Brokers Need More Discipline to Avoid Trading Errors, Finra Says

Debacles like Knight Capital Group Inc.’s August trading loss will be avoided if brokers exercise more vigilance overseeing their risk controls, according to the head of the Financial Industry Regulatory Authority.

Rules requiring brokers to check orders before sending them to markets to ensure they’re correct and don’t exceed capital and credit thresholds went into effect last year. While most firms are complying, more discipline is needed overseeing operations and risk, Richard Ketchum, CEO of Finra, said at a Security Traders Association conference in Washington yesterday.

“Firms need to re-examine how prepared they are to deal with inevitable problems that come out of testing,” Ketchum said. That involves “ensuring that there’s someone on the trading desk always with responsibility to make a determination on whether to stop the flow going to exchanges,” and “reviewing how quickly that order flow gets stopped,” he said.

Kill switches, or mechanisms that would shut off a company’s trading activity, are being discussed by regulators, brokers and exchange executives in the wake of Knight’s $440 million loss when it mistakenly fired orders to exchanges on Aug. 1. A second set of protections for errant orders at exchanges, which could supplement what brokers do, may make sense, Ketchum said.

The U.S. Securities and Exchange Commission’s so-called market-access rules, devised to reduce systemic risks caused by disruptive trading, apply to all orders from brokers including those they submit on behalf of clients and their own proprietary activity, Ketchum said. While brokers have “clearly complied with the spirit of the rule,” based on compliance examinations Finra is conducting, the efforts need more rigor, he said.

Sponsoring Orders

“There are instances where there isn’t nearly the type of testing, nearly the type of rigor, particularly with respect to sponsoring customer orders,” Ketchum said. Still, “most firms really are taking it seriously,” he said.

Brokers should make sure they have written and up-to-date protocols for how to respond when trading goes awry, Ketchum said. Spelling out the process in advance is a “no-brainer” and more effective than deciding what to do on the fly, he said.

“Firms should consider testing the systems they use to monitor and identify problematic activity and early warning signs of such activity,” Ketchum said. The ability to stop trading should also be tested. In addition, “kill switches have to be far more hair-trigger than they have been in the past” to limit problems before they snowball, he said.

Kill Switch

Executives at NYSE Euronext, Nasdaq OMX Group Inc. and Bats Global Markets Inc., the largest U.S. stock exchange operators, said yesterday they’re willing to discuss how kill switches could be implemented by their companies to augment what brokers do. The onus on catching accidental trades should remain with brokers, they said.

Any kill switch from an exchange should be a “backstop” and trigger infrequently, Joseph Mecane, head of U.S. equities at NYSE Euronext, said Sept. 18 at a Georgetown University conference on financial markets in Washington. “The primary responsibility should still lie with the firm generating the orders.”

Eric Noll, an executive at Nasdaq OMX, said it’s important to distinguish between a broker-dealer’s errant trading behavior and activity that may injure the broader marketplace. Firms that rely on exchanges for tasks they should oversee themselves may have less incentive to do the checks on their own, he said.

‘Kneejerk Reaction’

“It sounds great as a kneejerk reaction,” Chris Isaacson, chief operating officer at Bats, said of exchanges instituting kill switches. Figuring out the threshold for cutting off a firm may be harder in practice and raises questions about who’s liable if the decision to end trading hurts the broker financially. “Who handles the liability of shutting that off?”

While Bats is open to a discussion about kill switches, the triggers should be automated and objective, Isaacson said. Numerical thresholds may need to be set too high to be useful to eliminate the possibility of stopping trading that’s a legitimate response to the day’s events and volatility, even if it exceeds normal daily volume levels, he said.

Finra’s examinations related to the market-access rule have driven the organization, which oversees about 4,400 securities firms, to focus on manipulation and potentially improper trading practices in equities and options, Ketchum said. These include surges in order message traffic without sufficient monitoring of that activity, he said.

The SEC is also conducting its own examination sweeps about risk controls, according to Robert Cook, director of the agency’s trading and markets division, who spoke yesterday at the Security Traders Association conference.

Certified Controls

The SEC’s Office of Compliance Inspections and Examinations is conducting reviews of brokers to make sure they’ve instituted the required controls and that the chief executive officer is certifying that the risk management checks and processes are in place, Cook said. It’s also examining “order processing technology,” he said. One focus is on ensuring that the controls are “reasonably designed” to catch mistakes, he said.

The SEC’s trading and markets division will work with OCIE “to review results from these sweeps and to assess how well the rule may be working,” Cook said.

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