatile markets also affects brokers’ so-called best execution obligation to provide customers with the most advantageous overall transaction at the time the order is received, given the existing market conditions, he said.

Brokers should study their trading and order-routing decisions in times of stress, Ketchum said. Discount brokers with retail investors, mutual funds and others that trade away from exchanges must weigh decisions they make at times when a third of equities volume is “likely to be redirected” from their usual execution venues to exchanges, he said.

Off-Exchange Trades

About a third of the industry’s volume trades off-exchange. Orders from retail investors that can be executed immediately are usually sent to so-called internalizing brokers such as Citadel LLC and Knight Capital Group Inc., which transact buy and sell requests within their own walls at prices that are at least as good as those available publicly. Larger orders from institutions are often sent to dark pools, or private venues that don’t display quotes, to avoid moving prices.

“People have different views” about the supervision they’re required to do, Ketchum said. “That’s what makes a regulated environment.”

To contact the reporter on this story: Nina Mehta in New York at

To contact the editor responsible for this story: Nick Baker at

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