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News April 16, 2012 Issue

OCIE Releases Unauthorized Trading Risk Alert

The problem with unauthorized trading is that usually a trader is involved.

Fortunately, not everyone in your organization is a trader.

Only traders, trading assistants, portfolio managers, brokers, advisers, order placement personnel, and trading desks are "traders" in the SEC’s eyes. Oh, and the SEC recommends watching mid- and back-office, risk management, and other personnel, too.

How to ferret out the bad traders and maintain the integrity of your operations is the subject of OCIE’s second National Examination Risk Alert released this year.

In the alert, titled "Strengthening Practices for Preventing and Detecting Unauthorized Trading and Similar Activities," OCIE offered guidance to advisers and broker-dealers alike for the prevention and detection of unauthorized trading. "While broker-dealers and investment advisers are subject to different regulatory requirements, their risk exposures can be similar," said the alert.

Unauthorized trading, in the SEC’s view, can run the gamut from rogue trading by bad actors, to exceeding firm position limits and risk tolerances, to the intentional mismarking of or creation of sham transaction records.

"The risks posed by unauthorized trading are a permanent concern to financial institutions and regulators," said the alert. Critical to mitigating those risks is the presence of independent and mutually reinforcing controls.

The alert offers insights and staff observations regarding a variety of such appropriate controls.

Front office supervision.

Front office supervision is the most important control, said the staff.

Strong and effective business line supervision at all levels can not only detect and prevent unauthorized trading, but also will promote the overall culture of compliance.

The staff offered the following specific observations:

  • Define independent and clear reporting lines, and ensure that more than one person is responsible for monitoring the integrity of business operations.
  • Make sure managers and supervisors adequately understand any complex products and trading strategies employed by the firm’s traders.
  • Talk to your traders. Understand why the good trades are good and the bad trades are bad – and how your trader managed to hit that one big one out of the park when no one else even got on base.
  • Think about your compensation structure. Ensure compensation and financial incentives align with responsible, not excessive, risk-taking.
  • Discourage aggregating functions in one trader or desk.
  • Encourage early "open door" communication with supervisors when a position begins to lose value in unanticipated ways.

Transfer of personnel into trading positions.

The alert suggests that firms might "rotate" a trading desk position among other firm employees. Such rotation not only might offer a fresh perspective and new ideas for the function, but also can offer the firm an opportunity to review appropriate systems accesses.

Extended settlements/"rolling" of positions.

Both extended settlements and positions that are rolled over many times can raise concerns, said the alert. Consider special controls here, such as verbal confirmations from clients or multiple firm personnel, maintaining exception reports, and other heightened supervisory controls.

Trade confirmations.

Inter-company transactions where confirmations may not be present, and delays in obtaining required client signatures or authorizations warrant closer scrutiny. "Management may want to consider providing training to middle and operations personnel to emphasize the need to receive timely signed confirmation acknowledgements and when to escalate backlogs," said the alert.

Mandatory vacations.

Trust but verify.

Give your traders an enforced vacation every once in a while, without any access to the firm’s trading systems. While they’re gone, take a look at what they’ve been doing.

The alert indicates that many firms have adopted this practice, sending traders on holidays of at least ten consecutive business days or more.

In addition to cutting the trader off from any remote trading system access during that specific time frame, the staff suggests that firms may want to consider other general limitations on remote trade-book access by firm personnel.

Silo systems.

The alert highlights potential problems from unintegrated legacy systems and multiple trading platforms that can prevent "seamless" trade management and "full picture" monitoring across the firm. Robust reporting functions, data migration, and ‘middleware’ products can mitigate those problems.

Tone from the top.

"Financial firms operate in an environment focused on performance but must also create a culture where personnel can acknowledge that the firm’s reputation and financial well-being is a shared responsibility." Management should train employees to be sensitive to suspicious activity and encourage quick escalation of matters that seem unusual or inconsistent with compliance, financial and operational controls, said the alert.

And just like in school – bullying is bad and should not be tolerated by management.

Important take-aways.

The alert notes FINRA’s past emphasis on the importance of not ignoring unauthorized trading "merely because it proved to be profitable."

The alert advises firms to remember the value of an independent review function, and the importance of testing the controls themselves.

"The SEC staff is obviously concerned about the adequacy of supervision in this area, so it is fair to assume that this might be a focus area in regulatory examinations," said Beck Law Firm founder Joel Beck, a former NASD enforcement lawyer.

He observed that while the alert offers a number of measures firms can use to help prevent and detect unauthorized trading, the listing is not exhaustive, and it does not provide a safe harbor for firms that adopt or use the practices.

"Ultimately, adequate and appropriate supervisory systems and controls must be adopted and utilized by firms to help manage their risks in their business, including risks relating to unauthorized trading activity," said Beck.