FINRA and the SEC have approved an amendment to NASD Rule 1032(f) (the “New Rule”), expanding the scope of individuals associated with a FINRA member broker-dealer who will be required to register as Security Traders as defined in the New Rule.

As per the SEC rule amendment release and as described in FINRA Regulatory Notice 16-21, starting on January 30, 2017, each associated person of a FINRA member broker-dealer who is primarily responsible for the design, development or significant modification of an algorithmic trading strategy relating to equity, preferred or convertible debt securities, or who is responsible for the day-to-day supervision or direction of such activities, must pass the Series 57 exam. Currently, the Series 57 is required for individuals engaged in various kinds of firm proprietary trading or the direct supervision of proprietary traders.

Practice Point: We would expect that, on or prior to January 30, the composition of the Series 57 exam may change somewhat to better include the duties encompassed under the expanded definition of “Security Trader.”

Definition of Algorithmic Trading Strategy

Under the New Rule, an “algorithmic trading strategy” is an automated system that generates or routes orders (including sending orders for routing and order-related messages, such as cancellations), but does not include an automated system that solely routes orders, in their entirety, to a market center. Applicable systems include those that generate or route orders (or order-related messages) in any equity security (including options), preferred security or convertible debt security, whether sent to an exchange or handled over the counter. FINRA notes that various examples of systems that are considered algorithmic trading strategies if they generate or route orders include, but are not limited to:

  • 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 involves 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.

Exceptions to Algorithmic Trading Strategy and New Rule

An algorithm that solely generates trading ideas or investment allocations, including an automated investment service that constructs portfolio recommendations, but that is not equipped to automatically generate orders or order-related messages to effectuate such trading ideas into the market (whether independently or via a linked router), would not constitute an algorithmic trading strategy under the New Rule.

Further, as noted by FINRA:

FINRA does not intend that the registration requirement apply to every associated person who touches or otherwise is involved in the design or development of a trading algorithm. However, each associated person who is primarily responsible for the design, development, or significant modification of an algorithmic trading strategy or the day-to-day supervision or direction of these activities must register. For example, if a sole associated person determines the design of the trading strategy employed by an algorithm, writes the code to effectuate such strategy, and executes or directs the significant modification of such code going forward, then that person alone would be required to register as a Securities Trader under the rule with respect to that algorithm.

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In some cases, a firm may use an algorithmic trading strategy that did not originate in-house and, therefore, was not designed or built by the firm’s associated persons. In such cases where the design and development of an algorithmic trading strategy was performed solely by a third-party, the registration requirement would not be triggered with respect to the firm’s activities relating to the design or development of such algorithm. However, to the extent associated persons are able to significantly modify the algorithmic trading strategy in-house, such significant modifications must be performed by a Securities Trader.

Practice Point: While the New Rule is applicable only to associated persons of FINRA members, some investment advisers may have dually registered individuals who may perform functions directly connected to algorithmic trading strategies. Depending on facts and circumstances, it may be appropriate to consider whether such individuals should take the Series 57 exam.

Supervision of Securities Traders engaged in Algorithmic Trading Strategies

FINRA is allowing member firms a degree of flexibility in designating the appropriate supervision of a lead developer (or other non-trading personnel) registered as a Securities Trader. For example, a FINRA member may assign direct supervision of a Securities Trader’s applicable activities to a designated Securities Trader (or Securities Trader Principal) in the individual’s trading business line – or in some cases, to personnel that supervise trading activities outside of the Security Trader’s usual reporting line. It will also be acceptable to assign supervision responsibilities concerning a given Securities Trader supervision to more than one registered person. As such, depending upon a firm’s structure, a Security Trader’s standard “business line” supervisor may not necessarily be required to register as a Securities Trader or Securities Trader Principal if that person is not involved in the day-to-day supervision or direction of the development process with regard to an algorithmic trading strategy.

Practice Point: One likely result of the New Rule is that firms actively considering engaging in algorithmic trading strategies may wish to have at least their Chief Compliance Officers register as a Securities Trader or Securities Trader Principal (becoming a Securities Trader Principal requires passage of the Series 57 and Series 24 exams) so as to have at least a basic supervision structure in place for when/if such a need arises.

Should you have any questions about this alert, please feel free to call or email the author of this alert or your contact within our Investment Management Group.