FINRA to Expand Registration Requirements for Developers of Algorithmic Trading Strategies

June 2016Securities Alert

In its continued efforts to monitor and regulate algorithmic and high frequency trading, FINRA has received SEC approval to amend NASD Rule 1032(f) to expand the scope of individuals required to register as a securities trader. Beginning January 30, 2017, the amended rule will require a person to register as a securities trader if that person is primarily responsible for the design, development or significant modification of an algorithmic trading strategy relating to equity, preferred or convertible debt securities; or responsible for the day-to-day supervision or direction of such activities.

What types of algorithmic trading strategies fall under the amended rule?

The threshold question in examining the amended rule is whether the automated trading system qualifies as an “algorithmic trading strategy.” FINRA has defined an “algorithmic trading strategy” as an automated system that generates or routes orders, as distinct from automated systems that simply route orders (i.e., makes no trading decisions, but routes retail orders in their entirety to a particular market).

Examples of systems that are considered algorithmic trading strategies if they generate or route orders include:

  • an arbitrage strategy, such as index or exchange-traded fund (ETF) arbitrage;
  • a hedging or loss-limit algorithmic strategy that generates orders on an automated basis;
  • a strategy that involves simultaneously trading two or more correlated securities due to the divergence in their prices or other trading attributes;
  • an order generation, routing and execution program used for large-sized orders that involve dividing the order into smaller-sized orders less likely to result in market impact;
  • an order routing strategy used to determine the price or size for routed orders, the use of “parent” or “child” orders, or displayed versus non-displayed trading interest;
  • a trading strategy that becomes more or less aggressive to correlate with trading volume in specified securities;
  • a trading strategy that generates orders based on moving reference prices;
  • a trading strategy that minimizes intra-day slippage in connection with achieving volume-weighted average prices and time-weighted average prices; and
  • a strategy that creates or liquidates baskets of securities, including those that track indexes or ETFs.

If the automated system in question falls under FINRA’s definition of an “algorithmic trading strategy,” the new registration regime in amended Rule 1032(f) applies.

What type of “primarily responsible” individuals is FINRA looking to have register?

One of FINRA’s general objectives is to have individuals who are knowledgeable about the business or area in question be registered to ensure that those individuals are knowledgeable also about the regulatory regime covering those areas. To that end, FINRA has stated that with respect to an “algorithmic trading strategy:”

FINRA’s goal is to ensure that firms identify and register one or more associated persons who possess knowledge of, and responsibility for, both the design of the intended trading strategy (e.g., the arbitrage strategy) and the technological implementation of such strategy (e.g., coding), sufficient to evaluate whether the resultant product is designed not only to achieve business objectives, but also regulatory compliance.

Amended Rule 1032 does not contemplate that every individual that works on, or interacts with, the algorithm will need to be registered. Instead, FINRA suggests that the individual who is primarily in charge of each of the three enumerated life cycle events – design; development; and significant modification – must be registered.

For example, if a lead developer and head trader meet so the head trader can lay out a trading strategy for the lead developer to use when designing an algorithm, those two individuals would have to be registered as Securities Traders under the amended rule. However, the team of programmers that works for the lead developer and implement the design, and the team of traders who use the algorithm would not be required to register under the amended rule.

Further, if the algorithm undergoes any type of “significant” modification, which FINRA defines as “any change to the code of the algorithm that impacts the logic and functioning of the trading strategy employed by the algorithm,” then the person directing the modification must also be registered. For example, if an individual directed that the parameters of a trading strategy be adjusted, that change would be considered a significant modification and the individual with primary responsibility for directing that change would require registration.

Are third-party algorithms affected?

To the extent a firm uses an algorithmic trading strategy that was not designed or built by the firm’s associated persons (i.e., a third-party was solely responsible for the product), the amended rule’s registration requirement would not be triggered. However, if a third-party is hired to develop an algorithm based on a trading strategy designed by the firm, then the individual responsible for communicating the trading strategy to the third-party developers would be required to register as a Securities Trader.

Any modifications to the algorithm that are completed in-house or which are communicated to a third-party by the firm would still require the individual directing those modifications to be registered as a Securities Trader.

How does the rule amendment affect supervision responsibilities?

The individual who supervises and/or directs the day-to-day activities of the team of developers (who is also likely the individual responsible for the development of the algorithm), must also be registered as a Securities Trader. This amended rule dove-tails with FINRA Rule 3110, which requires that all registered persons have designated an appropriate supervisory principal for the business line and a registered representative or principal who is responsible for supervising the person’s activities.

In order to comply with Rule 3110, FINRA states:

With the addition of this new activity to the Securities Trader registration category, firms will be required to designate developers to registered persons for Rule 3110(a) purposes. In practice, these developers may not currently report to a registered person. In such instances, FINRA believes it is acceptable for firms to “assign” a lead algorithm developer (or other non-trading personnel) engaging in covered activities to one or more other registered persons of the firm that supervise trading activities outside such developer’s or other non-trader’s usual reporting line.

In addition, the associated person responsible for monitoring or reviewing the performance of an algorithmic trading strategy must already be registered pursuant to NASD Rule 1032(f). Thus, regardless of the amendment or the use of a third-party algorithm, each firm must still have an individual registered as a Securities Trader who supervises the firm’s automated trading activity.

© 2016 Herrick, Feinstein LLP. This alert is provided by Herrick, Feinstein LLP to keep its clients and other interested parties informed of current legal developments that may affect or otherwise be of interest to them. The information is not intended as legal advice or legal opinion and should not be construed as such.