Now that you’ve seen what ACA Insight has to offer, don’t be without it. Subscribe now!

The weekly news source for investment management legal and compliance professionals

Current subscribers - please log in to the website in the upper right-hand corner

News February 6 & 13, 2012 Issue

Trading Practices

IM Office of Chief Counsel assistant director David Grim lead off the panel with an outline of what the staff looks for in a firmís trading practices.

"Weíre looking for fairness," he said. Does your firm allocate fairly? In the staffís view, allocations are not fair when thereís a conflict driving the allocations, for example, where certain fee arrangements create incentives.

Other classic areas of conflict involve proprietary investing, or personal investing that can drive allocations said Grim. IPOs, for example, tend to be allocated in unfair ways.

Pro rata allocations and transactions accompanied by good disclosures offer the indicia of fairness, as do consistent practices in handling deviations from policies and procedures.

For more guidance on what the staff looks for in fair trading practices, look at the SMC Capital no-action letter and the Mass Mutual no-action letter, said Grim.

In cross-trading, conflicts can also give rise to unfairness. Are differing fee structures driving cross trades? Do firm stakes vary among the accounts?

For example, in the municipal bond area, say a smaller bond account or fund has a bond the portfolio that the manager feels good about but has a concern regarding a short-term hit to performance. The staff has seen a manager shift the asset to a larger account to absorb the hit more effectively. That kind of activity will catch our eye, said Grim.

Other cross trade issues the staff is looking at:

  • Section 17 prohibits affiliated sales and purchases. An adviser will use an unaffiliated broker-dealer to accomplish purchases and sales between affiliates because having the security in the hands of an unaffiliated party overnight breaks the prohibited link. Does this rule make sense in all situations? For illiquids, for example? Does overnight ownership really break the chain when thereís a repurchase the next day?
  • A 2006 Federated Municipal Funds no-action letter which offered guidance for pricing service valuations in the municipal bond space is now being used beyond municipal bonds and the staff is looking at if and when that makes sense.

Best execution can be affected by conflicts, too.

The staff is looking at when best execution is driven by conflicts, such as client referrals, or relationships with affiliates, rather than the best interests of clients. Look at the Value Line case, Grim suggested. Also Jamison, Eaton & Wood, and Mark Bailey. Then-OCIE director Lori Richards gave a speech in 2001 that is still very relevant, he said.

Current issues in this space include the need for best execution guidance in fixed-income transactions and the derivatives space. The most current guidance offered by the staff is equities based, he observed. We agree there is a need for more guidance, said Grim, but given other SEC priorities, donít expect to see it any time in the near future.

Expert networks also raise issues in trading practices. Carlo di Florio gave a speech last year that offers useful ideas on structuring a compliance program around expert networks, he said. In 2010, the Division of Trading and Markets issued a concept release on equity market structure issues. The May 6 flash crash happened soon after. SEC Chairman Mary Schapiro made several speeches in 2011 on the Commissionís agenda in this space. For example, the consolidated audit trail proposal is big in this space. Without a consolidated audit trail in place, it impedes the SECís holistic review of trading. The Commission is working hard on comments to the proposal.

Fidelity Investments head of corporate compliance Charles "Chuck" Senatore highlighted the firmís fiduciary culture. "Metrics are important, but they are only the beginning of the conversation," he said.

Thereís a Securities Industry and Financial Markes Association (SIFMA) 2008 white paper that offers a good layout of trading issues, management engagement, and robust supervision, he said.

It is preferable to have a segregation of duties for compliance purposes, said Senatore. The Morgan Keegan case is a good example of how problems can arise when that doesnít happen. If you canít segregate duties, implement compensating controls, he said.

The heart of trading practices Ė the traders themselves.

Chilton Investment Company compliance officer Jennifer Duggins offered some advice regarding traders themselves:

Understand who they are as people, what makes them tick, she said. One way to do it Ė actively involve the head trader in the compliance committee, have them report to the committee on trading issues. "Traders are not larger than life," she said.

The head of operations who partners with the head trader should be involved in compliance, too.

Training is critical. We as compliance officers have a responsibility to educate firm trading personnel, said Duggins.

Why are we "bothering" traders in the middle of the trading day? Trade errors must be reported and corrected immediately. What notes are traders making to compliance flags in the system? How do they make us understand why they bypassed a certain rule and why?

In todayís investment environment, there is a marked increase in investor due diligence, said Duggins. Traders are more frequently talking to investors and their knowledge of compliance is important. Can the trader effectively communicate that transactions are effected in accordance with guidelines, and that fills are fair and allocated pro rata at appropriately negotiated prices?

When you are testing best execution, doing a trade cost analysis, or a blotter review of a third party software system, how vital is any of that to traders? Duggins asked.

If you donít have the buy-in from the head trader and the other traders, if they canít answer the SECís or an investorís questions, thatís a failure of your compliance program. You need a partnership with the trading staff to make that happen, she said.

When does a mistake become a trade error? Put it in your policies and procedures, she advised. Define it, and train your personnel, she said.

How to mind the quant shop.

Technology plays a key role in modern trading practices, and SEC senior specialized examiner Erozan Kurtas offered some perspective on the challenges.

Technology has lots of dimensions and constitutes a large component in the power of todayís computers. Every two years or so, computer power doubles, he observed.

Alpha capture systems, developed by the Marshall Wace firm in the UK in 2001, are not just buy and sell ideas, but rationales Ė why they like what they like, also time horizons, and how bullish or bearish the buyer or seller is.

Add into the mix regulatory arbitrage, the lack of strong controls in overseas markets that can be attractive to some market participants. When ideas are coming from overseas, how do you account for the regulatory differences?

Is high frequency trading just the natural evolution of the markets? The high frequency trading arena experiences high cancel rates, which distorts liquidity, said Kurtas. High frequency trading creates privileged access.

"What worries us is what we donít know, and itís not trivial," said Kurtas.

For instance, ask an algorithmic programmer "what time is it?" and he will respond "when? now? or when you asked?" Thatís the attitude youíre dealing with, he said.

The goal in this environment is to create efficient, adaptive, smart, learning regulations.

Odd lot trading is not reported, and a study showed that approximately 60 percent of high frequency trading is in odd lots. It raises a flag, said Kurtas.

Hereís a nice story, he said. When the staff is in the field, they hear "itís all nice and orderly." What the staff sees, however, is a land of many languages, lost in translation. "We find our compliance friends locked in a dungeon," he said. The people who are writing the code are not even part of the operation, and outside the compliance regime altogether.

Compliance personnel who canít understand the language of the algorithms Ė that creates a systemic risk, said Kurtas.

Electronic market making uses algorithms similar to those that drive programs for robots playing soccer Ė but whoís the referee? Is there one? Is the referee another robot? Letís give the robots thousands of balls and let them play at any speed they want. Now whoís the referee?

These robots are the markets, every day, he said.

The SEC wants to see proper documentation of a trading model; source code alone is not sufficient. How does the firm monitor changes in the model? A common answer is "version control." Kurtas said that in his opinion, compliance in this circumstance needs to evolve into a "quant state" when you hire financial engineers. The 21st century is about conversions, and the need to focus on the right problems to create the right solutions.